The Fed’s ‘Bad Bank’ could make the financial crisis worse

MoneyWeek ^ | 19 Sep 2008 | David Stevenson

[BGHater]

Turn on this morning’s business programmes, and what do you see?

In the middle of the worst financial crisis since 1974 - or is it 1929? -and share prices are soaring all round the world. As I write, the FTSE 100 is up 8%!

Why? Seems the so-called financial ‘authorities’ have had enough. Despite bigger and bigger bailouts, the nationalisation of large chunks of the US financial system – and part of the UK’s too – and pumping more cash into the money markets than Croesus could count, they hadn’t been able to stem the tide.

So the latest effort contains yet more stellar wheezes.

“Let’s set up a new firm to take over all that dud debt at the root of the problem. And while we’re at it, let’s stop people ‘shorting’ – i.e. selling shares they don’t own in the hope of buying them back later at a lower price – all those bank stocks whose prices have been plunging.” (That temporary shorting ban, by the way, includes 29 UK financial firms and 799 in the US. And the Fed will be acting as backer to money market funds, too).

This must do the trick, mustn’t it? Surely everything’s going to be all right now?

Well, no actually, it won’t. Here’s why.

On shorting, inevitably we’ve seen plenty of drivel about ‘spivs’ from politicians wanting their media moment. But as my colleague John Stepek points out today, shorting isn’t the problem. Brutal it may be, yet it’s just a symptom of a much deeper malaise.

And banning it merely adds to the sense of things being out of control. Short-selling “undoubtedly speeds up a share price in decline”, says Damien Reece in The Telegraph, but “these kind of panic measures after the event reduce, not increase, confidence”.

Then there’s the dud debt fund, or ‘Bad Bank’ as several pundits have described it. The proposal set to go before US Congress involves “moving troubled assets from the balance sheets of American financial companies onto a new institution”, says Bloomberg.

“I think the market’s just so relieved to see somebody doing something,” said Pavlic Investment Advisors’ portfolio manager Terence Pavlic, referring to the bounce.

We can understand the relief. But sadly, that’s all there is to this rally. Because all those dodgy loans won’t disappear overnight. They’ll just be shovelled onto the poor old American taxpayer, already lumbered with a massive possible $900bn (£496bn) bill for pledges on the bailouts so far.

Nor will property prices benefit. In fact, “we may just be prolonging the housing slump”, says Republican Congressman Scott Garrett. “We should let the markets work”. Peter Boockvar at Miller Tabak agrees that unless the Fed stops interfering, Wall Street's problems will continue. “The market can get to the right price on its own. Anything that prevents it from happening is just prolonging the inevitable”.

And with lots more defaults in the pipeline, this new deal might be the last straw. “A giant dumpster for illiquid assets brings up the troubling question of whether the US government is big enough to take on the whole problem”, says Mirko Mikelic at Fifth Third Asset Management.

“Random bailouts confuse markets”, says Professor Joseph Mason of Louisiana State University. “Such a policy will certainly draw out the economic effects of the crisis for far longer than would otherwise be the case.” And as Peter Schiff of Euro Pacific Capital puts it, “every time the authorities intervene, they do more harm than good.”

So it’s only a matter of time before that share price rally goes the way of the last one, i.e. disappears into thin air. But at least it’s a chance to dump any remaining financial stocks you have left – provided, of course, that you don’t sell them short.

[politicket]

Thank you. Now we have something to discuss...

"I have no problem with the current Fed solution of buying these debts for a set rate."

And what rate would that be? Part of the problem is that most of these "assets" do not have a "value" associated with them.

"The market is panicking and these debts are basically worthless at this point, which in turn is halting the ability to raise additional funds."

If the debts are "worthless" then I ask again - how much should the U.S. government buy them for?

"The government taking on these debts helps to remove this uncertainty from the markets."

Actually, it adds more uncertainty, because the U.S. government has never nationalized a whole sector of private business before.

"The government, having the luxury of time, plans to hold this debts until maturity."

That doesn't make sense. Why would they hold the debt to maturity. They're creating $50 billion dollar tranches. Wouldn't they want to sell the higher rated tranches?

"Hopefully they will be able to earn more from these debts in the future than they are worth now."

You previously stated that these debts are worthless. How can you ever hope to "earn" anything from them?

"The only other option is to let the U.S. financail system collapse which would cost the taxpayers much more in the long run."

Really? I would think that the market would be healthier in the long run. It sure would be hell in the short-term, but the long-run would hold great promise.

See, maybe the author had a valid point or two. It's not easy defending your position...is it?

[frankjr]

“It’s not easy defending your position...is it?”

Actually, it’s not more difficult than defending the other side. If you believe letting that market collapse now will be better for the country, then so be it. I’d rather take a chance on assuming the real estate market will improve in couple of years and in turn it will improve the value of the underlying debts.

Yes, this is low rated debt, with questionable collateral based on the real estate market, but the market moves in cycles and we appear to be at a low point. The markets are not willing to take on the risk at this point because no one wants to be left holding the bag. I have no idea where to value these securities, but the Treasury is going to have to set a price and these financial institutions are going to need to determine if the price is reasonable. Just because a security is worth close to zero now does not mean it will be zero in the future. That is the risk the government (and taxpayers) are going to have to take.

No guts, no glory. Or maybe too much guts, gorey.

I’ll get back to you in 5 years.

[bruinbirdman]

"a guy whose nickname is Helicopter Ben?"

Uncle Ben's helicopter couldn't hold enough greenbacks of any denomination. He had to look to Uncle Sam for his 747.

yitbos

[AndyJackson]

Uncle Ben's helicopter couldn't hold enough greenbacks of any denomination. He had to look to Uncle Sam for his 747.

For heavy socialist lifting you need this brute

[bruinbirdman]

I hear that's hauling bananas for Hugo.

yitbos

[Freedom_Is_Not_Free]

The real estate market will not correct itself in a couple of years. Have you seen this? The Option ARMS are just now beginning to reset in rates and this will go on until 2012 and I understand the volume and value of Option ARM loans are larger than for sub-prime = Bigger Problem for housing.

[Notary Sojac]

Nor will property prices benefit.

It's hilarious to hear comments on "housing prices recovering" when the bubble is still only partially deflated. A real recovery of housing prices would take them back to their income and rent based fundamentals.

One might as well talk about Pets.com "recovering" to its 1999 share value.