Banking Bailout: A Modest Alternative

The truth is: No amount of money, and certainly not $700 billion, is enough. Here's the way forward.
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As a former bank analyst, I don't think a $700 billion

bailout

is enough to make up for the fallacy of mark-to-market accounting for one-of-a-kind securities for which there can never be a standardized market. No amount is large enough.

Banks and other financial-services firms can create new, complex securities to sell to one another faster than the U.S. government can legislate, appropriate and borrow money to buy them. In addition, Treasury Secretary Henry Paulson does not want to limit the bailout to mortgage-related investments, seeking the authority to buy a variety of so-called "toxic" securities including credit derivatives.

Part of the problem ...

Partly because of these securities, we have seen just this month the government rescue of

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

, the bailout of

AIG

(AIG) - Get Report

, the bankruptcy of

Lehman Brothers

, the purchase of

Merrill Lynch

(MER)

by

Bank of America

(BAC) - Get Report

and the decision by

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

to become bank holding companies.

Mark-to-market accounting rules force banks to value mortgage-backed and other securities at less than they would expect to receive if they waited a few years until the investments matured. Since they're booking losses based on low values, some banks may appear not to have enough capital to safely remain in business. Hence, we have a crisis in confidence that banks won't be able to pay back their current debts, let alone borrow new money.

Do We Even Need a Rescue Plan?

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With credit decisions, confidence is everything. If a deadbeat bank is bailed out by the government, I will have more confidence in the government's ability to borrow and spend money. However, this will not increase confidence in the management of the deadbeat bank or on the valuations placed on that bank's other securities.

One possible solution ...

For one-of-a-kind securities that may never be actively traded in a standardized market, I propose the use of a valuation methodology called "valued & insured-to-maturity."

Step 1: Value the assets. Banks choosing to participate would pay a nominal fee to submit their securities for pricing to a new government agency with all documentation and assumptions. That agency would determine what the security is worth and allow the use of that price for regulatory capital calculations and balance sheet reporting requirements.

Paulson's plan requires fair value pricing of securities to determine how much the government would be willing to pay, so step 1 is not much of a stretch. Plus, this action alone would go a long way toward re-capitalizing the banking system without costing future taxpayers billions of dollars to pay back interest on record government debt levels. Also, a government stamp of approval on a security's price would give confidence to private market participants willing to buy that investment, thereby unfreezing the mortgage security market.

Step 2: Don't buy the security. Instead of the government removing moral hazard and wasting tax dollars socializing corporate losses, it should just say "no" to buying these securities. There are billions of dollars, yen and euros floating around the world on the lookout for underpriced assets that, with some patience, could potentially generate a nice return.

Step 3: Insure some securities. For the securities valued above for which the government has high confidence in the composition of the investment and the determination of fair value, a premium could be charged to the banks to insure the new expected principal and interest payouts. The premiums should be high enough to cover losses over the coming years. This insurance would also make the securities easier to sell.

While setting up a new government infrastructure to value and insure securities would cost money, it would be just a drop in the bucket compared to Paulson's $700 billion budget-busting plan.

TheStreet.com Ratings' Bank Analyst Philip van Doorn expressed interest in exploring the above steps but pointed out that any plan should also consider the needs of community banks burdened with non-performing construction loans. Click

here

for the story.

Kevin Baker became the senior financial analyst for TSC Ratings upon the August 2006 acquisition of Weiss Ratings by TheStreet.com, covering mutual funds. He joined the Weiss Group in 1997 as a banking and brokerage analyst. In 1999, he created the Weiss Group's first ratings to gauge the level of risk in U.S. equities. Baker received a B.S. degree in management from Rensselaer Polytechnic Institute and an M.B.A. with a finance specialization from Nova Southeastern University.