Epic Failout and Thoughts On Moving Forward

So the news comes that the bailout package has failed to pass the House with 133 Republicans and 95 Democrats voting nay.  Well, at least it was a pretty bipartisan fail.  I’m sure we will be treated to much sound and fury from the talking heads and the chattering class as to why, who’s to blame, and so on.  At the same time, things are going to get worse before they get better, so I expect something new to come down the pike any day now.

I would like to recommend three immediate things that Congress and the Administration can do to buy some time while they work towards a more comprehensive solution that can survive a vote.  What we need now is time more than anything else, so all three suggestions are geared towards things that they can do in the next couple of days.

1.  Suspend the mark-to-market accounting rule for 90 days.

The bailout package included a provision that would have enabled the SEC to suspend the mark-to-market accounting rule:

A provision in the bill, whose adoption was in doubt after the House of Representatives rejected it Monday, gives the Securities and Exchange Commission the right to suspend — by rule or order — mark-to-market accounting under Statement Number 157 of the Financial Accounting Standards Board.

While the article linked to above shows that there are some powerful and influential people (among them Arthur Levitt, former chairman of the SEC) who are against suspending mark-to-market rule, I believe that as a short-term, breathing-room measure, it makes sense to do so.  Hence, I would do it for 90 days.

I want to make clear that I’m not against mark-to-market rule in general.  There are lots of good reasons to have this rule.  But I do agree with Jeff Miller on TheStreet.com that there is a difference between a normal market and a panic-driven, illiquid one.

Furthermore, while mark-to-market in and of itself may not be a major problem, when combined with reserve requirements of banks and other financial institutions, it can become a catalyst for meltdown.  Say a bank has to hold 10% of all deposits as reserve requirements (the Fed can set it between 8% and 14%).  If mark-to-market rules require a significant writedown of assets, such as mortgage paper, then the bank comes under enormous pressure to sell assets to keep its reserve requirements up.  That in turn induces further declines in asset prices, as paper floods the market, which in turn runs into reserve requirements, and so on.  That’s a pretty crappy feedback loop.

I had the opportunity to speak with someone who should know some facts (he’s a representative of one of the largest foreclosure-related companies) recently, and he pointed out that some 95%+ of mortgages in the U.S. are absolutely fine.  The debtors are faithfully making their monthly payments.  Some of these mortgages were combined with subprime mortgages and other more dubious debts into exotic mortgage-backed securities and sold — the source of many of our problems today.

With a bit more time, analysts can begin to delve into the morass that is CMBS and CDO and other instruments and start to figure out which ones are good and which ones are bad.  That in turn creates folks willing to buy mortgage securities at deep discount.

Plus, that bit of time can give the legislators and regulators time to work with industries to come up with a stronger, less interventionist, program to help deal with the crisis at hand.

2.  Rein in the breathless media

While the First Amendment prevents any direct government action to restrain the media, certainly the various leaders from the President to the Speaker of the House to the candidates for various offices can step up and act like adults.  They can explain to the nation that while we do have some problems to work out, that (again) 96% of mortgages are not in default, that people are still making their monthly payments, and that the problem can be dealt with.  Someone needs to point out — and directly contradict the breathless press reports of doom and gloom — that the fundamentals of the economy are (were) pretty decent.  Employment is still high, Q2 of 2008 showed a 4.3% gain in productivity, and things just aren’t that bad.

The whole situation, to some extent, was a creation of the media.  Part of the short-term solution needs to be putting the idiots running our newsrooms in their place.

It is no secret that most business and finance journalists have absolutely no idea what the hell they’re talking about.  Business leaders, economists, and others who do know need to step up now and start speaking up directly to the American public.

3.  Trial Run of Insurance Plan

While it would be great to have a single bailout package that calmed everyone down, without turning into a fascist/socialist state, I’m afraid it’s going to take some time to get done.  Why not try a trial run of the least-intrusive plan, that of the House Republicans?

Of course, it would be helpful if the “patriots” on the Left would stop playing partisan politics for a moment, but I think the Democratic leadership could probably make that happen if they wanted to do so.

Again, as a short-term measure to buy time and create breathing room, why not go forward with a $10B or so plan to insure “toxic assets”?

The “insurance” plan works by creating incentives for private market participants to take the risk of buying mortgage securities, because if they go into default, the insurance pays off.  But until they go into default, there is no massive cost on the part of the insurer (aka, the government).

The thought appears to be that offering to insure “toxic assets” might provide enough incentive for private entities to start going bargain hunting.  Again, with 96% of all mortgages safe and sound, it seems like a great time to go buying up mortgages for pennies on the dollar.  Insurance adds a layer of risk protection that further incentivizes private market players.

If the first $10B worth of securities are federally insured, and those securities get snapped up by the market, then the program can be expanded.  If they all go into default, then the losses to taxpayers is limited to $10B or so.  Seems like a low-risk approach to take that will have the effect of reassuring the credit markets that there are indeed buyers out there, if the risk/reward is low enough.  Again, while that is working its way through the market, legislators have time to work on the bigger package.

Breathing Room

This whole affair really reminds me of a Chapter 11 bankruptcy filing.  Contrary to popular imagination, there are situations where companies go into Chapter 11 (Reorganization) bankruptcies not because their business is fundamentally screwed, but because they experience short-term cashflow problems.  They may have customers, may have a valuable ongoing business, but due to loan covenants and the like, they face going out of business.  Seasonal companies, such as retailers, or big-ticket sellers (who may have $50m in outstanding invoices, but only $2m of cashflow) often face problems like this.

Oftentimes, they go into pre-arranged bankruptcies to buy some breathing space while the business works itself out.  Lenders are happy, as they get to reorganize the debt and get paid, instead of having to liquidate at cents on the dollar.  The business keeps going, the employees keep getting paid, etc.

What we need now is that pause, that breathing room, while Congress and the White House get together again and try again for a more comprehensive bill.

I think the three things above could help, not in the permanent solution, maybe, but certainly in the short-term (say the next 90 days or so).

Or… I could be dead wrong.

-rsh