PORKY PAULSON PLAN PASSES SENATE

The U.S. Senate passed this evening, by a wide margin, legislation that has at the heart of it the Paulson Plan:

AUTHORITY.— The Secretary is authorized to establish the Troubled Asset Relief Program (or ‘‘TARP’’) to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary.

So, the U.S. Senate blinked and granted Hank Paulson authority to spend an amount greater than the gross domestic product of Australia with virtually no strings attached.

Not only is this unprecedented, but it is of questionable economic and constitutional merit.

This legislation will do the following:

• Will cause the shares of financial stocks to rally as investors will perceive that the risk of outright failure due to "troubled assets" has diminished significantly.
• Will guarantee that the Treasury, and by extension the U.S. taxpayer, will be saddled with the absolutely worst bonds and securities that banks and other institutions, both U.S. and foreign, have clanking around in their basements.
• Will potentially provide the banks with an incredible windfall as they unload toxic assets at above market prices, and buy them back later at "fire-sale" prices.
  
• Will put extreme pressure on the dollar and will prove to be highly inflationary.
• Will dramatically limit the discretionary spending authority of the U.S. Legislature.
• Will increase the risk of a credit downgrade on U.S. Sovereign debt.
• Will cause U.S. interest rates to rise as inflationary pressures increase.
• Will be viewed in hindsight as a boondoggle the magnitude of which can never be repeated.

That being said, if the legislation helps unglue the stuck wheels of lending, that will be a good thing. However, as I mentioned in previous posts, the credit-worthiness of U.S. businesses and individuals is at a historic low, and any extended period of economic weakness will worsen this condition. In other words, the credit markets cannot come completely "unstuck" until the balance sheets of businesses and individuals regain their strength.

So, we'll see what the House has to say about it, but it looks like a done deal.

UPDATE 10/2/08

Continued study of the Senate TARP bill revealed a clause that could render the entire bill unworkable:

PREMIUMS.—

IN GENERAL. — The Secretary shall collect premiums from any financial institution participating in the program established under subsection 9 (a). Such premiums shall be in an amount that the Secretary determines necessary to meet the purposes of this Act and to provide sufficient reserves pursuant to paragraph (3).

AUTHORITY TO BASE PREMIUMS ON PRODUCT RISK. — In establishing any premium under paragraph (1), the Secretary may provide for variations in such rates according to the credit risk associated with the particular troubled asset that is being guaranteed. The Secretary shall publish the methodology for setting the premium for a class of troubled assets together with an explanation of the appropriateness of the class of assets for participation in the program established under this section. The methodology shall ensure that the premium is consistent with paragraph (3).

MINIMUM LEVEL. — The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.

The key language here is in the final paragraph, "The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected." What the legislation is calling for is bond insurance, or credit default swaps, both of which are at the heart of the financial crisis, as they have become prohibitively expensive.

The point of the TARP legislation, as I understand it, is to pay banks and other holders of distressed assets a price above the current market, or "fire-sale" price that they could currently earn if the assets were liquidated through public auction. How the Secretary of the Treasury is going to structure the purchase of toxic assets such that the taxpayer is "fully protected" without charging a premium that puts the net price of the assets below the fire-sale price, I have NO idea, but it will be very interesting to watch him try!

Christian Antalics