The Senate's Bailout Bill: The Devil is in the Detail

The bailout bill went through a series of cosmetic changes, some good in my opinion and also some bad. Ultimately, the basic idea that the government will buy up all of the "toxic" debt that American banks and financial institutions are holding will remain the same. Here are the most important details.

1) End to marked to market and increasing the FDIC insurance to $250,000

These are either small additions or they are vital improvements depending on who you talk to. Both Barack Obama and John McCain believe the increase in FDIC insurance will go a long way toward making sure that there is no bank run. As for marked to market, many conservatives, like Steve Forbes and Newt Gingrich, believe this accounting rule has gone a long way toward creating this liquidity crisis. Banks often use their assets as part of their portfolio to maintain required minimum capital levels. Marked to market forces those banks to give a current market price for everything including currently illiquid MBS. This mark down has caused many banks to scramble to raise other assets in order to maintain their minimum requirements.

Of course, there are also contrarian opinions out there.

To review, the accounting fiascos of 1999-2002 that brought us mandatory MTM
accounting taught us that traditional accounting methods make it easier for a company - through "aggressive" accounting - to appear solvent for much longer than the company actually is solvent. Everyone in the lending world remembers this. To further review, a large part of the genesis of the current crisis is a widespread fear that certain assets are toxic, and that it's impossible to identify the toxic assets from the good ones. So... I guess we're supposed to assume that allowing a change of accounting rules which leads the credit markets to believe that companies might be (but no way to tell for sure) faking solvency is a good thing?

If we suspend MTM in the current climate, what exactly is supposed to happen? Will companies hire accountants to come in and hastily rewrite their accounting books? If they do, will any lender actually extend them credit without forcing them to crack open the old MTM books instead? And if they can't force that, will they lend at all? Like I said, the market will go from widespread uncertainty about certain classes assets to having widespread uncertainty about every company, especially in these uncertain times. I fear that this may make the credit markets freeze even tighter than they are, even if we inject a bunch of liquidity into the system.

Personally, I think its ludicrous to give a current market value to a long term and illiquid asset. Marked to market forces companies to value both easy to value assets as well as illiquid assets. I firmly believe that this contributed to the artificial run on illiquidity. Only time will tell if this will help as much as I think.

2) What bonds will be bought and for how much. Here is how Andrew Busch described it.

From the portion of the bill addressing TARP: "PREVENTING UNJUST ENRICHMENT.—In making purchases under the authority of this Act, the Secretary will take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of as sets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings 3 under title 11, United States Code." This should mean that anyone who has taken over a troubled US financial institution with MBS that has been
written down can sell those securities to the US Treasury at a profit. I wonder how much this has come into play during the recent rash of takeovers or forced mergers has occurred?

First, for all the posturing about oversight, what is clear is that Congress will put into the hands of the Secretary of the Treasury an enormous amount of power. The Secretary will decide what securities to buy and for how much. The restrictions will be rather limited and the discretion, for the Secretary, will be rather grand. It appears the most powerful person in the world over the next year or so will be whoever occupies the Secretary of the Treasury.

3) Pork.

Once again, here is Busch.

The EES was larded up with over $150 billion in pork barrel spending ranging from tax cuts for riding your bike to work to a 39c excise tax for children's wooden arrows. I'm not kidding.

This is troubling on several levels. First, adding useless pork means that Senators aren't all together concerned with the state of the economy. Second, while they rail against the Bush administration's spending sprees, they can't seem to stop their own. Most troubling is that the addition of all this pork clearly demonstrates the Senators are totally clueless when it comes to the dangers of this bailout. Our Treasury is about to add on massive debt. That puts enormous upward pressure on inflation and downward pressure on the Dollar. The last thing either scenario needs is more useless debt. That's exactly what the Senators have done with $150 billion in pork.

4) Will this bailout include foreign financial institutions?

Would you be angry if your tax Dollars went to bailout foreign banks? I bet you would? Would you be angry if your tax Dollars went to a useless bailout? I bet you would. If foreign banks are included in this bailout, then you will likely be angry at the first question. Of course if they aren't, then this bailout will likely be useless unless someone bails them out as well. What should really make you angry is that it is totally unclear whether or not they are or aren't included.