This column was written by Michael Kao, CEO and portfolio manager of Akanthos Capital Management, a hedge fund specializing in convertible, capital structure and event-driven arbitrage strategies.
So far, we have seen expanded Term Auction Facilities, a $700 billion rescue package and global rate cuts. So why are all asset markets still falling? Simple. Given the recent severe violations of market trust and the basic sanctity of capitalistic conventions, the U.S. government
has done little to repair the damage dealt over the last several weeks.
Two weeks ago, I wrote an article called "
Four Ways to Help Us Out of This Crisis
," in which I outlined four basic issues and four suggested solutions. To briefly summarize, the four issues were:
. The "bailout" of
( FNM) and
( FRE) by the Treasury also simultaneously eviscerated a multi-hundred-billion-dollar market for preferred securities;
. the lack of support for
counterparty obligations, which severely undermined mutual trust amongst all counterparties;
. the undercapitalization of the FDIC and the low limit of FDIC insurance; and
. the ill-conceived ban on short-selling that ironically exacerbated the pressure of companies' capital structures and costs of capital.
Since that column was published, two of the four issues have been directly addressed. Specifically, the FDIC insurance limit was raised to $250,000 (one of the many "Christmas ornaments" attached to the TARP bill) and, as a result of the TARP's passage, the expiration of the ban on short-selling.
So why are the markets still in free fall? As I tried to emphasize, the answer lies in the government's grudging incrementalism in dealing with the issues. Not once in the last two months have the actions of the Treasury,
Securities and Exchange Commission
shown that they are ahead of the curve, or that they are throwing everything they have at the problem. In fact, the government's actions appear to be ad hoc and improvised without proper analysis of the ramifications.
Each "solution" has been hamstrung by an embedded "anti-solution."
"Bailing out" Fannie Mae and Freddie Mac shut down the entire market for preferred shares once Paulson decided to suspend dividend payments; allowing Lehman to fail without a plan to deal with the counterparty obligations caused an immediate run on
; seizing 80% of AIG's equity in return for providing a bridge loan directly caused runs on
; the disallowance of short-selling of equities forced market participants to pressure the debt market of the underlying companies, causing "death spirals" due to consequent ratings agency downgrades and forced selling by long equity holders; the arbitrary seizure of
and the government-assisted pillaging of its capital structure by
did not assuage investor confidence -- it severely damaged it and directly caused the run on
; the arbitrary treatment of Wachovia in the FDIC-assisted sale to
and now the federal meddling in the
/Citigroup spat again shows that there are no set rules or templates that investors can follow.
Little wonder that people who are otherwise paid to take risk refuse to do so in this environment.
There is a road map out of this morass, but the Treasury and Fed need to put the moral hazard concerns on the back burner now and find ways to re-incentivize investors to take risk. The two other steps I mentioned in my article are ways of addressing this. First, re-inject liquidity into the preferred markets first by reinstating the dividends on the Freddie and Fannie preferreds.
This would accomplish the twin goals of immediately restoring value to the myriad regional banks and insurance companies that took horrific writedowns on collectively $36 billion of formerly AA-rated agency preferred investments that traded down into single digits (as a percent of par!) upon the Treasury Department's unnecessary evisceration. This would also show the marketplace that the government wants to reinstate liquidity to this essential market.
Second, there has to be a fix to the Lehman counterparty issue. The biggest single underlying reason for the recent credit freeze-up is the complete lack of trust between counterparties.
This trust was destroyed, and a multi-trillion-dollar marketplace (credit default swaps) hamstrung, by the disorderly failure of Lehman. Even if the government does not do anything directly, the
it should do is to make it publicly known that any future failures of financial firms will include a backstopping of the counterparty obligations. Just as the increased FDIC insurance will prevent bank runs, this kind of statement will actually prevent the failures of the likes of Morgan Stanley and Goldman Sachs.
The Fed and Treasury do not have the luxury of adopting a "wait-and-see" approach right now. There is no room for timidity. Shock and awe is what is needed, not more incrementalism. That Fed chief Ben Bernanke only cut rates by 50 basis points during the global intervention is underwhelming at best. Fed funds were 1% in 2003, and we weren't even close to the precipice we're on now. What rainy day is Bernanke preserving his bullets for? Once again, Bernanke has squandered another "bullet" with his grudging incrementalism. When Paulson speaks about plans for deploying the TARP, what is he trying to accomplish by saying that he is still "weeks away" and that "not all institutions" can be saved? Is he trying to downplay expectations from current lofty levels?
It's a shame that so many potentially assuaging actions have been rendered impotent by the bumbling efforts of our government. To have any hope of curing the patient, the doctor must first display confidence in his or her ability to find the cure, and then be systematic in the administration of the cure. Our government has done neither, and it is resulting in unprecedented wealth destruction that is making a Depression scenario more and more likely with every passing day.
At the time of publication, Kao and his firm were actively trading FNM, FRE, GS, MS and WB.