And No One Outside Wall Street Executive Suites Likes It

For years now, many enlightened financial observers have been warning that the national debt was a ticking time bomb. Guess what? The time bomb has exploded.

But the so-called geniuses on Wall Street didn’t see it coming, did they? Apparently they were far too impressed by their own financial theories, “innovations” and models, not to mention extremely lucrative salaries and bonuses.

And the response of the global markets (and the DJIA itself) to the Great Bailout Fiasco of 2008 has been anything but enthusiastic. Even before the failed vote in Congress just now, the FTSE had already plummeted …

… the Hang Seng Index in Hong Kong had slumped …

… and virtually every other major stock market that counts including Europe (France and Germany), Japan, and Canada (our biggest trading partner) went nowhere but downwards.

Even traders on the NYSE know a financial turkey when they spot one, especially once Congress failed to assemble enough votes to pass it.

Some of America’s closest Western allies and trading partners have been particularly scathing.

Canadian Prime Minister Stephen Harper, who is currently running for re-election on October 14, has come forward and said, “A lot of things have gone wrong here and, by the way, there were a lot of warning signs. This should not be a huge surprise. I certainly had expressed my concerns about some of these things to my American counterparts in the time leading up to this.”

The rest of the Group of Seven (G7) industrialized nations have also been less than complimentary over the way the U.S. financial system has been managed.

French President Nicolas Sarkozy recently raised the idea of a November summit of the world’s major economies to rein in America’s “mad system” and establish “principles and new rules” to regulate financial markets and punish those who “jeopardize people’s savings.”

German Finance Minister Peer Steinbrueck last week also claimed that the “Anglo-Saxon” model of banking has “an exaggerated fixation on returns.”

On the whole, U.S. allies have refused to back Treasury Secretary Henry Paulson’s $700 billion rescue plan. This is despite their own problems which have snowballed over the weekend. Major Belgian-Dutch financial services firm Fortis has been partly nationalized by Belgium, the Netherlands and Luxembourg via a EUR11.2 billion ($16.3 billion) bailout following fears that the European giant was on the brink of insolvency following large credit-related write-downs.

The British government was also forced to nationalize mortgage lender Bradford & Bingley due to that firm’s risky $91 billion mortgage and loan portfolio.

But what stank so badly about the now-failed plan that Congress couldn’t bear to pass?

A 228-205 Failure As Congress Rejects The Bailout Package

Despite enormous pressure from the Treasury, the Fed and the White House, the House of Representatives voted to reject the $700 billion rescue package even though supportive House leaders kept the voting period open 40 minutes past the allotted time in a failed attempt to convert “no” votes to “yes” votes by pointing to damage being done to the markets.

It would seem that despite all the screaming and fear-mongering, congress is not entirely convinced that the credit freeze will actually drag down not just Wall Street investment houses but also the savings and portfolios of millions of working Americans.

Or at least, they want a far better deal than the one that was forced onto their laps with such haste. Even though the latest deal was supposedly strengthened by new taxpayer safeguards, there were still key problems about accountability and cost.

One of the things that stuck us as most peculiar was this section:

Section 135. Preservation of Authority.

Clarifies that nothing in this Act shall limit the authority of the Secretary or the Federal Reserve under any other provision of law.

This sounds awfully dictatorial to us despite so-called safeguards in the form of the Financial Stability Oversight Board (charged with ensuring that policies protected taxpayers and were in the economic interests of America) and a congressional oversight panel (charged with reviewing the state of financial markets, the regulatory system and the Treasury’s use of its authority under the rescue plan).

Further problems:

The SEC retained the ability to suspend mark-to-market accounting rules on a case-by-base basis, leading to all kinds of potential abuse due to lobbying and favoritism. Essentially, some banks would have been forced to report excessive losses (and then driven into bankruptcy) and others would have been allowed to “fake” solvency long enough to survive. There have already been a lot of fingers pointed as to why Lehman Brothers was allowed to fail completely and other institutions (such as Merrill) were allowed to merge with a suitor. This package would have magnified that conflict of interest immensely!

Also, Paulson could have chosen to buy assets from any financial institution that does business in the United States (including pension funds and even foreign central banks!) with wide discretion over what he could buy and how much he could pay.

And don’t forget that if this had passed, another $2,300 would have been added to your share of the national debt, with all bailouts potentially amounting to a staggering $1.8 trillion (or $15,000 per US household).

Where To From Here?

It won’t take long before Paulson comes up with another version of his plan. What could he do to make it more appealing to U.S. politicians and taxpayers? He might want to take a look at what Sweden did in 1992.

After years of ineffective regulation, short-sighted economic policy and a property boom that was going bust, Sweden was faced with a major financial crisis of their own, one very much like the one facing America right now.

But the Swedes didn’t just bail out its banks and investment houses by having the government take over bad debts, they forced all banks to write down losses and issue warrants to the government. In turn, the government announced that the state would guarantee all bank deposits and creditors of the nation’s banks, formed a new agency to supervise institutions that needed recapitalization, and created another agency to sell off mainly real estate assets originally held as collateral.

The government became an owner and when distressed assets were sold, the profits flowed to taxpayers including final payouts as the banks were taken public once the crisis was over. No banks were spared unless they wanted to find their own way out of the mess, and several subsequently decided to preserve their shareholder equity by arranging their own recapitalizations. Even so, the government seized a large proportion of the country’s banks and drained share capital before injecting cash.

The plan cost 4% of the country’s GDP (as compared to 5% of U.S. GDP for the now-failed Paulson Plan) and the final cost was less than 2% — perhaps even zero depending on rate of return calculations! — once all positions were wound up. The country was back on its feet in record time with minimal damage to its reputation and economic viability.

Now how’s that for a vastly improved plan?

However, it remains to be seen if our own government will have the will and the integrity to implement a similarly tough program. We can only hope!

Good investing,

Nick Thomas
Analyst, Oxbury Research