Done Deal

We are by no means ready for the post-mortem on the economic crisis yet, but the Wall Street Journal (and every other news outlet) has been reporting all day on the bailout negotiations on the Hill, and it looks as though a deal has been sealed, one way or another. As I was watching last night when House and Senate leaders from both sides of the aisle emerged to announce an agreement was on the table, on one hand, I was wondering along with everyone else what the deal was. But then, it occured to me that I knew a deal would happen.
Regardless of the fact that the majority of the policymakers on the Hill did not understand what was at stake earlier in the week, by the end of the trading day on Friday, I think they all realized how critical it was to get a deal done before the markets opened in Asia. So, I knew it would happen and since I know the economics behind the financial crisis and what it will take to restore stability, whatever deal is delivered will inevitably include a large pricetag.

This is what has really surprised me about peoples’ opposition to Paulson’s plan. Everyone, it seems, is complaining about the fact that the bailout involves $700 billion, as if the roughly $2,000 per person would immediately be withdrawn from the checking account. But, I find it perplexing that much of the general public has failed to comprehend that whatever decision is made on Wall Street, the White House or the Hill, if we are ever going to emerge from this crisis, capital will be needed, in order to stabilize the financial markets. So, one way or another, the Fed would have to intervene as a lender of last resort, because the markets could not support the failure.

It never ceases to amaze me that people thought our economy was just going to magically emerge from crisis without the needed liquidity injection or stabilization efforts. Whatever is done to get out of this crisis, it will involve a hefty price tag. And, the pricetag will inevitably be more than $700 billion; indeed, I have consistently said it will exceed $1 trillion.

More important than the lack of details about the costs of this crisis, is what struck me after I heard the the Members talking at last night’s press conference. The second question that I thought of is what exactly has been holding the process up, as we’ve watch the volatility in the markets shoot through the roof all week.

It appears that the key negotiating factor over the past few days has been executive pay. House Democrats were intent on injecting some measure of restricting CEO compensation into the bailout legislation as an earmark. Leave it up to the Democrats to earmark a bill that is meant to restore stability into our financial markets, a key component of which is urgency, as each minute costs our economy large amounts of money and risk.

So, as Americans all across the country are becoming more and more anxious about what is going to happen to the financial markets, and more importantly, how the inevitable recession will affect their pocketbooks, Members of the House were busy earmarking rescue legislation to death, almost to the point of risking the stability of the equity markets.

Like I mentioned previously, the bailout package was inevitable. We must have it, in order to stabilize the markets and allow the short-term liquidity needed to support the rebuilding of our credit markets. Monetary policymakers have known this the entire time. Now, fiscal policymakers have realized it, and the general public is gradually catching on to the fact that a failing Wall Street does not just impact rich bankers and financiers.

I have said repeatedly that allowing the markets to fail is not something to take casually, as many commenters here have done. Thinking failing markets doesn’t affect Main Street is not only naive, it’s downright foolhardy.

But, in the end, this thing is going to happen; indeed, it’s happening as we speak. So, people better get on board. Thus, it’s time to start restoring confidence in our markets and economy. I’m not saying that I’m ready to go out and take all kinds of equity positions, but now that the bailout is happening, we must begin to think about what comes next, because don’t be fooled, this is just a temporary stabililization effort.

Next, we have to look at long-term stabilization efforts, and this is where things get really complicated. The reason this concerns me is that if it took this long for policymakers to agree on an earmark in a stabilizing bailout, then I can’t imagine what will be required to inject long-term stability to rebuild the financial markets.

A key thing to remember in macroeconomics is that while the Fed’s role as a lender of last resort is a legitimate action to stabilize the economy, but stabilization efforts through fiscal policy is rarely effective. The primary reason for this, as I believe, is that fiscal stabilization involves too many information assymitries, not to mention the fact that politics always obstructs true stabilizing policies from taking place. This past week has been case in point, as policymakers have attempted to put earmarks into the bailout legislation.

What is the long-term solution to this crisis? Simply put, I don’t know, but neither does anyone else for sure. I can tell you a couple of things that must happen: first, the housing situation must be turned around, which will require both capital and time. Second, the faulty debt instruments that drove volatility into the credit markets must all be cleaned out. This is already happening, as the entire landscape of the banking industry is changing. Most of the funds that managed high amounts of risk from the housing industry have either died or are gradually fading into the darkness. Another key trend in this sector is the move to the universal model, where banks will follow the traditional model and investment banks as they have existed in recent years will be gone. And finally, one of the most critical components that both Wall Street and Washington will not get wrong again is making sure the existing regulations are enforced.

I have continuously maintained that two things caused this crisis: 1) poorly managed debt on behalf of Wall Street firms, where efficient risk management was ignored; and, 2) banking regulations that went unenforced. I have also argued that more regulations are not needed, but if we are going to make sure that this crisis does not re-emerge, the existing regulations on the books must be adhered to.

Of course, there will be numerous other changes throughout the entire market dynamic, as we rebuild from this crisis, such as amending accounting methods, new risk management strategies, and the emergence of new models on Wall Street, but the key for the next phase, in my opinion, is to get back to fundamentals. Now that we have (or nearly have) resolved the short-term instability, addressing the long-term volatility will depend on fundamentally changing the landscape of market risk.

How we do that today is anyone’s guess, but I can assure you the ones that figure it out first will emerge the new powerhouses.

NOTE: This post was originally published on my blog at www.marktomarket.typepad.com.