HOUSE DEFEATS PAULSON BAILOUT

In what media pundits called a "great surprise", the U.S. House of Representatives defeated, by a substantial margin, proposed legislation that would have granted the Treasury Secretary of the United States unprecedented authority to buy securities and debt in the open market in an effort to prevent continued deterioration in the value of these assets.

Although he didn't participate in the vote, presidential candidate and U.S. Senator John McCain stated in a brief post-vote news conference that legislators from both houses would have to go "back to the drawing board" to fashion a new plan, which seems to imply that the Paulson Plan is dead. In the mean time, the stock market reacted violently; financial stocks lost 13% but ended the day 10% above the lows posted in July, which implies that they could have much further to fall.

Also in the news today the FDIC put down another massive bank, North Carolina-based Wachovia (formed by the merger of First Union and Philly-based Corestates banks), and fed it to Citigroup, only days after they had euthanized Washington Mutual and fed it to JP Morgan, and folded Merrill Lynch into Bank of America (for some reason, Lehman Brothers was left to the bankruptcy courts to sort out). At the moment there appears to a consortium of five banks that the Federal Reserve is utilizing as the repository for the deposits of competitor banks that become functionally insolvent: Goldman Sachs, JP Morgan, Citigroup, Bank of America, and Morgan Stanley. It appears that the Federal Reserve has decided that these banks must not fail, and is prepared to print as much money as it has to in order to keep them solvent. That could be expensive, especially if JP Morgan fails to sell enough stock to fund their capital base. In fact, the capital positions of all of these banks if far from certain, as a deep recession and increased defaults could push them into insolvency, in particular JP Morgan which is more highly leveraged. However, if you feel the need to buy the common stock of a U.S. bank, these five would be a good place to start looking.

So, what can the Congress do at this point to prevent another Hoover-era financial meltdown? Right now, without Congressional approval, the SEC can alter a rule that says that banks must price their mortage-backed paper and derivatives to market, rather than face value, increasing the book value of the banks that hold the paper; however, since the paper is highly illiquid (nobody wants to buy it off them), it does not really guarantee the solvency of the institution, and other institutions will still view these banks as vulnerable. In any event, a move such as this will buy the banks additional time and could forestall an FDIC take-over, which may be enough to allow the free market to find a solution without government intervention. Additionally, the FDIC can help assuage the fears of depositors over the security of their deposits, especially small businesses who have more than $100K of deposits in U.S. banks, by increasing the federal insurance amount to $250K.

Finally, Congress can focus on the segment of the economy that suffers the most from a dysfunctional credit market: small business. Small businesses, which are generally more lightly capitalized and usually cannot tap the equity markets for funding, are highly dependent upon short-term lines of credit to buy raw materials and make payroll. Congress can act quickly to allocate additional authorizations to the Small Business Administration so that it can secure loans to small businesses that cannot get the necessary capital from the commercial banks. With the SBA guarantee, the commercial banks will gladly extend the loans at reasonable terms, and small businesses can continue to operate.

So, the failure of the Paulson Plan, which would have allowed companies like his former employer, Goldman Sachs, to sell their toxic paper to the U.S. Treasury, and then buy it back at a later date at a discount, is a good thing, and kudos to the American public for having their voices heard.

Christian Antalics

Ron Paul on Government Price Fixing

During his questioning of Ben Bernanke on 9/24/08, Ron Paul's diatribe was all over the place (as is his style), but by the end he had hit on the key points in one of the most lucid and candid assessments of the predicament:

1) The so-called "toxic assets" that the investment banks are trying to dispose of are only "illiquid" because the holders of this paper do not want to mark them to their market value. Instead of auctioning some of this this paper to the market in order to seek true price discovery, the banks want to place reverse bids to the Treasury Dept., essentially telling Treasury what price they will accept for the paper, which the Treasury Dept. is obligated to pay, until the $700B is gone, or until more money is authorized. When the buyer must accept the seller's price and must execute the transaction, it becomes a form of price fixing which elevates the price above the intrinsic value. Not to mention that this is a government transfer payment (read: welfare payment) equal to the difference between the "market price" and the price paid. Only if the assets appreciate over a reasonable period of time will the government be made whole, but if this expectation were rational, there would be a liquid market for mortgage-backed paper. The government tried price fixing in the 1930's, as Ron Paul astutely pointed out, which deepened and prolonged the Great Depression.

2) The heart of the problem is that home prices went up too far too fast, and now they have to come down, which is depressing the value of mortgage-backed paper and derivatives thereof. If problem is one of home price inflation the government, by essentially putting a floor under mortgage-backed paper, is fighting inflation with more inflation, which is a lot like pouring gasoline on a fire (to be fair, they are fighting the deflation in the debt instruments linked to property values). The point that I think Ron Paul was getting at is that the issue is less one of illiquid assets and more so one of fundamental solvency: a number of the investment banks cannot remain solvent if their assets are priced correctly. By inflating the value of mortgage-backed paper, you are simply allowing the taxpayer to stop a bullet that was meant for the investment banks. It does nothing to solve the underlying problem, which is that the asset backing the debt is deflating, and must continue to deflate, to reach equilibrium with rents and personal income.

3) The credit markets have "seized" because, as occurred in 1920's, credit was grossly (some might say insanely) over-extended for many years with poor underwriting standards and little oversight. Less-so than the credit markets having "seized" is that borrowers are fundamentally over-extended, and cannot handle any more credit. When the economy was growing robustly, and home prices were marking double-digit annual price gains, it may have seemed like a reasonable bet to issue mortgages to individuals of limited means, at least if you were willing to extrapolate those home price gains off into eternity, or if you have the opportunity to bundle all these loans together (making it difficult to judge their risk) and let the Wall Street banks sell them to pension funds. However, trees don't grow to the sky, and home prices had to fall to come back into line with rents and personal income (neither of which were growing nearly as fast as home prices). The home loans that were issued near the peak, especially variable-rate mortgages that kept the early payments affordable, are at the center of this storm, and are the loans that the investment banks want the government to take off their hands.

So, kudos to Ron Paul for shining a bright light on the faults of the government bail-out plan.

Christian Antalics

P.S.

For a comic yet surprisingly erudite interpretation of the Paulson Plan, check with the fictional character, Paul Bernankson.

VOTE NO ON THE PAULSON/BERNANKE WALL STREET BAILOUT PLAN

The way to properly resolve this crisis is to put banks that fall below minimal capital ratios into Treasury receivership, canceling the common and preferred equity and allowing the Treasury to retain the assets of the institutions as collateral against the current obligations of these companies, shielding holders of cash equivalent deposits against default (i.e. money market funds).

Treasury can then unwind those assets in orderly auctions, thereby permitting other institutions to price similar assets on their own books.

We as a Nation cannot stand idly by as private investment banks attempt to socialize their losses, however large and frightening as they may be, when they took risks as private and largely unregulated institutions and retained in their private coffers billions of dollars in profits since the last banking crisis.

OUR SYSTEM OF FREE MARKET ECONOMICS IS NOT BROKEN -- IT WILL ABSORB THE IMPLOSION OF YET MORE INSTITUTIONS AND WILL BE STRONGER ON THE OTHER SIDE.

Allowing these banks to foist the worst of their paper off on the U.S. taxpayers in unconscionable.

Any bank that needs the U.S. Treasury to bail it out should be fully prepared to be seized by the government, restructured, and sold back onto the open market at a profit to the U.S. Treasury and taxpayer, either in pieces or as a newly formed financial institution.

Christian Antalics