Paulson/Bernanke: A Conspiracy of Dunces

The stock market should not be disappointed that the $700B slush fund bill failed in the House. I hear all the talk that the government’s captive investment bank will be a boom for taxpayers, and the mortgage paper carry trade for the Treasury could be as high as a 7 or 8 point spread before losses. The government’s private equity portfolio included Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG); before its latest addition of Citigroup (C) – via the Wachovia (WB) steal. More equity interests would have been added with the defeated bill. It is good to see the government is seeking diversification in its portfolio.

The government latest tactic is preemptive strikes on banks that are weakening, but still meet the government’s well or adequately capitalized standards. This parallels President Bush’s military doctrine. While preemptive intervention by the FDIC might save taxpayer money in the short term, it comes at a high societal price. Financial institutions are not able to nurse their way back to health, and we are migrating to a limited number of mega banks that will severely restrict consumer choice. The Philadelphia Inquirer “3 banks to control a third of U.S. deposits” reports that after consolidations, Bank of America (BAC) will control 12% of domestic deposits, Citigroup 9.79%, and JP Morgan Chase (JPM) 9.75%.

The government’s lessons in moral hazard, portfolio building and encouragement of the formation of mega banks has not increased either consumer or investor confidence. Treasury Secretary Paulson and Federal Reserve Chairman Bernanke “conspiracy of dunces” accelerated the loss of confidence with each infliction of pain: AIG, Bear Stearns, Fannie, Freddie, Lehman (LEH), Wachovia and Washington Mutual (WM). The dunces have no increase in confidence to show for their money. Why should we give them $700B more to continue down the same path?

Everyone laughed when Senator Hillary Clinton called for a freeze on interest rate adjustments for mortgages, and the Republicans are fighting letting bankruptcy judges modify mortgages. But now the government has to save the bankers from themselves. A current mortgage paying 6% is certainly more valuable than a 10% or 12% delinquent mortgage paying nothing. Step 1 should be to temporarily cap interest rates on all owner-occupied residential mortgage loans at 10% - across the board, no means testing.

Depositors are fleeing suspect banks, even when their accounts total less than $100K. Step 2 should be to insure businesses and consumers are not inconvenienced by bank closures. Not only does the FDIC have to increase deposit insurance, but it has to guaranty quick access to funds in all cases and that all checks will be processed as usual. Check processing interruption is a major risk for both business and consumers.

Step 3 should be flexible capital requirements. Higher capital requirements in boom times will put a break on bubble formations, and lower capital requirements will stimulate the economy during recessions. Replacing mark to market accounting for banks with tougher regulatory review does have some merit, but I like capital flexibility better.

So now what should the dunces do with the extra $700B their clambering for? First and foremost, backstop the FDIC so we don’t need any more preemptive attacks. Second, create a fund for lending capital to banks based solely on the impact of mortgage modifications to consumers. Third, lend funds or backstop to non-bank financial institutions and mergers where the systemic risk is high. Above all keep shareholder pain to a minimum.

The dunces have lacked any consistent policy or methodology throughout the crises. First we had shareholder pain, then bond holder pain, and finally counterparty pain. We bankrupted Lehman, but stopped short of AIG because it would have too painful to our precious Goldman Sachs (GS). We killed WaMu bondholders, but the same treatment for Wachovia would have been too painful. How can we trust $700B to someone with no plan who operates with no rules.

We need to switch to a bottom up plan. In essence start paying banks (via temporary capital loans), to modify mortgage on primary residences. This will lead to recovery on both Main Street and Wall Street, and provide real liquidity to the financial system.

Disclosure: Author is long multiple financial institutions.

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