Chairman Bernanke Finally Spills The Beans

The attention of financial markets yesterday was fixed on the Congressional testimony of Treasury Secretary Paulson and Fed Chairman Bernanke. It was an up and down day, mostly down. Bernanke finally gave us an (elliptical) answer to one of the questions that most concerns Wall Street about the bailout plan: the valuation at which distressed mortgage-backed securities will be purchased. The other question, whether there will be a deal in Congress at all, remains unanswered.Markets generally had a mostly negative tone yesterday, but well short of the near-panic conditions we saw on the night between Wednesday and Thursday last week. Credit and money markets remained very, very tight, but not at the edge of insanity. Stocks and commodities were generally lower, and interest-rate action was muted.

If you’ve been following my posts, you know that the most critical variable in the proposed purchase by the Treasury of up to $700 billion in MBS and related assets, is the valuation.

Get the valuation too low, and a lot of banks and Wall St. firms will bust because of the capital losses. Get it too high, and it’s a big transfer of wealth from the taxpayers to Wall St.

I’ve been trying to get some sense for how Paulson and Bernanke are seeing this, for days now. Yesterday in open Congressional testimony, Bernanke finally spilled it: the purchases are to take place at “a price close to the hold-to-maturity price.”

I’ll say it straight out: that would be far higher than the current market for these securities. The Troubled Asset Relief Plan is a bailout of Wall Street, at taxpayer expense. Pure and simple.

This puts everyone in a very difficult position, for two reasons: First, it’s morally wrong and politically a disaster. Second, it represents a misallocation of resources that can only hurt the economy later.

So as we’ve learned (after five days of asking the question), the objective of the plan is to reflate the economy. The idea is to pull money into the US economy from global investors, including foreign central banks, through heavy issuance of US Treasury debt.

The purpose of the capitalization is to counteract the effects of the enormous losses that everyone has suffered as housing prices have fallen.

The people who are at the point of the spear are the banks and Wall Street firms who own the notes on your house. They’re the ones with such large losses that they can’t pursue any new business.

But the body of the spear is everyone who owns a home and is paying on a mortgage. If you’re a homeowner, your situation is stable because you can keep paying that mortgage (unlike leveraged Wall St. firms who face bankruptcy). But you’re not going to be buying a whole lot of new goodies (and therefore expanding the economy) as long as the value of your house is lower than it used to be.

Apparently the hope is to flood enough additional capital through the system to loosen everything up. The downside risk if that this enormous misallocation of resources will produce high inflation over time, and restrain growth in the whole global economy.

I’m starting to see some of the dimensions of what is happening here. Bernanke, who is a deeply-knowledgeable expert on the subject of deflation, is going to err on the side of inflation.

And I can broadly agree with this. Inflation reduces the value of your savings, but deflation throws people out of work. Taken to an extreme, deflation frays the social fabric and leads to radical, even revolutionary tendencies in politics.

The other thing I think they’re trying to do is to manage this situation in light of the lessons learned by Japan’s horrible mismanagement of their housing deflation a decade ago.

We’ll all need a bit more time to figure this out, and I think Paulson understands that this deal can’t be done in a few days.

And that’s where it gets sticky. In terms of the politics, the whole situation is coming at an unfortunate time.

I’m not talking about the Presidential election, which is between a man (McCain) who is not known to believe in free markets, and another man (Obama) who is not known to believe anything at all. As far as economic management is concerned, the Presidential choice is nearly random.

I’m talking about Congress. They’re scheduled to get the hell out of Dodge on Friday, to go get themselves re-elected. Three more days isn’t enough time to get this deal done. Congress should ideally work on this for a month (forget about it), but at least they should stick around for another week or two to put a few markers down.

Otherwise financial markets will be in turmoil for months to come.

-Francis Cianfrocca

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