Are we buying a $700 billion 'maybe'?

In practice, that gives financial companies a huge amount of wiggle room, because the rules also allow the companies to decide what fair value is depending on what they intend to do with the assets in question. So if a financial company holds a mortgage-backed security and says it is part of an actively traded portfolio, then it must mark the price of that asset to its market value. That is, if someone sells a credit-default swap at 60 cents to the dollar and that swap is similar to the Universal Amalgamated credit-default swap Goldman holds in its trading portfolio, then Goldman is supposed to write down the value of the swap that it holds to 60 cents on the dollar. Supposed to.

The rule has a lot of wiggle room, though, because most derivatives are handcrafted agreements between parties, and investment banks have been known to argue that what they hold is different from what just traded.

Watch 'em wiggle

But the rules have even more wiggle room for institutions that don't trade as much as Goldman Sachs does. So, for example, if the company says an asset is "intended for sale" but is not actively traded, the company marks down the value of the asset on its balance sheet but doesn't have to recognize the write-down when it reports earnings. If the company says it intends to hold an asset to maturity, then it doesn't have to mark it to market at all but can carry it at cost. Assets held to maturity are supposed to be written down when they are impaired -- for example, when a borrower falls behind on payments. And they must be written down in the event a company is acquired.

What all this wiggle room has done is to leave financial companies with huge discretion in how aggressively they've written down the value of their portfolios in this crisis. Goldman Sachs, for example, has been aggressive in marking its assets to fair market value. At the end of 2007, according to Fitch Ratings, it had marked 86% of its portfolio to market. Merrill Lynch (MER, news, msgs), Morgan Stanley (MS, news, msgs) and Lehman, on the other hand, had marked less than 50% of their portfolios to fair value. Some European financial companies, including Deutsche Bank (DB, news, msgs) and Credit Suisse Group (CS, news, msgs), had been nearly as aggressive as Goldman. According to Fitch, Deutsche Bank had written down 75% of its portfolio to fair value as of the end of 2007.

But the big commercial banks have lagged well behind Goldman Sachs and Deutsche Bank. At the end of 2007, HSBC (HBC, news, msgs) and Citigroup had written down only about 40% of their portfolios to fair value. Bank of America (BAC, news, msgs) came in around 30%, according to Fitch.

Why does this matter? Because if the bailout plan is put in place, once a CEO goes to the Treasury to sell toxic assets, those assets will get an immediate markdown to market value, plus or minus whatever premium or discount the Treasury is paying. That would be a huge problem for financial companies that were still carrying the majority of their damaged assets at well above market prices.

A financial company could go to the Treasury with an asset that was on its books at 80 cents to the dollar, find that Paulson & Co. were being very generous with taxpayer money and paying a premium of 15 cents on top of the market price of 40 cents on the dollar and still walk away with just 55 cents on the dollar. That would be a whole lot better than getting just 40 cents on the dollar, but that 55 cents would still be far below the 80 cents the company had claimed before it went on its journey to the Treasury.

And that drop from 80 cents to 55 cents could blow a huge hole in a financial company's balance sheet. In a worst-case scenario -- and there are a lot of worst-case scenarios out there these days -- the hole would be big enough to force the company to go to the financial markets to raise capital. Of course, that's exactly what the financial company CEO was trying to avoid in the first place, because if the company could raise capital at anything short of a ruinous price it would have already done so.

The Fitch Ratings numbers are by now out of date, but I think the trend they expressed in December still holds. A lot of banks have been fighting desperate rear-guard actions to avoid write-downs to fair value. Some of them wouldn't be able to afford to go to the Treasury bailout window. How many? I don't have any estimate of the number, but I can guess where the damage would be: in the smaller community and regional banks, the same ones that were slammed so hard when the Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) preferred stock they held went to zero after Washington took over those companies.

In the second quarter, the Federal Deposit Insurance Corp., or FDIC, had 120 or so banks on its watch list. That's up from 61 in the second quarter of 2007 and 90 in the first quarter of 2008. None of those banks could take a government bailout offer without raising the odds to near certainty that it would have to merge or go under. I don't have any idea how many banks would face a similar choice between a quick death or a lingering one.

A fix, maybe -- and then what?

The number of banks in that situation would determine the success or failure of the bailout plan. If too many banks were in the high-risk category, the plan would fail because of a lack of participation, and the crisis would drag on with toxic assets of unknowable value still clogging the financial markets. The Treasury and Fed would have made the money available but found too few takers to get the system working.

If the banks facing the death/death alternative were relatively few and their role in the financial system was highly contained, the plan would work. The FDIC would have to arrange for the takeover of the assets of a few hundred banks, but as frightening as that would be, investors would see that the financial markets were starting to work again.

So yes, we could actually throw $700 billion at the financial industry and not put an end to this crisis. And it is almost certain that we wouldn't know for months whether the plan was working. That's why I think investors, if a plan goes into place, will need to be very careful about assuming that what happens in the first month or two will continue through 2009.

Divide the near-term future into two parts in your head. First, there's the very near term of the next two to three months, when world stock markets are likely to rally on the hope that the crisis is over. And then there's the near term about four to six months out, when we could learn whether the plan had worked.

Continued: Get ready for a rally

< previous |  1 | 2 | 3 | next >