The Main Street Guide to the Wall Street Bailout is an explanation in plain English designed for the person on Main Street America. It is brief, but not short. Use it as a reference and feel free to contact me directly with additional questions. Be sure to Look for links to additional informaiton.
Simply put, due to a number of factors, banks are hoarding cash and afraid to lend money due to a lack of confidence. It matters to you because, if the problem persists, companies and consumers will not be able to borrow money resulting in an economic contraction and job losses.
The government bailed out Fannie, Freddie, and AIG because the problems resulting from the failure of companies that guarantee and insure mortgages would be severe. They let Lehman fail because they thought it would not cause collateral damage.
Main Street decided it wasn’t going to “bailout” Wall Street and the politicians who caused these problems and let the politicians know with phone calls and emails.
Treasury Secretary Paulson did a horrendous job gaining support for his plan. Paulson was not a salesman. He was an investment banker who solved problems and told people how to fix them. From his perspective, “How could anyone not understand this problem and want act immediately? Well, politicians in an election year!
The financial markets are suffering from significant fear and strain. The strains appear in multiple areas:
The difference, or spread, between the interest rates of two investments over time is a relative measure of fear in the market. The higher the spreads, the higher the fear, indicating lenders/investors are demanding a much higher interest rate to lend/invest.
One example is U.S. Treasuries Vs. the LIBOR, the London Inter-Bank Offered Rate – the rate at which banks in London lend to each other. The spread between Treasuries and LIBOR is at an all time high indicating banks do not want to lend money to each other out of fear. The rates banks are charging each other for short-term loans are equivalent to a 30 year fixed mortgage going from 6% to 20% overnight.
Investors consider U.S. Treasury notes and bonds zero risk investments because they consider the U.S. Treasury the most secure investment in the world. When investors are fearful and seek security they sell other assets like stocks and buy Treasury Bonds. As more people buy these bonds, the price goes up reducing the interest or yield the holder receives. The lower the yield, the greater the fear, indicating investors are willing to accept a lower return on their money.
In the last few days and weeks, both the one month and three month Treasury Bonds traded down to records lows near 0% from normal ranges of 1% to 3%. Investors are not worried about the rate of return ON their investment… they are worried about the return OF their investment from banks that might be gone tomorrow.
Simply put, Credit Default Swaps are insurance for investments. An investor who holds bonds, corporate debt, or mortgage-backed securities will buy insurance to transfer some or all of the risk of their investment to the seller of the insurance. The parties “swap” their risk of default. The higher the price, the higher the fear, indicating increased risk of default the assets in question.
The problem is the result of the combination of several factors that all reduce the assets of banks and financial institutions and require them to increase their cash reserves. The result is the drop in lending.
Money Markets are liquid, low risk, short term investments used for cash management by large investors. You probably have had money in a money market as an individual through a money market fund where you owned shares.
Because Money Markets were not FDIC insured, companies and investors began withdrawing their assets. The withdrawals reached a panic when a few Money Markets could not meet withdrawals. The withdrawals reduced the reserves at these financial institutions. The FDIC now insures Money Markets similarly to regular bank accounts, but does not cover large clients that are removing their funds.
Large brokers provide premium services including cash management to large clients, primarily hedge funds. When Lehman failed several weeks ago many clients could not withdraw their assets from their Lehman accounts. In fear of losing their assets, Prime Brokerage clients then pulled their money out of other brokerages and banks with other high balance clients following their lead. The withdrawals reduced the reserves at each of these banks.
