More Questions

As Congress debates the bail out’s final form—or even whether it will be approved and signed by the president—remains uncertain.  Like all Americans, IFTA members are watching the plan’s advocates and Congress’ reactions.  The concerns we have include these two basic questions:  First, we are concerned that any transactions authorized by the eventual bail out plan be recorded on the nation’s financial statements truthfully.  Second, we are concerned what effect the transfer of assets will have on the nation’s long-term fundamental financial position.

The most fundamental questions include how many loans are outstanding, what is their face value, how many are in default, how many are subject to interest rate resets over the next 12 months, what is their mark-to-market value, etc.  These basic questions must be answered before any plan can be approved.  Perhaps President Bush will answer some or all of these questions when he addresses the nation tonight.   

Next, how will any relief be booked on the financial statements?  When Fannie and Freddie were nationalized, it was reported that the president was surprised at the transaction should be added to the nation’s assets and liabilities.  The suggested solution  was to create a new set of books—sort of an Enron “off balance sheet” approach,”  We must be truthful in the way we account for the bail out, regardless of the structure it might eventually take.  

Let’s next consider the troubles facing the likely beneficiaries of the bail out.  These are companies subject to the Sarbanes-Oxley “mark-to-market” rules which requires that portfolios of sub-prime mortgages be written down to their present market value.  The bankers tell us these assets are “illiquid” which means there are no buyers for them.  If there is no market, what is today’s book value of these assets?  In the article posted in the “News” column nearby, The New York Times suggests that these loans may have been marked to 25% of their face value.  But, if there is no market, shouldn’t they be on Goldman or Morgan Stanley’s books at zero value?

Repealing Sarbanes-Oxley’s mark-to-market requirement might be the fastest way to slow or even arrest the financial slide but the Treasury and the Fed seem intent on a federal bail out.  If a funded plan is approved, the most likely method will be for the federal government to purchase distressed assets from the current owners.  These are the assets that have been marked down under mark-to-market rules so, what transfer price will have the desired effect for the bankers?  If the government buys at book value, for example, should the price be zero?  If they buy at book value, won’t the bankers still have impinged capital?  IFTA members would like to know.

To help the bankers, one presumes that the government would have to buy these “illiquid” assets at prices higher than today’s book value—whatever that number is.  To pay more, we have to convince ourselves that such higher prices will be realized in a future market that would more objectively estimate the likelihood of repayment by the borrowers.  But, if Sarbanes-Oxley is good for the private sector, why shouldn’t the government be subject to the same bookkeeping requirements? 

Assuming there is a bail out plan, who should be eligible to participate?  A generation ago we bailed out the savings and loan industry but then, the government waited until a financial institution actually failed before it took over.  The likely plan here will be to purchase the assets which will cause failure but before failure is certain.  This means that institutions that own sub-prime mortgages--but are not in trouble--will be able to socialize their normal collection issues.  How will the government plan discriminate between banks which have mortal exposure to toxic loans versus other banks which have non-fatal exposure?  Will both be eligible under the equal protection clause?

Perhaps the best way to deal with this problem would be to reprise an element of the savings and loan strategy by re-capitalizing the failing banks rather than buy the loans.  If they were over-leveraged, would it be less expensive to make up the capital rather than buy the loans?  Leaving the loans on the balance sheets of the banks might induce them to work out deals with the debtors and essentially rehabilitate these assets.  That would  allow them to revalue the loans upward with a salubrious effect on the banks’ capital.  Wouldn’t it be wise to hire consultants to determine which path would be best?   

If it’s an asset-based plan, will the government actually take title to the loans or will this be a loan to the banks with the loans serving as collateral?  If it’s a loan, we have the Federal Reserve model which discounts the value of an asset and provides a loan against a specific asset’s value.  There is a stiff interest charge for this privilege.  On the other hand, a purchase of the assets would provide taxpayers with an equity interest in the loans and an incentive to resell the loans at a profit.  Which method will the plan propose?  

Assuming that a plan develops, the next question would naturally be “how much will it cost?”.   That cannot be known until the structure of the relief is known.  That’s one reason why Secretary Paulson is asking for “unlimited” authority to undertake his industry’s rescue.  Does the bail out money need to be spent all at once?  If there is a firm commitment to fund a rational plan with well-understood rules, will the markets react positively?

Beyond the structure, bookkeeping and valuation questions, there is the question of what the Congress will extract as its price to approve the plan.  If history is any guide, the “gilding” of legislation is one of the primary reasons the United States has a $57 trillion accumulated deficit.  Keep your eye on this part of the plan.