Monday, September 22, 2008

Dr Jekyll and Mr Hyde

A regulator can be of two minds about things but he can't be schizophrenic. Despite an ability to see two sides to a story a regulator needs to choose ONE course of action and have one underlying philosophy to govern actions. Changing persona's in mid crisis is odd. But with the switch in the front-man for the regulatory fix-up we are seeing a brand new philosophy take root.

Fed's Dr. Jekyll to Paulson's Mr Hyde
Under Hank Paulson the the MAP (Market Assistance Plan) has come 180 degrees. The Fed led MAP put the hammer to shareholders and fired CEOs. It treated the failing institutions as having a failed plan and failed management. It punished them as well as the shareholders, opting to protect the financial system by cushioning the blow of their failure on the economy. Under Paulson the MAP treats financial institutions as VICTIMS. I suppose the criminals are the short sellers who have attacked them. Short selling of the shares of these financial firms has come to be banned. The SEC has finally donned its white hat and ridden to the defense of those financial firms that the Fed used to treat as scoundrels.

From 'Kill 'em all and let God sort 'em out' to 'Pay 'em all and let God sort 'em out'
Financial firms are still troubled. They are actually loaded with nonperforming assets. Short-sellers were not clueless in selling their shares. In some real-world sense everything is not OK. But apparently the firms with troubled assets and their management teams are not to be made accountable for this ('this' being their poor performance and their poor business plans). Instead, they are slated to get monies from the Paulson MAP with no punitive actions. Paulson wants no prohibition placed on corporate executive bonuses for participating firms or any other stricture as far as I can tell. He does not want to discourage banks from participating. This brings up he question: what is Hank's objective?

Fed MAP: The Fed's objective was to stabilize the teetering financial institution and protect the financial sector from any fallout that a weakened institution might create. It also wanted to eliminate moral hazard so it made sure that the institutions it helped paid a steep price for assistance. The Fed did not fix them and send them back into the fray, with the exceptions of Fannie Mae and Freddie Mac, where government obligations were special.

Paulson MAP: In contrast, the Paulson plan is to take an injured player off the field and send him back into the game as soon as possible. Heal him by any means: surgery or steroids and don't worry about long run health just get him right back into the game.

On the road to perdition- not Morocco
The Paulson plan is not concerned with long run health only short run health. That statement is a reference to moral hazard. Since there is free money being doled out to make repairs and remove troubled assets from the balance sheet, and no punishment is meted out, moral hazard under the Paulson Plan is about as great as it can be. The institution is not punished, shareholders are not punished, the management team is not punished- nothing/no one is. Indeed, they were all paid out for their past performance which turned out badly and now they are being bailed out, instead of paying the piper. This is a reward for a job poorly done.

Eating for dinner the goose that laid the golden eggs
Paulson wants the economy back on its feet. But it's still not so simple. Markets are not cheering this plan. Stocks did rise sharply last week on word of a bailout. But as the plan is being fleshed out stocks are uneven, the dollar is weaker and commodity prices are up strongly. The Fed's approach had created positive and beneficial reactions from other markets as oil and gold prices fell and the dollar strengthened. The Paulson plan creates just the opposite effects. Of course, the stock market eventually fell sharply under the Fed's hand, but putting an end to short selling stopped that more than anything else.

No alternative...Do or Die
Paulson asserts that his plan must be done. But unlike Bernanke who thought long and hard to come up with ideas to stabilize the economy, Paulson's plan is just to just throw money at it. It is as old school Wall Street as can be. There is nothing modern or sophisticated about it. Because of the macroecomic fallout it is not clear that this plan, a plan that is geared to put everbody right back inthe game as soon as possible, will work. Remember these are the guys that got us into the mess to begin with. And then there is the economy itself...

The economy stupid! Fuuggetabbouddit
One problem is that Paulson's plan does nothing for the economy. It saddles the government and its taxpayers with a ton of debt, roughly another $1 trillion. It does not help the embattled homeowner but instead the banker who has been paid in 'full' for the homeowner's liability while the homeowner is still on the hook for his entire debt. The housing market remains troubled so even healthy banks are unlikely to lend too much there. House prices will continue to fall. The economy will remain weak. Exactly what is supposed to make this plan work and worth the $1 trillion we are spending on it?