You Can't Get There From Here

Two weeks ago, when faced with the decision regarding whether or not to rescue the financial services industry, Congress, after some pressure by the President and the Treasury Secretary, chose "whether," and passed the $700 billion dollar bailout legislation. The hope was, and is, that injecting fresh capital into the banking system will cause banks to start lending again, which will then reverse the downward trend in the economy, and begin the recovery. This week that capital began flowing as the Treasury gave $125 billion to nine large banks, including Bank of America and Citigroup. These banks really did not want the money, but the Treasury made them an offer they couldn't refuse. Another $125 billion will be given to other banks, although what the banks do with it, may not directly involve lending. PNC Financial Services Group, Inc., for instance, received $7.7 billion from the Treasury and purchased National City Corp. Government officials encouraged this deal. It follows Banco Santander SA, of Spain buying Sovereign Bancorp, Inc., Wells Fargo buying Wachovia, as well as purchases by Bank of America and JP Morgan Chase.

The question leading up to the bailout vote was how to best help the banking system get out of the mess it made. When deciding the bailout qeustion, the misperception that proponents of the bill focused on, was that the choice was to passs the legislation or do nothing. Choices in life are rarely all or nothing. After the vote failed initially in the House a representative from New Jersey, who voted against the plan, was interviewed and said that the reason the plan did not pass was that representatives on both sides of the aisle just did not think the plan would work. he said that as soon as the plan was voted down, Republicans and Democrats began to work on alternatives. He recalled asking Treasury Secretary Paulson whether he thought the plan would work, and Mr. Paulson admitted he did not know. That's fair. No one has a crystal ball. Alternative plans were available, though, including reviving the Resolution Trust Corporation, or RTC. The RTC was the vehicle that the government used to sell off the assets of the Savings and Loan industry when it collapsed in the early 1990s. In fact, weeks before the vote, a Congressman from New York proposed reviving the RTC, and an article appeared in the Wall Street Journal, penned by three notable economists, including former Fed Chariman, Paul Volker, detailing how the RTC would bring back stability and liquidity to the markets, while costing the taxpayers little or nothing. Just for the record, the RTC made money in the 1990s.

The way it works is that banks would have to write down their bad loans. No ifs, ands, or buts. Some would survive, and some would fail. Those that failed would have their assets bought by the RTC, bundled, and sold. One of the fallacies that is currently being perpetuated is that there is no market for the bad loans. The proper way to phrase this is that the market does not value homes as high as banks and homeowners would like. There is a market for almost everything. By propping up home values instead of forcing their write-downs, though, the bailout legislation is not allowing the market to correct itself, which it would do, given enough time. How much time? Who knows? But the market can, and must, figure it out on its own, without interference from the Treasury, Congress and the President, if we are to begin to truely recover.

Think about it for a minute. Let's say that you are in the market for a house. You know that it is a buyers market, meaning that those trying to sell their house, are having a difficult time doing so. You have your eye on a particular house, and want to make an offer. You feel you can negotiate the price down, but the homeowner is not going to give the home away. So, somewhere between zero and the price the homeowner is asking, is a price you can each agree on. Since this is a buyers market, that price is lower, probably much lower, than normal. So, while the seller may not get nearly the price he wants, he will sell eventually. You just have to find the right price. The banks are in the same boat. They have bad loans on their books. If they have to write them off, they may go bankrupt. So they are claiming that they cannot value these assets (loans are assets to a bank), since there is not a market. For my money, if there is not market, the value is zero. That is absurd, though, so banks must write down the loans. The free market will sort out the winners and losers. That is what banks are waiting for.

Banks are nervous because these bad loans are on the books. You do not lend to a company if you do not know if they can pay you back, and a bank cannot know if another bank will pay them back if they cannot be sure about the assets backing up the loan. Write down the loans, and the uncertainty goes away. That is what the RTC would do. Then the recovery could truely begin. Recovery would not happen over night. Many would certainly lose their jobs in the recession, and possibly their homes to foreclosure. But, the pain will be less, overall, than if the government trys to bailout those who are struggling. (more on that in a future blog)

What do we do, though? The bailout was passed and the money has started to flow from the Treasury to the banks. Well, while I admit that I disagreed with the bailout, I am glad that the Treasury is encouraging deals like the PNC/National City deal. When a strong bank buys a weak bank, that takes the pressure almost completely off of the taxpayer. True, the taxpayer is potentially on the hook if the deal goes sour, but the chances of that are much lower. Banks, like PNC, that have come through this crisis healthy enough to purchase another bank should be OK. The taxpayers should make some money on these deals also, since the money is lent at 5 percent for five years. So, some of the money is being put to good use. We'll have to wait and see what the rest is used for.

Getting back to the free market, though, we would get out of this mess much quicker and be better off in the long run if the market sorted all of this out itself. That topic will be continued in the next few blogs, in which I will deal with free market solutions that are occurring now, and the possible foreclosure bailout plan that is being proposed.

Thanks for your time. Talk to you soon