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How Congressional Democrats Can Pass the Paulson Plan and Dodge the Bullet

Henry Paulson: Greatest Trader Ever?

We’ve all now been debating the Paulson mortgage-bailout plan for over a week now. We’ve been told endlessly that rapid passage of this plan is necessary to prevent an imminent meltdown in financial markets. That is actually not untrue.

But we’ve been told nothing to dispel the now widely-held perception that this bill calls for an immediate transfer of $700 billion (more than the Pentagon spends in a year) from the pockets of ordinary Americans into the coffers of a very wealthy few.

If that were true, I’d be marching in the streets in protest against this bill, too. In truth, the extensions that Democrats have added to the bill as their price for rapid passage, are much more accurately described as a transfer of wealth to a favored few, including some hard-left political activist groups.

The Democratic amendments that re-direct the profits from the bailout need to be stripped out of this legislation. And Congressional Republicans are the people who need to make that happen.

But let me tell you more about what the real Paulson Plan, not the fictitious one being reported by the media, specifically does. As you’ll see, if it works out, it could make Secretary Paulson the greatest trader in world history.


The bailout plan authorizes the Treasury Secretary (whoever that person will be after next January) to raise up to $700 billion for the purpose of purchasing mortgage-backed assets.

The money for the purchases will come from new issues of Treasury debt. Global investors, who have shown no reduction in their desire to lend money to the Treasury at low interest rates, will be the source of funds.

So where is the taxpayer liability in all of this? There’s no direct taxpayer liability. We’re basically adding another $700 billion (about two years’ worth of Federal deficits, at current rates) to the national debt.

But this is actually a little different. We’re not using borrowed money to buy infrastructure at prices overinflated by labor-union wages, or pork-barrel spending, or handouts to groups like La Raza and ACORN.

We’re using the borrowed money to buy up the mortgage notes of many American homeowners. The vast majority of those mortgages will not go into foreclosure. Most Americans will keep paying every month, right on schedule.
There are many toxic mortgages out there that will go into default over the next two years or so. The presence of these accounts for the fact that many mortgage-backed securities now owned by banks and Wall Street firms are worth far less than 100 cents on the dollar.

The Treasury proposes to buy up the notes at a price well below par, but probably somewhat above their current market. As Chairman Bernanke pointed out, today’s low market prices reflect the fact that the only private investors now in a position to buy these securities, are “vultures.”

Vulture investors are using what bond-market people call “real money,” meaning unleveraged money. They must use low leverage ratios, because there’s basically no leverage available out there, due to the credit-market freeze-up.

Therefore they must pay prices far below what the sellers are willing to accept. That’s why the secondary MBS market is so dysfunctional.

The Treasury plan is intended to enter the market with a bid that should be much more acceptable to sellers.

So think about what the Paulson plan actually is.

It’s a leveraged purchase of mortgage-backed securities, using an extremely stable, relatively low-cost source of funds (Treasury borrowings in the belly of the yield curve, backed by the full-faith-and-credit guarantee). The purchase will be executed at a favorable price, by a buyer that has the financial strength to hold the portfolio to maturity, if necessary.

Speaking as an old trader, this has the makings of a great trade, a historically-great trade.

The cash flows from the mortgages will fund the coupon payments to global investors, and the MBS payoffs at maturity will very likely be higher than the purchase prices. Five to seven years from now, the $700 billion in Treasury bonds will mature and be paid off. And the nominal return to taxpayers will most likely be a positive number.

There’s no net liability to the taxpayers. There is no long-term encumbrance to the capital position of the United States. The only challenge is that some amount of global investor dollars may be less available to fund the vast expansions of government programs that Barack Obama has promised, if he were to be elected President.

And the net potential upside in raw dollars, to be realized over five to seven years (the typical duration of a mortgage-backed security), may in fact be larger than one trillion dollars. Forget about George Soros. This deal could make Hank Paulson the greatest trader in history.

Unlike your typical private-sector leveraged buy-out, Treasury has no need to make a pretax annual profit of 15 to 40 percent on this deal. The investment objectives of the bailout will be met if they do no better than break-even. That’s another reason why only the Treasury is in a position to make this trade.

And this is such a favorable trade that, I predict, global investors like central banks and sovereign wealth funds, will be lining up to lend us the money.

So what could mess it all up?

The Democrats in Congress could mess it all up. We’ve already seen that they have larded up the legislation with mandates to spend any revenues from the bailout on programs like foreclosure relief, aid to cities and states, and funding for so-called community activist groups, like ACORN and La Raza, that actually don’t share the values of a majority of Americans.

But spending the profits from the bailout on anything (much less on politically-odious projects) undermines the logic of the trade. All of the cash flows from the bailout must go to coupon payments on the borrowed $700 billion. All of the at-maturity payouts must be used to retire the borrowed money and get it off the balance sheet of the United States.

Otherwise, Congressional Democrats like Nancy Pelosi, Harry Reid, Barney Frank, and ACORN-attorney Barack Obama, will have converted the greatest trade in history into the greatest expansion of national debt in history.

Congressional Republicans MUST insist on the removal of all of these earmarks as their price for signing on to the legislation.

And they can do it, too. The American people are so overwhelmingly opposed to the bailout plan that Speaker Pelosi dares not pass the bill without Republican support.

In fact, she has stated that her price is at least 75 Republican votes, or 100 if she can get them.

Democrats know that financial markets continue in an exceptionally precarious state. They have to pass this legislation as soon as they can, ideally before the end of the weekend. Every senior Wall Streeter I talk to is using phrases like “very stretched,” and “can’t hold out much longer.”

The Republicans are therefore in a strong position to ensure that this bailout retains its potential to be the greatest trade in history, rather than one of the greatest expansions of national debt in history.

The latter would be the outcome, if the Democrats are able to ensure that the profits from the trade will be spent rather than returned to investors.

Republicans must insist, as the price of their support for this bill, that all of the provisions which direct that bailout proceeds will be spent on any particular program, should be stripped out.

-Francis Cianfrocca

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