Five Things You Don’t Know About the Bailout

09/25/2008 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Very soon, Democrats and Republicans will take a deep breath and hammer out a deal on the $700-billion bailout of the finance system proposed by Treasury secretary Henry M. Paulson, Jr., and Federal Reserve chairman Ben S. Bernanke. 

And it’s going to be a very, very bad deal—the worst possible use of taxpayers’ money at a time when there’s a pressing need to get our fiscal house in order.

But the alternative—a meltdown of the financial system—is unthinkable. When Treasury bill yields are practically zero and investors pull $120 billion out of money market funds in one week, then the financial system has basically had a heart attack. It will take more than a tablet of low-dose aspirin to shock it back to health.

And who knows? Maybe if the Treasury plays its cards right, taxpayers’ losses will be minimized, and the Fed won’t have to keep the printing presses running. But that would be only the icing on the cake.

I’m sure you’ve seen the massive coverage of this huge event in newspapers, on television, and on the Internet. I’ve followed it, too, and overall I’ve been very impressed. But here are five things I think are getting lost in the shuffle.

1. Glass-Steagall’s repeal may have helped, not hurt.  A cornerstone of the “regulatory failure” explanation of the crisis was the 1999 repeal of the Glass-Steagall Act, the Depression Era legislation that formally separated investment banks from their commercial cousins. By doing this, Congress and President Bill Clinton allegedly caved into the banking lobby and gave banks free reign to speculate with depositors’ money.

But until now, free-standing investment banks, insurers, and government-sponsored entities like Fannie Mae have been the biggest losers in this crisis. Despite the problems of banks like Citigroup—whose investment banking arm produced tons of toxic mortgage debt—a strong deposit base and tougher regulation has actually given banks like JP Morgan Chase and Bank of America flexibility that Bear Stearns and Lehman Brothers didn’t have.

 “If they hadn’t repealed [Glass-Steagall], B of A couldn’t have bought Merrill Lynch,” says John Steele Gordon, author of The Great Game; a History of Wall Street.

2. But unregulated derivatives markets are a problem. Over-the-counter derivatives (such as credit default swaps) are not regulated, as parties and counterparties agree on pricing in private deals. The “notional value” of that market ballooned to an astonishing $596 trillion by the end of 2007 (with a gross market value of $14.5 trillion)—and nobody’s watching it.

By contrast, exchange traded derivatives (like many futures and options) are traded on transparent markets and overseen by effective industry associations, says Franklin R. Edwards, professor of finance at Columbia Business School.

“Clearing associations provide oversight and guarantee all trades,” says Professor Edwards, author of a textbook on derivatives (financial instruments derived from an underlying asset or transaction). These groups set position limits and appropriate collateral levels and ensure the markets function smoothly.

Nothing like that exists in over-the-counter derivatives, largely because of intense lobbying by the financial industry. According to BusinessWeek, some officials at the Commodities Futures Trading Commission pushed for more regulation of over-the-counter derivatives during the Clinton Administration, and were shot down by then Fed chairman Alan Greenspan and Bob Rubin, the do-no-wrong Democratic Treasury Secretary.

In 2000, Republican Senator Phil Gramm, who was chairman of the Senate Banking Committee, pushed through a massive bill on the brink of Christmas recess that made many swaps and over-the-counter derivatives completely unregulated. 

This, not Glass-Steagall’s repeal, is the real regulatory scandal, and Congress must fix it as soon as possible if taxpayers’ money is not going to go up in smoke.

3. Moratoriums on short-selling won’t do much. The Securities and Exchange Commission’s missing-in-action chairman, Christopher Cox, has imposed a temporary ban on short selling in stocks of hundreds of financial institutions. The goal: to stop coordinated “runs” on financial stocks by short sellers, particularly hedge funds.

That may be a temporary band aid, but there’s little evidence of massive short selling of financial stocks or any others. Less than 5% of the shares traded on the New York Stock Exchange were sold short, a modest increase from last year, when the SEC ended its decades-old “uptick rule,” in which short selling was permitted only when stocks were moving up.

And although financial stocks got a bounce during the last ban on short selling in the summer, they rallied less this time, indicating these short-selling bans are yielding diminishing returns.

Short selling plays an important role in markets in helping investors hedge positions and letting the air out of overhyped stocks. But CEOs hate it. John Mack of Morgan Stanley reportedly lobbied Paulson and the SEC to ban short selling because he thought there was an attack on his firm.

Did it ever occur to him that disenchanted investors who owned his stock were just dumping it? And why is anybody still listening to people like Mack after all the damage his firm and others have done?

4. The winner is: Goldman—and Paulson

I’m certainly not impugning the motives of Secretary Paulson, who is working tirelessly to save the global financial system from catastrophe. But some of his interrogators on Capitol Hill obliquely raised the question of his own culpability for the whole crisis.

In fact, isn’t it interesting that Goldman Sachs, the firm he served as CEO, may wind up to be the last man standing on Wall Street when the dust finally settles?

And here are some other interesting facts to consider, courtesy of John Gapper’s excellent blog at FT.com.

Just before his nomination as Treasury Secretary in May 2006, Paulson presided over Goldman , which was at the time securitizing some $20 billion of “financial assets” per quarter.

I’m taking a wild guess here that some of these “assets” will wind up in the toxic waste dump that our tax dollars will help dredge. And I wonder how well the secretary understood what his firm was buying at the time and how he feels about his own role in the worst financial crisis since the 1920s.

Incidentally, as Gapper points out, Paulson got an $18.7-million bonus for half a year’s work in 2006 (in part for booking all those fine “assets,” I’m sure). And he sold Goldman shares for over $500 million before taking over at the Treasury—without paying any capital gains taxes.

Let’s hope he gets as good a deal for the American taxpayer as he did for himself.

5. Keep your eye on the banks. The bailout will no doubt calm markets, and it may even cause a nice rally in stocks. Debt markets will thaw, and the panicked flight of money to the mattress should end.

But remember what Churchill said about being at “the end of the beginning”?

This war, too, has many battles ahead. “We haven’t begun to see the banking problems yet,” says Professor Edwards. “The banks are at the heart of this derivatives problem.”

Citigroup already has taken write-downs of some $40 billion on subprime and other mortgage-related securities, and it has had to raise billions of dollars in capital to shore up its balance sheet.

But earlier this year it just began to take reserves on things like auto loans, student loans, credit cards, and other items exposed to the strapped consumer.  If the economy weakens and unemployment continues to rise, these consumers will have more and more trouble paying off those loans, too.

And let’s not even mention the huge volume of adjustable-rate mortgages that are due to reset over the next two or three years—or any severe downturn in commercial real estate. A deep recession could take a big toll on the balance sheets of even healthy institutions.

Get the picture?  “[The Feds] want to be prepared to handle the banking problem,” says Professor Edwards. “Is $700 billion enough? Probably not.”

So, let’s get the bailout done and hope for the best for now—but don’t be shocked if we have to pay more down the road. I don’t envy the next president, whoever he is.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and don’t necessarily reflect the views of InterShow or MoneyShow.com.

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