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Tuesday, March 24, 2009

A contrarian view on Obama's bank bailout and spending plans

The stock markets might like it – but who wouldn't like the government giving them a few hundred billion ?

by StFerdIII

The stock markets rallied in one of their biggest gains in history, on the news that the US government under the benign leadership of Prophet Obamed had developed a plan to eradicate toxic US bank debts. It is not surprising that the markets rallied on the news – which industry would not gladly receive $100 billion or more in government bailouts and handouts ? What is more surprising is the lack of analysis by the 'market' or the mainstream media on the Prophet's plan. When scrutinized it becomes clear that this plan will do very little to alleviate US bank woes. It might actually make them worse.

The plan by government to 'save' US banks is pretty straightforward. Banks have bad debt premised on bad mortgage loans and securities. The government will work with the private sector to buy off this debt. Once relieved of this debt the banks will start lending. Once they start lending the economy will expand. As money flows into the economy, firms and people will take on more debt and buy more products. Once they occurs, we will be in happy-land.

Plan in skeleton:
-Governments will use $100 billion and probably a lot more, to buy bad bank assets in conjunction with the private sector

-Governments will own about 75% of the toxic portfolio and the private sector the rest. The actual government and taxpayer guarantee will be given by government agencies such as the Federal Deposit Insurance Corporation and Treasury. The private sector will only be adding 6% to the purchase of the assets:

“FDIC would guarantee 72 cents in funding for an asset purchased for 84 cents on the dollar. The feds and private investors would each put up six cents in capital. If the asset rises in value over time, the taxpayer and investors share the upside. If it falls further, then the taxpayers would absorb by far the biggest chunk of the losses. Better hope the recovery really is, as the White House says, just around the corner.” [WSJ]

-The initial $100 billion might grow depending on the extent of the toxic assets which need to be bought

-The idea is that if the value of the asests grows, the taxpayers and private sector will make profits.

It could be worse – but there are a number of major issues with this program that make it in various degrees, too small; too restrictive and too interventionist:

1.The total amount of US Bank bad assets is estimated to be $1 to $ 3 Trillion in total.
2.Many analysts see housing prices declining by another 20-30% which would mean that the toxic bank debt will only get worse.
3.If banks follow this plan they might actually have to disclose the real value of their diminished assets – resulting in yet another sell off of bank stocks and a public panic over their solvency.
4.The original $100 Billion would need to be increased 10 fold to deal with what is perhaps the real level of bad assets inside US banks.
5.This would mean another $1 Trillion US tax payer bailout to buy off bad mortgage based securities.

Other problems with the plan include the obvious objections:

1.If house prices go down the taxpayer funded bailout will lose money
2.If the government is involved most savvy investors will not participate – why would anyone trust a government which is ferociously advancing the role and scope of the state, with their private money?
3.As time wears on the government can change the rules and wipe out the owners of this debt.
4.At what point will this program be wound down and how ?
5.Why are bad banks and bad managers being rewarded and saved ?

It would be better simply to mark down the assets to market, write them off and then restructure the banks. If some banks go into bankruptcy, than the law will protect the firm, the deposits and its workers, as the bank goes through a restructuring. It would punish wrong doers; inept managers and greedy banks. It would send a clear message to the banking market and its executives – when you screw up, when you defraud, when you engage in debt manipulation, you will be punished.

In summary this banking package will not save the banking system. It will only be a costly failure which will only delay the inevitable restructuring of the banking system, banks and the executives who manipulated the markets and who should not be receiving anything but congressional investigations and jail terms.