The accounting rule that requires financial institutions value assets at the current market value each quarter. The rule prevents financial institutions from inflating the value of their assets, which is a good thing. The problem is that there is no market for many mortgage-backed securities and the only pricing data available is from distressed sales of assets from failing financial institutions. Based on this data, the value of a bank’s assets drop requiring them to increase their cash reserves. It would be similar to the value of your house falling and your mortgage company requiring you to put $100,000 in a CD or sell your house even if you don’t plan to sell the house in the next 10 years. The resulting selling
When you short a stock, you sell a stock you do not own with the intention of buying it back later at a lower price. Sell high and buy low - the same as regular investing but in reverse. The significance for financial stocks is that they lose their credit ratings if their stock prices fall requiring them to raise cash reserves. Short Sellers knew this and could use the fear of bank failures and their rapid short-selling to cause credit ratings drops possibly setting into motion actual bank failures before the banks had time to increase their reserves.
Similar to the Resolution Trust Corp. in the 1980s that resolved the S&L Crisis, this is the basis of the Paulson Plan “bailout”. The government would essentially buy the mortgage assets at fair market value and keep them to maturity or sell them to investors when the markets stabilize. The benefit is that this move would immediately free up the financial markets. However, it is totally un-free market, puts the entire risk on the taxpayers, and is seen as a bailout by Main Street.
The U.S. Government could offer insurance on the mortgage-backed securities to the banks and institutions that hold them. The benefit to the banks is that they can limit their risk. The problem is that it would cost them a lot of money at a time when they are hoarding cash and it would shift the risk to the taxpayers.
The SEC temporarily banned shorting financial stocks in an attempt to reduce the pressure on these stocks. It does not mean that stocks won’t go down, but it prevents short sellers from piling on and forcing stocks down. While I think the benefits are very limited adn that short selling provides a valuable market function, look for the SEC to extend this ban.
The Uptick Rule, established in 1934 and eliminated last year, required people shorting stocks to find a buyer willing to pay more than the last trade. It slowed the pace of a stock’s decline when multiple sellers were trying to short the stock and allowed the banks time to increase their cash reserves.
Currently, the FDIC insures accounts with member banks up to $100,000. Increasing this amount will reduce the runs on banks and decrease the need for banks to raise cash. Additionally, the FDIC could offer bank paid insurance over the FDCI covered limit. Look for this to increase to $250,000.
THE FED can cut the FED Funds Rate, which reduces the cost of borrowing, increases lending, and increases the profitability of banks. Obviously, it is not a solution by itself as the FED reduced the Fed Funds Rate 3% in the last year, but it is an additional tool. With inflation waning, look for a rate cut in the next few months. Current futures indicate 100% chance of a quarter point cut and 38% chances of a 50 basis point cut at the October 29th FED meeting.
Similar to the FED Funds Rate, the BoA and ECB adjust their funds rate. The European economies are slowing and inflation is easing so look for the BoA and ECB to cut rates. The benefit to the US is that it should strengthen the dollar and cause international investors to buy more U.S. bonds, which will reduce interest rates and mortgages in the U.S. The downside is that a stronger dollar will hurt exports that have helped buoy the economy.
Other Options
There are many other efforts ongoing such as allowing banks to borrow from the FED using different assets as collateral and easing mark to market rules. Suffice to say the FED has been trying different options for the last year without much success.
I am disgusted that we are at this point, but know the basis of the Paulson Plan is the best option at this point and something that we need before the problem gets worse. The piecemeal solutions address the symptoms and not the cause of the problem. They are not working and the problem is only getting worse.
I do not think the plan is a “bailout” because the taxpayer would be buying real assets. If a house in California with 100% financing worth $300,000 two years ago is now worth $150,000, but the taxpayers only pay 30 cents on the dollar, then they paid $90,000 for a house now worth $150,000. The taxpayers have risk and could lose money, but the money is not evaporating.
If you do not agree, then call it a Main Street bailout of a bunch of rich guys on Wall Street. However, the cost to taxpayers of doing nothing will be much higher in the future.
I think you will see a version of the Paulson Plan very soon, possibly the one they are voting on tonight. It will not immediastely solve all of the problems, but will remove the single biggest problem and allow the housing and financial markets to continue to improve.
Todd Huettner
303-758-7402
todd@toddhuettner.com
www.huettnercapital.com
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