Markets Need More Than Random Acts of Congress: Caroline Baum

Commentary by Caroline Baum

Oct. 6 (Bloomberg) — What next?

Now that both houses of Congress and the White House have agreed on a $700 billion financial-institutions rescue adorned with enough ornaments ($150 billion) to break the boughs of a 15-foot Christmas tree, we can get down to business.

Will it work?

“We’ll feel good for a while, and the markets will react positively for a while,” said William Isaac, former chairman of the Federal Deposit Insurance Corp. and currently chairman of the Secura Group, an LECG Co. “The main problem, aside from spending $700 billion wisely without good controls, is it does not address the fundamental question affecting the banking system of who is going to fail, and will the creditors be taken care of.”

Until now, the decision on the treatment of creditors has seemed fairly random. (If there was a method, it wasn’t obvious.) Washington Mutual Inc.’s bondholders were wiped out when the thrift was acquired by JPMorgan Chase & Co. last month. Wells Fargo & Co.’s offer for Wachovia would keep the bondholders whole, along with all the bank’s businesses and obligations.

Bear Stearns Cos.’s creditors were protected when the Federal Reserve coughed up $29 billion to seal the deal with JPMorgan in March. Lehman Brothers Holdings Inc.’s were left out in the cold.

Isaac said the FDIC has tools at its disposal just waiting to be activated. It has a “net worth certificate program to provide a capital infusion to banks considered viable if they are given more time,” he said. “That hasn’t been done. And it doesn’t need congressional authorization.”

Emergency Request

Second, the FDIC can declare an emergency, enabling it to protect all general creditors of banks, not just the insured depositors, during this period, Isaac said. All it would take is a “request from the Treasury.”

Alas, instead of acting calmly and confidently to reassure the markets and the public, Treasury Secretary Hank Paulson told Congress on a Thursday he needed legislation that weekend.

One week ago, the House voted down the measure by a margin of 228 to 205. Editorial pages, both left and right, wagged their fingers at the nay-voters, accusing them of irresponsibility and a failure to put partisan interests aside and cast a vote to save Western Civilization.

It took years for the financial system to deteriorate to a dysfunctional state. How could Paulson expect 535 legislators, all padding on the pork, to fix it in three days?

Besides, it wasn’t about doing nothing. With credit markets frozen and major banks falling by the wayside, it was clear the government had to do something. The only question was, what?

Better Mousetrap

There were much better ways to stabilize the financial system without turning the U.S. Treasury into the largest hedge fund extant. No one in Washington wanted to listen.

Former U.S. Treasury Secretary Paul O’Neill tried, only to have his calls unreturned. His idea was to guarantee the troubled assets instead of buying them, in the same way the government chose to guarantee money-market funds to stop the exodus.

“A guaranty, provided at the price at which the Secretary is prepared to deliver cash, is the same as cash but it doesn’t transfer ownership to the government,” he said in an e-mail this week. “Ownership stays with the private holder, and in the longer term it avoids the need to try to reinsert this paper back into the market. There is no capacity in the government to manage a $700 billion portfolio.”

Michael Aronstein, president of Marketfield Asset Management in New York, had another idea: Allow financial institutions to fund selected mortgage-related assets for a term of three years. “Get them financed in a way that isn’t volatile,” he said.

Calling John Galt

The Fed could exempt these assets from inclusion on the asset side of the balance sheet, thereby obviating the need for capital to be held against them, he said. “This doesn’t allow the poor decisions of the holders to be fully jettisoned, but it does give them a window without having to sell or mark to market,” Aronstein said.

Instead, we have the 451-page Emergency Economic and Stabilization Act of 2008, which is something right out of Ayn Rand‘s “Atlas Shrugged.”

The legislation won’t arrest the plunge in home prices. There are too many homes and not enough buyers. To the extent that taking banks out of their bad assets gives them the wherewithal to make new loans, it may help at the margin.

At the same time, the economy is souring fast, and the pace of job losses is accelerating. Non-farm payrolls fell 159,000 last month, the ninth consecutive monthly decline. Private payrolls have fallen for 10 straight months. Rising unemployment will only exacerbate the problem.

Pork Fest

Banks aren’t going to extend credit to potential homeowners who don’t have a job, a good credit history or the ability to make a down payment.

Nor does the rescue address the issue of inadequate bank capital. No wonder the stock market, the ultimate arbiter of all things financial, wasn’t thrilled. The Dow Jones Industrial Average fell 157 points Friday following the House passage of the bill, erasing an earlier gain of 313 points.

Just look at the bright side. Without the $700 billion rescue as a host organism, parasites such as a 39-cent excise tax exemption on children’s wooden arrows never would have become the law of the land.

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