Paulson’s Plan in Review - Why Is It Suspect?

Okay folks I know it is difficult to bite, chew and digest this plan all in one bite.  So, the only way to eat this huge elephant is to take it one bite at a time.  So here we go!  This bailout or rescue plan (depending what side of the tracks you are on) is designed to keep banks from failing by recapitalising them. I read somewhere where they used the analogy that It is like a massive financial organ donor program where the Treasury replaces the guts of the current system with new, unclogged guts.

So what happens to our financial economy if our boys on the hill pass this plan and Paulson gets the $700 billion?  My guess is that other banks are going to fail anyway. Folks, banks borrow money short term to buy long-term assets like these infamous mortgage backed securities and collateralized debt obligations. But the bottom line is that the money must be paid back!  However, no one wants to lend short term. Why? The assets keep falling in value.  When this happens it totally wipes out equity capital.  So in essence you have a little bit of capital backing a large amount of assets.  So if you take a write off on the assets you eliminate your capital.  You know what happens then….As Dave Chappell would put it, “You are done, son!”

Now let’s look at the price tag, $700 billion!  Is this really going to be enough moolah to remove these cancerous assets from bank balance sheets. I doubt it and so do millions of others.  Economist say that this plan would require about $5 trillion dollars!  But then, Paulson must know that too! He’s hoping that the Treasury buying jump starts the market by establishing a price.  Paulson is also praying that hedge funds, and others with cold hard cash will flood in from everywhere to make deals with the banks and get those darn bad assets off the balance sheet so the banks don’t tank. The key is establishing a price for the garbage above the current price. You guessed it! That’s Paulson’s strategy for the $700 billion.

Now let me play devil’s advocate for a moment.  The problem seems to me is that the price Paulson wants to pay for these assets is much higher than what the market is willing to pay.  Jump starting this thing won’t fly if the first bidder (the government) comes in and pays a price the market has already kicked to the curb.

The reality is that it’s not the price of the assets that’s at issue here. It’s their value!  Right now that value is much lower than the current price.   Paulson can’t change that fact.  If Congress wants to save Americans from the crisis of more foreclosures it has to come up with a plan that simply removes from the market all the homes linked to all these bad mortgages.  Easier said than done!  How to you stop the price of homes falling? But then on the other hand, maybe this may not be a good idea at all!!  Either way, no one knows how to cut the cancer out without dismembering the patient. More than likely we will see some new government agency formed to  buy up these bad mortgages from the banks and now as the new owner of the note, offer refinancing to folks of longer-term, government backed 30-40 year mortgages at lower than market interest rate.

Lastly, the way I speculate that the Feds will try and recoup some of this money back would be to guarantee that note and sell it back into the marketplace.  Kind of the how Fannie Mae and Freddie Mac worked before it colapsed. This makes for great politics, especially at election time but it seems to defy economics.  You can’t pretend houses are worth more than they really are. 

So the plan is back on the hill for a vote with some additional changes like increasing the insurance from $100,000 to $250,000 as well as some tax breaks for middle Americans and small business.  So if congress passes this plan today it may well be that markets may believe for awhile, that the plan will fundamentally alters the dynamics in the system.  But you tell me if you think it does?  How do we end this credit crunch?  Not sure but I do know according to my creditors that borrowed money has to be paid. Period!  Send me your comments.