Can the bailout work? Fat chance

By Jon Markman

The recent volatility on Wall Street is virtually unprecedented and is likely to remain so until every trader dies of heart failure or the banking system is recapitalized with pixie dust, whichever comes first.

But don't blame Wall Street vacillation for the jumpiness. It should be seen in the context of a decisive, coordinated effort by governments worldwide to manipulate stock markets higher by every means possible without regard to such niceties as fundamentals, the rights of shareholders or the laws of financial gravity.

Few citizens will wish to complain, of course, for U.S. equities actually have a shot at advancing as much as 10% over the next few months. Wall Street veterans call this the "free-lunch trade," and it could be very tasty for a while.

Yet experts say it will likely fail eventually, by running into the usual set of bugaboos that we have discussed for some time: levels of debt deleveraging and slowing growth that no additional amount of monetary or fiscal stimulus can vanquish.

Battle lines for this epic contest between the physics of debt and government efforts to prop up the system with toothpicks and rubber cement can be seen most clearly in the rhetoric in Congress this week. Virtually every respected authority in the world of real capital believes the bailout bill approved by lawmakers won't solve our banks' problems. Yet the nation's political leadership pressed to pass it with the breezy confidence of the captain of the Titanic.

It will pass, but it won't work

After it's signed into law, the Federal Reserve will flood the system with additional money, just as it did in 1999 to ward off expectations of a financial meltdown from the Y2K bug. Then markets will lift. But that won't mean all is well, not by a long shot, as eventually the plan must actually work. And every credible expert I've spoken with believes it won't. (The experts also have solutions, though, which I'll share with you in a moment.)

So here's the problem: As explained by John P. Hussman of the Hussman Funds, the financial bankruptcies we've seen in the past six months have come in order of their gross leverage, or the ratio of total assets to shareholder equity. The more leveraged -- Bear Stearns, Lehman Bros. (LEHMQ, news, msgs), Washington Mutual (WAMUQ, news, msgs), I'm talking to you -- the more vulnerable they were.

The reason is that as loans of a financial company lose value because of underpayment, company executives must write down the asset side of their balance sheets and at the same time reduce their shareholder equity on the liability side. Banks are allowed to lend only in proportion to their shareholder equity, so as the equity becomes thinner, banks are less able to lend money to make a profit.

Sophisticated customers then see that the banks are in precarious condition and make withdrawals. And so to satisfy those requests for withdrawals, banks are forced to liquidate more assets at distressed prices, prompting further reduction in shareholder equity. Yow! This process is then repeated in a vicious cycle until shareholder equity goes to zero and the company becomes insolvent. So long, banko.

Got that? What the government now proposes to do is to buy the questionable assets to protect the institutions against failure. So far, so good. Yet just taking the assets out of the mix would do nothing to provide additional bank capital, so the balance sheets would be just as fragile and prone to bankruptcy. At best, Hussman adds, you'd be allowing banks to liquidate their bad loans more easily to meet the demands of customer withdrawals.

The only way buying the bad assets could increase capital would be if the Treasury overpaid for them. And that would be so politically unpalatable that it isn't worth even contemplating.

What they should have done

Hussman has this solution, which is a variation on what credit derivatives expert Satyajit Das recommended last week: have the government provide capital directly via a high-interest "superbond." It would be counted as capital, yet in the event of a bankruptcy, it would have a senior claim above stockholders and senior bondholders. That would protect the financial system, Hussman says, while also protecting customers and taxpayers. Bond interest would be deferred until a bank met a certain level of profitability.

This is essentially the route that Warren Buffett has taken with his investments in Goldman Sachs (GS, news, msgs) and General Electric (GE, news, msgs) over the past two weeks: provide capital in return for a financially viable security that is senior to shareholders' stakes, accrues at a high rate of interest and can be called early, as soon as the bank can secure cheaper financing.

Continued: 'Fannie Mae in every IRA'

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