A Canadian Perspective On The Bail-out

Rescuing a financial system from toxic waste TheStar.com - Business - Rescuing a financial system from toxic waste

September 27, 2008 David OliveBusiness Columnist

By Monday, it appears, the U.S. Congress will have approved the biggest corporate bailout in history, amounting to $700 billion (U.S.), to rescue America's stricken financial sector.
The bailout's sponsor, irony of ironies, is free-market champion George W. Bush, who used the word "panic" in justifying a massive government intervention in the private sector, using language more alarming than any president since Franklin Roosevelt in the earliest days of the Great Depression.

The fear and urgency is justified. Total losses from the low-grade residential mortgages accumulated during the U.S.'s biggest-ever housing boom are now estimated at about $2 trillion (U.S.). Only a quarter of that financial toxic waste has been written off by the world's leading banks and brokerages, leaving the potential for utter global collapse very real without a government rescue mission of drastic proportions.

And given the complexity of the work to come, getting on with the task can't begin soon enough. What comes next is more difficult than prising the bailout funds out of a reluctant Congress, and entrusting the U.S. Treasury Department with the task of buying from lenders their most toxic "assets" – that is, failed or delinquent loans for which there usually are no other buyers, and which are inhibiting lenders from providing the liquidity on which capitalism runs.

No one, least of all the managers of the crippled institutions, knows the true value of these dismal loans and other soured investments that Treasury will buy. "The reality is that we are not going to know what the right price is for years," Boston bond manager Andrew Feltus of Pioneer Investments told the New York Times on Wednesday. "It might be 20 cents on the dollar or 60 cents on the dollar, but we won't know for years. No two pieces of paper are the same."

And there is a lot of paper, about 1.1 million troubled residential mortgages of a total of 51 million U.S. home mortgages. The soured assets, as you've heard repeatedly during this crisis entering its 13th month, are monstrously complicated.

Mortgages were bought by Wall Street banks and brokerages from mortgage brokers in the field, then repackaged, or "bundled," into as many as three dozen different types of bonds. These were flipped, for lucrative upfront fees, to other banks, brokerages, pension funds, hedge funds, insurance companies and credulous buyers worldwide, until the diaspora found its way into university endowments funds, the portfolio of the Caisse de dépôt et placements du Québec and UBS AG, Europe's largest bank, which has already taken a staggering $36 billion in losses on its U.S. securities.

Some of those bundled bonds were re-bundled as "collateralized debt obligations" (CDOs), a type of derivative now trading at pennies on the dollar, since placing an accurate value on these black boxes is impossible. Citigroup Inc. carries its CDOs on its books at 61 cents on the dollar, claiming they are of relatively high quality. But Merrill Lynch & Co., forcibly merged into Bank of America Corp. this month, firesaled $31 billion worth of CDOs earlier this year at just 22 cents on the dollar in a desperate bid to shore up its eroding reserves.

In a process increasingly referred to as the Great Unwind, Treasury minions will spend years cracking open the black boxes and tracing the ultimate assets on which the Wall Street-invented paper is based – a split-level in Lansing, Mich.; a tract-home development in suburban Phoenix; a luxury condo in overbuilt Miami. Treasury will then have to decide whether to take an immediate loss on a hopeless asset, or hold the property to maturity in hopes of an eventual rebound in the local real estate market.

The quandary for the Treasury is that if Uncle Sam pays a San Diego bank the undoubtedly inflated value at which the bank is carrying a troubled loan on its books, the bank is being rewarded for its fecklessness by U.S. taxpayers.

Conversely, if Treasury officials drive a hard bargain, paying less than the bank's claimed value for its impaired assets, the bank will have to take a writedown on the difference. That would eat into the bank's reserves, and make the bank even more gun-shy about lending to creditworthy customers – the very condition the massive bailout is intended to reverse.

There is arguably a silver lining to this catastrophe, which is that capital diverted for most of this decade to housing and consumer consumption, dating from the buying panic that began after the terrorist attacks of Sept. 11, 2001, when Bush exhorted Americans to keep shopping "or the terrorists win," can now be deployed more usefully.

Housing and shopping sprees at Target and Home Depot contribute little to the nation's productivity. Economic activities that strengthen America's competitive advantage have been starved of capital for years. These heavy investments in infrastructure, education, R&D, energy saving retrofits of buildings, and more efficient – and efficacious – delivery of health care.
"This crisis could become a chance to re-evaluate our priorities as a country," Business Week economist Michael Mandel argued this week. "Rather than stressing home ownership and consumption, we should focus on investment and innovation, which have a bigger long-term payoff."

Certainly there are more productive uses of capital than the eye-popping salaries and bonuses Wall Street managers accumulated in the fat years from knowingly peddling shoddy goods.
The new government controls on executive pay that are part of the extraordinary bailout plan under negotiation are a dagger planted in the free-market doctrine of the current Republican administration.

But without them, the rescue package urgently sought by Bush would have been politically impossible.

David Olive writes on business and political issues.