"I See Dead People"

Last week, a couple of friends (who are also professional associates) were talking to me about the government's latest bailout plan. Referring to the economic near-collapse that precipitated the panic that led to the plan, they both commented that I had predicted this, anywhere from six to eighteen months ago.

"I know," I replied. "And I'm beginning to feel like the 'I see dead people' kid - I don't know if this is a gift or a curse."

In other words, I'm beginning to be terrified by what I see.

What do I see in this plan?

Abject failure, just like the New Deal that it's modeled after.

First, I don't like the idea of Congress being pushed to cobble together a near-trillion-dollar plan for anything in just a few short days' time. Especially given the general lack of economic and financial literacy in Congress. Take your time, folks. Think this one through. We're not talking about a few million dollars' worth of pork here.

Second, I don't like the way it came together. Here's a timeline:

Tuesday, Sept. 9. S&P downgraded Lehman's debt. Lehman had been shopping itself to potential suitors, and as they examined Lehman's books, they discovered Lehman had not been as aggressive as other Wall Street firms, like Merrill, in writing down its subprime crap. In other words, like so many other financials, it was overstating the bonds' value. So S&P took a fresh look, and cut its ratings. Lehman's stock plunged 45%.

Wednesday, Sept. 10. Lehman reports a record $3.9 billion loss. Lehman's stock plunged 46%.

Thursday, Sept. 11. AIG, which was also overvaluing its subprime and other mortgage-related holdings, saw its credit default swap spreads rise 42%.

Friday, Sept. 12. AIG's default swap spreads jump another 29%, and its stock price falls 31% after S&P says it may downgrade AIG.

Now, here's where it gets interesting.

That night, Hank Paulson and New York Fed Chief Timothy Geithner - two of the architects of the Bear Stearns bailout - tag-team a group of Wall Street execs, including Lehman's. They quickly state that Lehman - then the fourth-largest Street firm - isn't too big to fail in their view, even though Bear - then fifth-largest - was. Paulson's explanation:

"The situation in March and the situation and facts around Bear Stearns were very, very different with what we were looking at in September."

He added these words in arguing against government intervention:

"You have a responsibility to the marketplace."

By September 18, that responsibility to the marketplace had been abandoned. And Paulson's tone had gone from "the situation is very different from March" to "we're facing Armageddon." But we'll get to that momentarily.

Monday, September 15. Lehman declares bankruptcy. And B of A buys Merrill Lynch, after cutting off Merrill's credit lines over the weekend, essentially putting the firm at B of A's mercy. The market tanked.

Tuesday, September 16. AIG's stock fell 34% after Fitch, Moody's and S&P had cut its ratings after trading closed the day before. Tuesday night, Mr. "responsibility to the marketplace" intervened with a capital I, and had the Bernanke Fed lend AIG $85 billion in exchange for an 80% ownership stake.

The world's largest insurer had been nationalized by the supposedly capitalistic United States government.

One market observer rightly noted, "The banks are the recipients of the Fed's largesse." Well, almost rightly. Since the Fed is funded by the taxpayer, it was OUR largesse. I'd better get a Christmas card.

The AIG bailout was supposed to be the end-all fix. But the market kept tanking.

So on the afternoon of Thursday, September 18, as the market was once again in free-fall, New York Senator Chuck Schumer - the same Chuck Schumer who said IndyMac was going to fail, then absolved himself of all responsibility when the ensuing run on the bank caused it to do just that - announced to the press that "the Fed and Treasury were planning a 'comprehensive solution' to the financial crisis," according to Bloomberg.

Oh, really? That was news to Paulson and Bernanke. But Schumer's announcement caused the Dow to recover, staging a 400+-point rally. Hmmmm ... maybe there was something to this "comprehensive solution" idea after all. (It's not lost on me, by the way, that this was the second of Schumer's public comments to significantly affect the markets during this credit imbroglio. And he's the Senator from New York, you know, where Wall Street is. His top nine campaign contributors are financial institutions.)

