Trust them? We don't have a choice

By Jon Markman

The Bush administration's attempt to forestall financial disaster began as political theater last Friday but has ended this week as farce, imperiling the confidence of foreign lenders and American taxpayers alike, and turning our economic system upside down.

Since it has already gone into the mortgage and insurance businesses, it's almost as if our political leadership next decided to make a foray into television by launching two reality shows.

The first was a pilot starring Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke in "The $700 Billion Pyramid." The concept was to see how many lawmakers they could get to sign off on a law that gave them control of a mountain of money with no strings attached. The second starred members of Congress in "Are You Smarter Than a 5th Grader?"

Neither is doing so hot in the ratings, and for good reason. American and foreign fund managers alike are already upset at being suckered into buying overrated U.S. mortgage derivatives from companies like the one Paulson used to run, Goldman Sachs (GS, news, msgs). But now the TV appearances are making the public realize that the folks in charge of these debacles aren't even very clever. This is aggravating because it's one thing to lose billions in an ingenious con, but to realize you were taken by fools just makes you furious.

In his close-up this week, Paulson appeared uncomfortable, unknowledgeable, uncaring and often unintelligible, as if notes he had scrawled on a cocktail napkin on the way in were just out of reach. Bernanke was more patient with senators' dumb questions and self-serving speeches, yet he clearly gave the impression of an egghead who would rather be teaching Econ 363 back at Princeton.

Since our leaders failed to explain much, let me give it a try -- and provide my own review of their efforts.

Sieves and tarps

Bernanke originally burst into investors' consciousness as a junior Fed official in November 2002, after giving a speech in which he said the government could solve deflation problems by dropping money out of helicopters. Fast-forward six years, and he is amazingly trying out this academic theory by teaming up with his sidekick at the Treasury, whom some are calling "Helicopter Hank."

These two started kicking taxpayer money out of their helicopter all the way back in August of last year, after two Bear Stearns hedge funds went belly up and investment bankers first started to complain that life on Earth was threatened (along with their yacht club memberships).

While trying to tell the public that all was well in breezy congressional hearings last year, Bernanke and Paulson came up with a dozen bank-rescue plans with fun titles like term auction facility, term securities lending facility and, my favorite, the master-liquidity enhancement conduit, or M-LEC. All were geared toward lowering the bar for the type of collateral that the Federal Reserve would accept to launder bad bank assets into fresh, green cash. The M-LEC maneuver, meant to shore up banks' troubled structured investment vehicles (SIVs, pronounced "sieves"), was deemed so unsound that even the banks themselves wouldn't go for it. And now the latest in the series, the troubled-asset-relief program, or TARP, pretty much allows banks to turn in baseball cards, old sweaters and scratched yard-sale LPs in exchange for taxpayer funds.

None of these prior efforts to stanch bleeding in the bank-loan market have worked, and it's not hard to understand why. As I have explained in many previous columns, these billions are mere pennies against the worldwide avalanche of financial-industry deleveraging. The Bank of International Settlements reports that Wall Street created and sold $600 trillion in financial derivatives worldwide, and a lot are coming unglued as financial institutions lack the cash flow from their underlying instruments. Those were, strangely, mundane things like residential and commercial mortgages, equipment leases and auto loans -- all debt contracts that go bust in recessions. And now that fallen investment banks have fired thousands, a lot of the math geniuses that built these papier-mâché castles of debt are at their local Starbucks polishing up résumés rather than keeping the glue from melting.

A burst of enthusiasm, and then . . .

Since those past rescue efforts with price tags in the $10 billion range haven't worked, Bernanke and Paulson have moved on to their new $700 billion effort. Many experts I trust believe it's the first step in the right direction -- give this duo a year, and even they can nail it -- but because it has taken so long, it won't be enough. Not even close. And you can forget the fairy tale that it'll all be paid back.

Think of this $700 billion gambit as just one more levered-up deal from Paulson, whose old company was the master of borrowing. In the private sector over the past decade, the answer to problems with leverage was to add more leverage, created more opaquely. But now it's not Goldman partners that are on the hook; it's my mom and sister, my kids and probably my future grandkids' grandkids. I know we're supposed to think the plan will work because those guys in the hot seat are smart, but the evidence that Paulson and Bernanke really know what they're doing is thin at best.

Paulson, after all, earned his bones at Goldman Sachs as a master of the short-term deal -- or nothing like the sort of long-term thinking demanded by federal financial policy. And Bernanke's key experience before this job was running the Princeton economics department. These résumés qualify them to run a $700 billion mortgage book at a time when home values are melting like ice cubes? I despair.

My bet, however, is that Paulson and Bernanke are actually going to be allowed to put some part of this program into production because their audience is weary and out of alternatives. Investors will likely reward them by pushing up stock prices as much as 20% in the next few months, but figure it will be just another bear market rally. Ultimately a deteriorating global economy will take precedence over wishin' and dreamin', as folks realize the assets will have to be acquired at inflated values that did not provide any clarity as to their true worth -- and thus many are likely to go into default and undercut the whole purpose of the exercise.

Is there any hope that it will work out? Sure. David Kotok at Cumberland Advisors provides this calculation: Assume the entire $700 billion will be deployed in acquiring damaged or toxic financial paper and any recovered money will be redeployed doing the same. Further assume that the ultimate recovery will be zero. The U.S. economy is $14 trillion in size; $700 billion is 5% of one year's output. The entire amount can be financed with Treasury bonds at an interest rate below 5%. Assuming the $700 billion never gets repaid and is refinanced indefinitely, the cost is $35 billion in interest for each of the next 30 years. He concludes that $35 billion a year is not much to pay if it can avert another Great Depression.

I asked Kotok why we need to buy into the assertion that the alternative is a depression, and he argued that the real issue isn't the actual amount of new credit made available but that the lack of lending today has dramatically reduced the global credit "multiplier" -- or the amount that borrowed money is reused and re-lent. "We need a huge credit extension to offset the shrinking multiplier, which is now at 12 and is normally 14 -- a massive difference," he says.

Kotok says that in the world of credit unseen to most politicians and equity investors, credit spreads are widening, corporate bond issuance is growing more costly, and bank failures are expanding. A contagion is spreading, in other words, and Wall Street is dying. And dying with it, unfortunately, are the financing vehicles for houses, small businesses, autos, college education, cities and bridges.

In this context come the two actors who may not be perfect, but they're all we've got. "Our leadership says, 'Trust me.' Should we do this? The answer is no," says Kotok. "Should we authorize the $700 billion? The answer is yes." Reluctantly, I agree. The show must go on.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.