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What Happens If There’s No Bailout?

Handicapping the Downside

Yesterday morning, the new week started off on a hopeful note in world financial markets, as all eyes turned to the action in the US Congress. Secretary Paulson and Chairman Bernanke had managed to create enough fear among lawmakers to convince them that a large emergency bailout is needed, in order to repair the balance sheets of banks, Wall St. firms, and other financial intermediaries.

The mood darkened throughout the day as it appeared increasingly likely that there will be no deal in Congress, and no bailout. I’m going to fill you in on the flaws with the deal as currently proposed, the political action in Congress and elsewhere, and what happens if there’s no deal.

The Paulson/Bernanke bailout plan is called “TARP,” for Troubled Asset Relief Program. I’ve given you the details here and here.

Reactions to the plan from politically-minded people have been uniform, and uniformly mindless.

Conservatives: “It’s all Clinton’s fault! No bailout! That’s socialism!. [But the commercial paper market may freeze up, the company where you work may not be able to operate, and your paycheck might bounce.] Hmm, umm, well, ahhhhh, umm… No bailout! That’s socialism!”

Liberals: “See, I told you free markets don’t work. Now I want to talk about foreclosure relief, federal aid to cities and states, increased funding for ACORN, and limits on executive compensation, in that order.”

Reactions from people who actually understand economics and markets have also been uniform. The glaring defect in the plan as proposed relates to valuation.

The objective is to create a bid for mortgage-based assets that are owned by financial firms, and which were purchased for more than they’re worth now.

In many cases, these assets are being carried on firms’ books at values above the current market (which is ragged and illiquid). This makes firms reluctant to sell the assets because they will then be required to realize large losses to capital, which in extreme cases can put them out of business.

There is also a great deal of fear that there will be many open-market transactions in distressed assets (perhaps by people who are forced to sell because of margin calls). By current accounting rules, that will force even firms that don’t sell to recognize the new lower prices when valuing their own portfolios.

All of that has conspired to freeze up the secondary market for mortgage-backed securities. And behind it all is the worry that when the losses are finally recognized, someday, somehow, a great many firms will be revealed to be insolvent.

But market participants have no need to wait for that day. They can sell first and ask questions later. In a nutshell, that’s what’s been happening these last two weeks, leading to the bankruptcies or forced sales of some of the titans of the industry.

So the most important questions for Paulson are: What will be the value at which you will purchase these distressed assets? Who will make the decision, and how will they be compensated?

These are the critical questions because they illuminate the underlying policy objective.

Does Mr. Paulson intend to systematically purchase MBS at higher prices than current market values would suggest?

This would save Wall Street’s bacon. A great many firms would be relieved of the burden of their past errors and mismanagement, and would get a fighting chance to stay in business and attract new capital.

Is that fair and right? No, it’s not. It would also put the taxpayers in a position to absorb Wall Street’s losses, through higher taxes, higher inflation, or both. (Politically, of course, this is dynamite.)

But what if Mr. Paulson’s intent runs the other way? What if he means to value his MBS purchases fairly, or to undervalue them? That will force the pain to be borne by the firms that made the bad decisions and took too much risk.

Is that fair and right? Yes, it is. But it will also force many of these firms out of business. And that would have severe follow-on effects in world markets, as a cascade of liquidations cause asset values to collapse across the world. More than one analyst has suggested that we could see a 25% drop in the US stock market, or worse.

Pick your letter of the alphabet. If we socialize the MBS losses by overvaluing the purchases, we face an “L-shaped” recovery: a long period of very slow growth, and a lot of pain for consumers. (Think about how Japan dealt with their real-estate/bad-loan crisis in the Nineties.)

If we force the financial firms to take the medicine, the recovery is “V-shaped”: a vertiginous plunge to far lower levels from here, with wreckage and busted financial firms all over the world, but (very likely)with an equally sharp and fast recovery, as capital floods back in from the sidelines.

So does the Paulson plan make any sense at all, if it’s not done at an overvaluation? Many have suggested that it does not, because that would do nothing more than recognize current reality.

But it does make sense to do the bailout. We need to perform the purchases of MBS either at a fair valuation or at an undervaluation. Because, as with the Resolution Trust Corporation, that will give the authorities time to control the process and work everything out carefully, perhaps over the next two years.

Under ideal conditions, this would give us a “U-shaped” recovery. It would avoid panic selling and market destruction in the near term , which is what we’ll get if Congress fails to act.

But it also avoids shafting the taxpayers, the consumer economy, and the financial firms that managed risk prudently and deserve to stay in business.

That’s the correct way to approach this process. And it’s the deal Congress should pass this week.

Instead, the perception is growing in financial markets that the deal will die in Congress. The culprits: Republicans who are dead-set against a bailout on principle, and Democrats who are seeing a chance to jump-start their plans for the government to take over the economy and run it in a corrupt way.

If there’s no deal, there’s no upside for Republicans. (Other than being able to cry in their beer that they fought the good fight.) For Democrats, there is significant upside because they can blame the coming financial-market crash on the Republicans. That charge will stick because ordinary people have no clue what’s really going on.

I’ll let you decide for yourself which side is being stupid, and which side is being evil.

Here are my bottom lines:

**Mr. Paulson: Come clean. Give us your view on the valuations, who will set them, and what their incentives will be. Are you trying to save your friends on Wall Street, or the rest of us on Main Street?

Members of Congress in both parties: Get your heads out of your lower intestinal tracts and do the people’s business for a change.**

-Francis Cianfrocca

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