The fear in George Bush’s eyes last night spoke volumes. I have come to the conclusion that we have to do something and so I have immersed myself in the various arguments for and against the bailout in the last two days. Two guys I really respect, Bill Gross and Warren Buffett say it can be done in a way that minimizes cost to the taxpayer.
The Treasury would own something — the mortgages themselves, which, if it pays the right amount for those loans, could earn it a yearly return of 12 to 13 percent when they are resolved. “All the capital gains will accrue to the Treasury,” he said. “There’s tons of equity here. It’s just that it’s very difficult for American taxpayers to understand.”
But it’s not the advice from smart guys that convinced me that something must be done, it’s the TED Spread. The TED spread is the difference between the 3 month US Treasury note and the 3 month Libor rate (London Interbank Offer Rate). The wider the spread, the more fear there is in the system. A long term average is a spread of 50 basis points, or 0.5%. The spread this morning is 317 basis points and it is widening. That’s 3.17% difference between the two. It tells us that banks don’t trust other banks for an overnight loan.
This morning the Congress has a basic agreement on the bill (without any help from John McCain), so I am convinced that the bill is going to pass. But the biggest hurdle now is in the details. I still believe that Schumer’s idea that we do this in $100 billion tranches is the right one, since even Paulson and Bernanke admit they don’t know what method will work (reverse auction, fire sale pricing, etc). Bob Eisenbeis of Cumberland Advisors, who was Exec VP of the Federal Reserve Bank of Atlanta has a cautionary note in contrast to Gross’ assurance of pricing.
To be successful in enabling financial institutions to restore their balance sheets, the prices paid for the assets acquired will have to higher than can be economically justified, given the likely losses embedded in them. Otherwise, if the mortgages were purchased at prices even approximating their current values, then losses would result and have to be borne by the sellers (financial institutions), which would require write downs, destroy their capital base and lead to insolvency for some. Bill Gross of PIMCO argues that the mortgages are a good deal for the taxpayer (putting aside the fact that PIMCO holds mortgage-related assets whose prices will be buoyed by the policy), because they can be held to maturity and financed at low Treasury rates. His argument is similar to that articulated yesterday by Chairman Bernanke who suggested that loans might even be priced close to par, and are suspect on several counts. First, the assets will have to be acquired at inflated values and many are likely to go into default. Thus, the returns will likely be substantially lower than the face interest rates the assets carry. If they are packaged and sold into the private sector, it will have to be at a loss relative to the price paid by the government. Second, with the huge increase in government debt and liabilities, Treasury rates are sure to increase, and this is even more likely if the Fed is constrained from addressing the inflation that will surely come with the flood of liquidity into the market place. Higher rates will lower the margins on carrying these assets and perhaps even inducing both negative carrying costs and capital losses if the general level of rates increases.
Ultimately the biggest danger is in the government buying $ billions in fraudulent mortgages, ones that are essentially worthless. I’m about to tackle an important story that Bloomberg is breaking about fraud at the ratings agencies, so I am immersed in the “gaming of the system”. It seems to me that that the idea that former Treasury Secretary O’Neill floated after the Enron crisis, which was quickly crushed by the Republican deregulatory crowd, is the right idea.
Mr. O’Neill, for his part, pushed to alter the threshold for action against chief executives from “recklessness” — where a difficult finding of willful malfeasance would be necessary for action against a corporate chief — to negligence. That is, if a company went south, the boss could face a hard-eyed appraisal from government auditors and be subject to heavy fines and other penalties.
Any Executive of a bank that sells fraudulent mortgage bonds to the government would be guilty of negligence and thus subject to “clawbacks” from his past compensation. That might put the fear of God into the greedheads.