A Few Important Questions for Mr. Paulson and Mr. Bernanke

We’re now into our second day of market reactions to the Treasury and Fed’s Troubled Assets Relief Program (“TARP”), or if you prefer, Mother of All Bailouts (“MOAB”). Market reaction in general is quite positive, which I’ll get to shortly. But the action is moving to Capitol Hill, where Paulson and Bernanke need to convince Congress to pass enabling legislation for the plan before they leave on Friday to face the voters. I’ll tell you how that’s going so far. And I’ll also tell you what questions Congress needs to ask, so that we all can get a better understanding of how the TARP will actually work.Two Crises

We face not one but two financial crises: a liquidity crisis and a credit crisis.

Both ultimately stem from declines in the value of securities and derivatives that are based on mortgages. But the liquidity crisis primarily affects the financial system in the near term, while the credit crisis affects the larger economy and is a longer-term problem.

And markets have responded favorably to news of the TARP, because it’s widely expected to relieve the near-term disruptions that have rolled through the financial world like one Category-5 hurricane after another.

The reason markets are in acute crisis is because the failure or near-failure of so many important institutions (including Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG Insurance, and many others) makes normal trading impossible.

You can’t trade with someone you’re not sure won’t be bankrupt tonight. And when “someone” is just about every big name out there, that means you practically can’t trade with anyone.

The Darkest Night

That drives a flight into the safest and most liquid assets, even at the cost of losing money. In the darkest hours of the crisis last week, which came as you were asleep on Wednesday night and Thursday morning, interest rates on short-term Treasury debt became literally negative for brief periods of time.

And money-markets showed nearly half a trillion dollars in sell orders that night, by some accounts. If this hadn’t been stemmed by an extraordinary intervention by the Federal Reserve at 3am EDT that morning, it’s possible that there might not have been enough money in the bank for the company where you work to open its doors that morning.

To say that we came to the edge of Armageddon last week may be understating the case.

Pulling Out The Biggest Weapon

After 24 hours of extreme tension, the Treasury leaked word of the TARP, an extraordinary program that will borrow money from world markets, guaranteed by the taxpayers, to buy up to 700 billion dollars’ worth of a range of distressed assets from financial firms.

That news broke on Thursday afternoon around 3pm EDT. It was the source of the roughly 800-point rally in US stock markets that you heard about, and of the nearly orgasmic sigh of relief that went up from trading desks all over lower Manhattan and elsewhere.

By Friday morning, the interest rate on short-dated discount Treasury debt had gone from around 5 basis points (a level last seen in the days following World War II) to a still low but workable 95 BPs or so, where it stands this morning.

For now, markets have stabilized and the fever has broken.

And an acrimonious debate has broken out over the details of the plan. The action shifts down the Atlantic corridor from New York to Washington.

The Debate in Congress

Many well-respected conservatives are dead-set against the plan, which of course is blatant socialism just as the RTC was. These voices are screaming at the top of their lungs that the TARP should not go forward.

These people need to look at the consequences of the instantaneous return to extreme market instability that would take place if they got their wish. This bailout plan is an absolute requirement.

Many liberals, on the other hand, are seeing an opportunity to embed once again the perception that free markets just don’t work. They’re trying to load the TARP special legislation with a raft of Democratic goodies, including more handouts for people facing foreclosure, additional funding for the hard-left ACORN and other “community organizing” groups, and more support for cities that face revenue shortfalls as foreclosures rise.

Secretary Paulson and Chairman Bernanke spent a good part of the weekend on Capitol Hill with key lawmakers from both parties, answering their questions about the TARP bailout plan. (Or not answering them, depending on who you ask.)

The basic idea, according to draft legislation that I saw on Saturday, is that Treasury will set up a two-year program to purchase a broad range of assets from financial firms. The purchases will be funded by sales of Treasury debt, which of course are guaranteed by the taxpayers.

It’s reminiscent of the RTC of the late Eighties and early Nineties, which purchased the assets of failed savings-and-loan associations for pennies on the dollar, and then sold them off over time. The end result of the RTC was that taxpayers made a profit, and it’s more than likely that the TARP will end doing the same thing.

But there are some critical questions about how the TARP will work.

Questions for Mr. Paulson and Mr. Bernanke

The biggest and most important questions regard the valuation at which the mortgage-backed securities will be purchased from the participating banks and Wall St. firms.

How many pennies on the dollar? And who will make that determination?

Banks and Wall Street firms are suffering because they own large amounts of mortgage-backed securities and related derivatives that are now worth less than they paid for them. The losses mean that they can’t go forward from here and fund new investments in productive business activity.

Ideally, you’d want to sell off your bad assets and either continue life with a smaller balance sheet, or else raise additional equity capital to start growing again. Neither option is available as things stand.

The point of the TARP is to provide a bid for the bad mortgage-based assets that, in Paulson’s words, are “clogging the balance sheets” of many financial institutions. He wants to provide a market so that financial firms can sell these assets and get on with life.

The price at which they will be sold is all-important. Get it too low, and you’ll put a lot of firms out of business, because they will be forced to realize capital losses they can’t recover from.

Get it too high, and you’ll be doing two extremely bad things: you’ll be rewarding banks and Wall Street for making bad decisions; and you’ll expose the taxpayers to losses and inflation.

So the key question for Paulson and Bernanke is: who will be determining the valuation? You want above all to make sure that this job is done right, which means getting the best available people from the private sector to do it. How will they be compensated, and what are their incentives?

Already Barney Frank is saying that the people who do the valuation must not be allowed to make a lot of money. How do you get really top people on that basis? Given the dire implications of getting this wrong, it’s charitable to say that Mr. Frank is being shortsighted and probably a little vindictive.

The really deep problem I have, however, is this: what if the true, correct valuation of distressed mortgage-backed assets is actually very, very low? Like, say, five or ten cents on the dollar?

This outcome, if it happens, would be reflective of the fact that the housing industry significantly overbuilt, in response to the price bubble that burst in 2006. And that’s a misallocation of resources that simply can’t be willed away by bailouts, taxpayer handouts to Democratic constituencies, or fairy dust.

If that indeed is where we are, then the TARP will solve the near-term liquidity crisis, but not the longer-term credit crisis. And the US may be facing a long, possibly multiyear period of very slow economic growth.

A lot like what Japan has gone through after their real-estate bubble popped. In Japan, they call it “The Lost Decade.”

All eyes on Ben Bernanke at this point. A close student of the Great Depression, he understands deflation as few others do. He’ll be mouthing the same words as Paulson, to get us through this immediate crisis.

But does he really believe we’re addressing the longer-term problem? That’s a question I’d dearly like to know the true answer to.

-Francis Cianfrocca