It is an understatement to say the world is in shock. We are living economic history – history that will be talked about and debated for many years to come. Everyone has an opinion about the flurry of recent bailouts and unprecedented government intervention. The only thing “experts” seem to agree on is more trouble is on the way.
Lawmakers, in an effort to thaw the freeze in financial markets, searched for ways to restore confidence and fixing Wall Street catapulted to the top of the list. However, despite what seemed to be bipartisan support for the bailout bill, the House of Representatives’ failed to pass a $700 billion package on September 29th and this sent markets reeling. As the blog Real Time Economics (a brainchild of The Wall Street Journal) said, “Congress just put a $700 billion hot potato back on Federal Reserve Chairman Ben Bernanke’s lap.” The very day the package was rejected, David Callaway of MarketWatch estimates that nearly $1 trillion was wiped off the value of the entire U.S. stock market as measured by the Dow Jones Wilshire 5000 Index. The key observation here is that the losses were across all sectors and not just in the financial sector. However, by October 3rd, the hot potato was passed to the Senate, approved and returned to the House for further debate. After intense scrutiny, the bill was passed and the President signed it into law. One might have speculated this was good news for Wall Street but those speculators lost a lot of money together with everyone else. The following summarizes some of the history of the bailout bill.
This original bailout package was the source of much debate. On September 24, 2008 a letter signed by 166 academic economists, including Noble Laureates Robert Lucas, James Heckman and Vernon Smith, expressed concerns regarding the bill’s fairness, ambiguity and long-term effects. Some explicit concerns were that it gave the U.S. Treasury Secretary too much power and placed too great a burden on the taxpayers (and too little a burden on those responsible for the crisis). One economist who signed this letter, Jeffrey Miron, a senior lecturer in economics at Harvard University, blames the current situation on the actions taken by the federal government with respect to Fannie Mae and Freddie Mac.
The U.S. government chartered Fannie Mae in 1938 to provide liquidity to the U.S. mortgage market and it retained virtual monopoly power within the secondary mortgage market through 1968. In 1970, Fannie Mae saw increased competition in Freddie Mac, a government agency established by the Emergency Home Finance Act and an oligopoly was born. According to Jeffrey Miron, “the current mess would never have occurred in the absence of ill-conceived federal policies…the government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.” On Sunday, September 7, 2008 the U.S. government seized Fannie Mae and Freddie Mac citing concerns for losses at the two companies which taken together threatened the nearly $6 trillion (roughly half of the total U.S.) outstanding home mortgage debt which they own or guarantee. Henry Paulson, the U.S. Treasury Secretary, explained “Fannie Mae and Freddie Mac are critical to turning the corner on housing.” Currently the two publicly traded companies still operate but with greater oversight and a new shareholder – the U.S. government.
In The Economist’s Voice, economist Luigi Zingales of the University of Chicago -Graduate School of Business expressed an alternative plan to Paulson’s $700 billion bailout in an article titled Why Paulson is Wrong. He explains that when there is enough time, filing for Chapter 11 is the likely route to address large liabilities as was the case when “Texaco lost a $12 billion court case against Pennzoil in 1985.” Now, however, there is not enough time for financial firms to undergo lengthy Chapter 11 procedures. Zingales’ plan involves “partial debt forgiveness” or a “debt-for-equity swap” all along the financial sector. This plan would have created minimal pain for taxpayers, but met opposition by large firms in the financial sector because these debt-holders found the bailout more appealing.
On October 3rd, the new $700 billion plan was signed into law. This plan includes provisions for, but not limited to, protecting taxpayers, providing tax breaks to households and businesses, putting limits on executive pay, forming two oversight committees, adjusting accounting rules and temporarily increasing FDIC insurance from $100,000 to $250,000. Despite the passage of this bill, its implementation remains questionable as James Doran of the Guardian reports. Mr. Doran cites that “fears are mounting that many Wall Street banks and financial firms will refuse to participate in the U.S. government’s bail-out package.”
Reading through the plan, it is not hard to parse out the underlying issues captured in Mr. Doran’s quote. Many of the mortgage-backed-securities are difficult to price yet the government intends to buy some of these assets (for a certain price) and James Doran explains that, “Analysts believe that the mere presence of the government as buyer of last resort will be enough to get credit markets moving again.” A second and perhaps more obvious issue is that the plan intends to curb executive pay for participating companies – which could deter participation all together. The increase in FDIC insurance is an attempt to address liquidity issues at banks as well as to improve consumer confidence.
Now that a plan is in place we will all have to wait to see its effect – some predict the wait will be at least a year or more. Although it is tough to speak to the critical impact this plan will have on all aspects of the economy it is equally tough to predict (with certainty) what would happen without a plan. What can be done though is to admire the words of John Maynard Keynes, “It is better to be roughly right than precisely wrong.”
As a firm intimately engaged in providing valuation and consulting services to major corporations waging this war from the trenches, we have a unique and timely perspective of the fight. As trusted advisors and experts at interpreting shifts in the marketplace we are standing shoulder to shoulder alongside our customers (our partners) fighting every one of these battles with them and for them. More so then usual, current economic conditions have prompted a rush to quality – a rush to AccuVal for very basic reasons. We have been the gold standard in the industry for almost 30 years. Clients have always come to AccuVal for the “real” answers and because we’re in the business of finding solutions – the best solutions to the toughest problems. We know what it means to hunker down in tough economic times – we’ve advised major corporations through three major economic downturns and we’ll get through this one too. Sure, this crisis is literally changing all the rules but we’re very fast on our feet – we help clients anticipate and react. It’s possible to keep our appraisals and consulting advice real world, but positive and proactive at the same time. We know times are tough. Think up. We do.