How to make the Bailout work?

Bloody Monday: Dow dropped 777.7 (6.98%), largest single day point loss in history, and largest percentage drop since 9/11/01 terrorist attack (or more accurately CIA attack). Nasdaq did even worse, dropping 199.76 (9.14%). S&P 500 declined by 106.62 (8.79%). There was no place to hide. Energy was hit the hardest, and even Health Care sector could not escape the sell-off pressure.

After working over the weekend in an attempt to come up with a modified $700B bailout package, the Whitehouse and bipartisan congressional leaders worked out a bill to present to the House for a vote. The bill suffered a surprising and stunning defeat, with 228 nays and 205 yeas. This morning, we were greeted with the news that Wochovia sold its entire banking business to Citi for a mere $2B, or $1/share. It looks like we are going to have only a handful banks left after this turmoil. That is certainly not good for consumers.

What is the root problem of the current financial crisis? In a very simple term, many banks have mortgage securities on their balance sheet that they have no idea how much they are worth. As a result, no one knows whether the banks have sufficient capital to operate. Many banks refuse to lend each other for fear of counterparty risk.

For the main street, many corporations find it hard to re-finance their short term debt now that the commercial papers market almost dried out, because of the scare of money market funds, caused by Lehman bankruptcy and Prime Reserve's Money Market Fund breaking the sacred $1/share mark (it traded 97c) in last week.

It seems that the contagion is spreading quickly. And I start to feel we have to have some sort of rescue plan to address the root problems of the financial market, because the crisis boils over to the main street.

I think the $700B bailout plan in its original form (3-page proposal by Hank Paulson) was a scam. But the insurance proposal by the House Republicans is even worse. Taxpayers may incur even larger loss under that plan.

I think the critical component of any rescue plan should contain the provision that allows the Treasury to purchase the mortgage assets from the banks at a fair value, thus establishing a liquid market for the mortgages that are currently hard to value. Once a market is established, banks' financial health can be easily ascertained. That will lead to banks more willing to lend to other banks with sufficient capital. It should not be a bailout for the failing banks. It should be an intervention of the government to establish and maintain an orderly market for the mortgage securities. I think if the rescue plan is presented in this way, it would be much easier for taxpayers to swallow.

You may ask how the Treasury determines what price to pay for the mortgage securities? Ben Bernanke's idea of paying at the hold-to-maturity price is scandalous. That would be a huge give away to the banks. I think a so called "reverse auction" process is much fairer. Basically banks would submit their bid to sell their assets. Treasury would buy the lowest bidders up to a certain percentage of the total bids (say 50%).

To address the democrats demand that taxpayers should participate the upside of the banks recovery, we may demand the bidding banks to issue warrants to the Treasury valued at 10% of the assets the banks sold to the Treasury. When the banks' stock recovers in the future, Treasury can convert the warrants to non-voting shares in the banks and sell the shares for a profit.

One more thing I think we should be addressing is the potential inflationary effect of the bailout package. In short term, I do not think the bailout to be too much inflationary. But once the market returns normal, the excess cash in the system would create inflation pressure. That is why it is important that when Treasury sells the mortgages it bought from the banks, the proceeds should not be considered government revenue. It should be ear-marked to pay down the national debt, which was taken on to provide the initial bailout money.


But who am I? Who would listen to me? Washington politics is not determined by reasoning or what is right or fair, it is determined by the final compromise among different interest groups.

Sigh!