House Majority Leader Nancy Pelosi called Paulson for an update on what was happening, and they agreed on a briefing of legislators that evening that would also be attended by the usual voice of calm reason, Ben Bernanke.

Ben said, "The credit lines in the American financial system, the lifeblood of the economy, are completely frozen. You could have massive failures within days," going beyond Wall Street and banks to "large brand-name companies," according to sources attending the meeting and quoted by Bloomberg.

So much for the voice of calm reason.

So, to recap our timeline, on September 12 Paulson and Bernanke stoically tell Lehman to go jump off a cliff, which it did. Less than a week later, AIG scares them so bad they do an about face. Two days later, they're ready to give the keys to Ft. Knox to China.

I also suspect that a big catalyst for the plan was pressure from foreign central banks, given that Paulson has since announced that foreign banks could participate in the US taxpayer-funded bailout, and that pressure from foreign central banks is what what precipitated the Fannie/Freddie bailout.

Speaking of which, it was reported this morning that it looks as if that bailout's price tag is going to be closer to $300 billion than the originally reported $200 billion - something I predicted two weeks ago, when Fan and Fred were propped up. Like I said, I see dead people. Why the higher cost? It appears the pair were overstating the value of their subprime holdings.

Are you beginning to see a pattern here? I hope so; the pattern is an important part of my criticism of the latest bailout plan.

And that leads me to my third problem with the plan. The price tag will ultimately be much, much higher once all this crap's valued, and the impact on things like credit default swaps is understood.

Fourth, many financials may not even want the government to buy their toxic waste. Why? Because too many of them are already overstating the value of the garbage, and if the government pays a market price, it'll reveal the true value of their holdings, and many of them will be proven to have been insolvent for some time now. That would be an unintended consequence, and is certainly something those institutions don't want.

Moreover, through the miracle of modern accounting, many of them are carrying those distressed securities on their books at "unrealized losses," meaning what mark-downs they have taken affect capital, but not earnings. But once they sell, the loss is "realized," and both capital and earnings are affected.

Exacerbating this problem is the accounting chicanery that some institutions have employed. The above accounting treatment only applies if the investment is classified as "available for sale," meaning the institution can sell the investment at any time. Bonds classified "held to maturity" don't have to be marked to market at all. But the institution has to demonstrate "the positive intent and ability" to hold them on their books until they mature, and if they sell bonds out of their "held to maturity" portfolio, they may have to mark their entire portfolio to market.

Some institutions, seeking to mask the true market values of their holdings, have been using an accounting gimmick that allows them to move bonds from available-for-sale to held-to-maturity, so they no longer have to show market values, thus masking their unrealized losses. They won't want to sell those bonds and expose the true valuations, thus booking realized losses that, again, could prove them insolvent.

So the bonds will stay on many institutions' books. They'll keep declining in value - especially once the Treasury's proposed reverse auction ensues - until eventually the losses wipe out their capital, and those institutions fail anyway.

Democrats in Washington are balking at the plan, but only because they want to add to its size. They want provisions that will help homeowners and other "little guys" affected by the credit collapse. That's noble - but expensive.

Speaking of the "little guy," how does this affect him? Bankrate.com, which is a consumer finance website that publishes loan and savings rates, has a little FAQ section on its website titled "What does the Treasury bailout mean for mortgages?", which I present in abbreviated form below.

"Q: What is the Treasury asking for?
A: The Treasury is asking for $700 billion to buy, own and sell mortgages and mortgage-backed securities.

Q: Will I still be able to get a mortgage?
A: It depends upon what type of loan you want. Mortgages are likely to remain available for qualified borrowers who get conforming loans, as long as they have sufficient equity. People who need to refinance, but owe more than their houses are worth, will not be helped. Jumbo loans might become more available and affordable. There's no guarantee of that, though. FHA loans remain available for purchasers and refinancers who can jump through multiple qualifying hoops.

