Friday, September 19, 2008

Paulson's Statement

The entire statement is here.

Let's look at the speech in more detail

We have acted on a case-by-case basis in recent weeks, addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers, and lending to AIG so it can sell some of its assets in an orderly manner. And this morning we've taken a number of powerful tactical steps to increase confidence in the system, including the establishment of a temporary guaranty program for the U.S. money market mutual fund industry.

Despite these steps, more is needed. We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses.

The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.

From a purely logical and technocratic perspective this analysis is very accurate. The Treasury is faced with a true lesser of two evils scenario: continue to deal with this situation on a case by case basis or make a comprehensive step to try and solve it. Either way they will be pilloried. Combine that with a Congress that is probably wetting their beds every night and this does make the most sense.

Earlier this week the WSJ had an article saying this was the worst situation since the great depression. Here is an excerpt from that article along with my commentary:

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

The first issue is huge because assets that were hard to value to begin with are trading an an illiquid market. That means the value is incredibly low -- if the owner can find a value at all. In other words -- this is the exact worst time to be trying too figure out what these instruments are worth.

Then remember that paying down debt takes money. Earnings are way down at financial institutions. The money they are getting for their assets is way low. So paying down debt is incredibly difficult.

And then there is rebuilding balance sheets. Who in their right minds would inject cash into any of these institutions? Their stock charts are all terrible and indicate traders are looking for bankruptcies across the board. The early round of infusions came last fall. Anyone else who puts money into one of these companies is going to ask for a ton of conditions.

Above is a long and involved process that is incredibly painful. It is also very stop and start and will cause the markets a ton of anxiety which will lead to great uncertainty. A comprehensive plan will at least stop the bleeding and put the financial system on the road to recovery.

Back to the speech:

As we all know, lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing. This simply put too many families into mortgages they could not afford. We are seeing the impact on homeowners and neighborhoods, with 5 million homeowners now delinquent or in foreclosure. What began as a sub-prime lending problem has spread to other, less-risky mortgages, and contributed to excess home inventories that have pushed down home prices for responsible homeowners.

At least he gets that part right -- as opposed to blaming the CRA like every other wing nut on the planet.

These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans' personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted.

To restore confidence in our markets and our financial institutions, so they can fuel continued growth and prosperity, we must address the underlying problem.

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible. The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even as it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative – a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.

First -- he's right. The central issue is everybody and their brother is holding assets that are illiquid (and not worth the paper they are printed on). They can't sell these things and they can't write them all off at once because of capital issues. As a result we get the scenario listed above -- fessing up to the bad debt, paying it off/writing it off and raising new capital.

On the surface I agree this is what has to be done. However, I reiterate a my objections as expressed in the Schumer story from last night.

1.) Where is this money going to come from?

2.) Will the companies who sell their assets be penalized?

3.) What is a bad debt?

4.) Will the purchase of these assets be non-political? (fat chance on that one)

5.) Will there be a maximum size of the fund?

6.) How long will the entity last?

7.) At a time when the US government is bleeding money it's going to spend more. Wonderful.