Ransom for Main Street: $700 billion

I lost sleep again last Tuesday evening watching the live telecast of the hearing of the US Senate Banking Committee on the proposed $700-billion bailout of Wall Street. One thing’s for sure: I wouldn’t want to be in the shoes of those senators who were under siege from angry constituents. Main Street America is in no mood to hand the Bush administration carte blanche to use $700 billion to fix up Wall Street.

On the other hand, there was Federal Reserve Board Chairman Ben Bernanke who likened the problem to a cardiac patient with serious blockage in the arteries and could suffer a heart attack today, tomorrow, next week or six months from now. One thing is sure, Bernanke said, it is going to happen and that is why the emergency proposal is needed to prevent that.

The medical allusion is chilling but I thought the situation is closer to that of a hostage situation. Bernanke and Treasury Secretary Henry Paulson are the negotiators in contact with the Abu Sayyaf on Wall Street and they are pleading with Congress to give the money to ransom the ordinary Americans on Main Street from certain financial catastrophe. The Wall Street Abu Sayyaf has already detonated their financial weapons of mass destruction and more toxic repercussions are threatened if the $700 million didn’t come soon.

The one overriding message of the senators in their opening statements was the strong feeling of their constituents that the naughty boys on Wall Street deserve a spanking and not a lollipop. Yet, the senators seem to believe the warning of Paulson and Bernanke that a financial Armageddon is upon them without this bailout. They don’t want to look like they buckled down to threats from Wall Street and sold out their Main Street constituents.

The worse part is the absence of assurances the Paulson-Bernanke plan will work. No one is even sure $700 billion will be enough. Paulson and Bernanke could well be back on Capitol Hill with a further request for more funds a week before the elections because they have exhausted the $700 billion and the end is not yet in sight. The bailout plan, Bloomberg observes, hinges on answering the question that has vexed global markets for more than a year and sunk two securities firms: What’s a bad mortgage worth?

I had fun watching the Republican senators squirm as they figure how to react to this “financial socialism” being peddled by their own party. These are the same politicians who, like Bush and McCain, are strong advocates of minimum regulation of business. Yet, here before them is precisely what happens when a near hands-off policy of the Bush administration allowed the bad boys of Wall Street to wreak havoc not just on the American economy but on the world’s.

What happens next means more to me than just an observer of the collateral damage from the global fallout. When my family made a decision to buy a modest townhouse in California instead of my daughter continuing to pay rent some years ago, I didn’t realize we were about to become part of this historic economic misadventure. We didn’t have an extensive credit record there, so I volunteered to help out with a down payment. As it turned out, I shouldn’t have bothered because mortgage agents were more anxious than we were in closing a deal.

What we ended with is what they call an ARM or adjustable rate mortgage. Silly ol’ me thought the rates adjusted with the market. As it turned out, we got a very low teaser rate and after a while, the rate started climbing with no regard to the market rate. We had to refinance at a fixed rate for 30 years. Two months after, the housing bubble had burst and banks were not as friendly.

Less fortunate Americans started getting thrown out of their homes because they cannot afford the ever escalating ARM payments. In fact, many of them couldn’t afford to buy a house, period. But the mortgage agents didn’t care because they got a commission whether they referred clients who could afford to pay a mortgage or one who couldn’t. They would even help out with a “liar’s loan” where a loan applicant of dubious credit worthiness was allowed to provide sham documentation that no one bothered to check.

It seems the banks didn’t care either. They bundle those loans off to the smart guys on Wall Street who used their financial wizardry to transform these crappy mortgages into new marketable securities. They work on the principle that individually, these may be pretty crappy loans. But if pooled together, only some go bad. The other assumption is that housing prices only go up so even the bad loans can be foreclosed at a profit.

These new securities are called CDOs or collateralized debt obligations. CDOs are an unregulated type of asset-backed security and structured credit product. These assets are divided into tranches: in layman’s terms — the good, the not so good and the ugly. The good gets paid first in case of a default, the not so good next and the ugly last. In terms of interest paid, the good is paid the lowest interest, the not so good, better interest and the ugly gets a fat interest rate.

They buy bond insurance for the good tranche and the not so good, enabling them to end up with AAA to BB ratings. They then sell these to sophisticated institutional clients like insurance companies, banks and school boards who are looking for high quality and safe investments. The ugly, the issuers keep and pay themselves a high interest rate for taking on the risk.

The CDO issuer, possibly an investment bank, then protects its own balance sheet by setting up shell companies in the Cayman Islands to take ownership of the smelly mortgages. These companies come with a fancy name: SPV for Special Purpose Vehicles.

When the shit finally hits the ceiling, no one really knows who to run to. Everything had been sold and resold a number of times and no one knows who is holding what. As delinquencies and defaults on subprime mortgages occur, these CDOs get severe rating downgrades as what happened recently. As a result of these downgrades, valuations for these instruments have dropped sharply. Banks and investment funds holding CDOs may also find it difficult to assign a precise price to their CDO holdings.

What follows next is the core of the problem: a large capital hole in the financial system.  A toxic brew of mortgage securities held by the big boys of Wall Street is underpinned by housing assets that are falling in value and have to be written down. Interbank lending has dried up as banks worry about the health of the other bank’s balance sheet.

As confidence in the system evaporated, the crisis spread to other non financial businesses who now find it difficult to get credit. Paulson and Bernanke hopes that by buying the toxic assets from affected banks, banks will be able to fix their situation enough to start lending again. But experts say it’s not guaranteed the plan would make that happen.

Paulson and Bernanke warned that if Congress fails to pass the bill authorizing the $700-billion bailout, “heaven help us.” Two questions are on the minds of every member of Congress: What if Paulson and Bernanke are right? What if they are wrong?

Truthfully, no one really knows how to go. They can number crunch all they want but as more and more economists are finding out, human behavior is difficult to reduce to a formula or a mathematical model. As Bernanke told the congressional hearing, it isn’t economics anymore… it’s more of psychology. Congress can act one way or another and there should be an even chance that they could be right or wrong whatever they do.

With a presidential election in six weeks, there is no margin for error. So the drama in this telenovela continues. I am resigned to moving my bedtime well beyond midnight as I savor the suspense playing out live on my cable business channel. It beats soap opera because it is all for real.

Bush economics

From the Jay Leno show.

“You know, I’ll tell you, once again, I don’t think President Bush gets it. He doesn’t really understand these economic issues. Like today, he was asked if customers should be concerned by all these bank closings. And Bush said, ‘If the bank is closed, you just use the ATM.’”

Boo Chanco’s e-mail address is [email protected]