Q: Help! I've fallen behind on my mortgage and I can't get up! Is the Treasury going to help me?
A: No. The Treasury plan is a bailout for financial institutions, not for homeowners who are in danger of losing their homes in foreclosure.

Q: My house has been falling in value for more than two years. Will this action reverse that decline?
A: No, and it's not designed to."

Great plan, huh?

Another reason I don't like it is that I'm suspicious of the prices Treasury will pay. As can be inferred from what I noted above, the only way they ensure more institutions don't fail is to pay above-market prices for the bonds. But when they then have to sell those bonds at their true market values - or hang on to them until they ultimately default because the underlying mortgages, the borrowers on which weren't helped by the plan, went into foreclosure - the taxpayer will take a hit. And there's a hold-harmless provision in the deal that says Treasury can't be sued for any of its decisions.

I'm also generally suspicious of any government intervention. (On that topic, my lovely wife had the line of the weekend. McCain was laying out his plan for a new super-regulator, the "Mortgage and Financial Institutions Trust," which he called the MFI. My wife said, "MFI - sounds like More Frigging Intervention to me.")

The government intervened in the natural course of free markets in 1932, with the New Deal. The result: a longer and more pronounced economic downturn, which required a global war to recover from, and long-lasting effects that are contributing to bubbles and recessions even today.

The government intervened in the natural course of free markets during the S&L crisis. The result: a longer crisis and more costly burden to the US taxpayer.

The government again intervened in the wake of the Long-Term Capital Management hedge fund collapse in 1998, by cutting the Fed funds target by three-quarters of a point in six weeks, from already-inflationary levels. The result: the dot-com bubble.

This time, the government intervention could spell the end of our economic and political independence. (I told you, I see dead people.) In focusing on this $700 billion (plus) albatross, we're forgetting the $800 billion the government authorized in July for the housing bill. Remember that?

Since that time, we've authorized (not we the people, we our socialist leadership) a $1.5 trillion increase in the limit on the national debt. That limit is now $11.3 trillion. Second-quarter GDP was $11.7 trillion. The actual national debt, as of last week, was $9.7 trillion. Add next year's projected deficit, the true cost of the Fan/Fred bailout, the AIG bailout, and this bloated hog of a bailout plan - even at just the $700 billion pitched thus far - and assume output growth will be flat, which is looking more optimistic all the time, and we're facing a national debt that's 95% of GDP by the end of the next fiscal year (September 2009).

You think China's going to want to buy Treasuries when the United States is teetering on the brink of insolvency, and may get its own debt downgraded? Not without much higher rates, they're not. And much higher rates mean higher mortgage rates, which means prolonging the housing melt-down, which means more bonds default, which means .... I see dead people.

But don't take my word for it. How did the markets like the way the plan's shaping up?

The Dow fell 370 points. The trade-weighted dollar index posted its largest one-day drop in a very long time, maybe ever - I was too depressed to look. Oil posted its biggest one-day jump ever. (Great - not only can the subprime borrowers not get a refi, they can't fill their gas tank, either.) Interest rates went up.

I think it's only appropriate that the acronym for this plan - Washington just loves a good acronym - is TARP, for Troubled Asset Relief Program. A tarp is something you throw on a destroyed home after a hurricane, as I've learned on my mission trips to the Gulf.

Or something you throw over a compost heap between turnings.

Hey, if my government is going to be socialist, I may as well move to France. It's a very pretty country, they've got the Riviera and that cool film festival, and the food and wine are better. Besides, I'm already minimally conversant in the language. And I'd get the whole month of July off to watch my former-fellow Americans whip the French's tails in their own bike race.

If this thing passes, I'm going to start getting seriously worried about the fact that I get paid in US dollars. I may pull a Gisele and ask to be paid in euros - since we're going to transfer US taxpayer wealth to foreign banks, that seems like a reasonable hedge. And I increasingly feel the need for a hedge. Because in the long run ...

I see dead people.