Dimon Throws Wrench Into Paulson’s Monkey Works

I have to give Treasury secretary Henry Paulson credit because he had me fooled.  I was all for a government "bailout" to add liquidity to the financial system.  And despite some flaws, I thought Paulson's plan had merits.  Aside from the lack of specifics, it resembled other plans that governments have used to fight credit crunches.   

But a couple items kept nagging me:

1) Paulson's language in the original draft that "decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency" made me very leery.  That's essentially declaring martial law on the capital markets.  Paulson must have figured that putting this kind of language in a plan would be political suicide.  Unless he actually needed this authority to pull off his scheme.  

2)  The idea that the Treasury had to pay "above market prices" for troubled mortgages and CDOs never made sense.  Neither Paulson nor Bernanke could reasonably explain why the government had to buy paper at above fair market value.   If a bank were about to go bankrupt, say a Merrill Lynch or some other bank with tons of toxic paper, wouldn't that bank take almost any price to get said paper off its balance sheet?  Didn't Merrill Lynch sell its toxic paper for $0.20 cents on the dollar?  So why would the government need to pay above market prices for stuff that the banks are literally dying to get rid of?  It made no sense unless Paulson's plan had an ulterior motive. 

3)  No one could explain this plan correctly to the American people.  At its core, the plan should be really quite simple.  Here's how I would explain it:

"America's banks own lots of troubled mortgages.  By helping the banks clear these loans off their books, you are helping everyone.  Creating a government entity to buy the bad mortgage paper, would give banks the cash to start lending on new mortgages.  That would stabilized the real estate markets and the economy.  

The government would only be acting as a buyer of last resort.  While the paper is "toxic" for banks which need short term liquidity, it still has intrinsic worth because of the housing assets backing it up.  The government would essentially buy the paper at such a deep discount that by the time the mortgages were worked out, the government would probably end up making money while at the same time helping the economy." 

I didn't think it would be so difficult to explain a relatively simple plan.  Unless, of course, working out the troubled loans wasn't the main point of Paulson's plan.  

4)    The reluctance of Paulson to use "tranches" of $150 billion to see if the plan would work.  This seemed like a reasonable request for the use of $700 billion.   

5)   The nagging suspicion that, after letting Lehman go bankrupt and subsequently banning short sales, Paulson might not know what he was doing, after all.   I think history will show that letting Lehman go under, rather than having the government force a merger, was a devastating mistake. 

It's obvious that Lehman had value.  Barclay's has purchased many of the company's assets in bankruptcy.  For the sake of the financial system, Lehman should not have been allowed to go bankrupt.  Rather the government should have negotiated a buyout and provided guarantees to the buyers to help smooth the transition. 

The Lehman failure created tremendous counter party risk and distrust in the system.  Two weeks after the bankruptcy, Lehman still has millions of dollars in prime broker accounts that it is not releasing.  This is money that essentially belongs to hedge funds, not Lehman.  I know, I know…no one is crying for the hedge funds.  Except these are the same people that are now causing runs on banks all over the world.  The fear that other investment banks could go bankrupt and withhold their prime broker accounts led directly to a run on Morgan Stanley and Goldman Sachs.   And that, in turn, led to a run on the jumbo accounts (accounts over $100,000) that many banks use to fund loans.  And that in turn lead to the ban on short selling.  Had Lehman not gone under and created a mess of counterparty risks, a run on the entire system might have been prevented.  

In his haste to punish Lehman CEO Dick Fuld and show his distaste for "moral hazard," Paulson himself pushed the financial system to the brink of failure.  Not a good move for someone who supposedly understands the system.   

Jamie Dimon Crystallizes The Paulson Plan

None of this became clear to me until Friday, when JP Morgan CEO Jamie Dimon came along and "bought" Washington Mutual.  Dimon essentially took $200 billion in deposits and loans for $1.5 billion in cash and $31 billion in "mark-to-market" write downs. 

The mark to market discounts Dimon took had me flabbergasted.  Dimon essentially assumes that 25 percent of all "option-ARM" mortgages could default.  Other banks such as Wachovia had taken just 12 percent write-downs on some of their most dicey loans.  Twelve percent seemed too low, but twenty five percent had even me stunned.

Jamie Dimon has essentially pushed Wachovia into bankruptcy because of his mark-to-market assumptions.  The September fiscal quarter comes to a close in a couple of days.  Wachovia will also have to mark its loans to market and the most respected bank in the country, JP Morgan, just took a 25 percent haircut on its loans.  Wachovia is now in a Catch-22.  If they follow Dimon's lead and mark their riskiest loans down 25 percent, they will have insufficient capital to continue operating. The  FDIC will take the company over.  If they don't take the mark downs, the stock market will realize the bank is being unrealistic in its assumptions and drive the stock down to $1, which will cause a run on the bank. The FDIC will then take the company over. 

Which brings us back to Paulson.  It's this Catch-22 scenario that he wished to avoid with the "bailout" plan.  I believe Paulson wanted to buy risky loans from banks at above market prices so they could mark all their loans to an artificially high level.  Once the artificially high marks were taken, the banks would no longer have insufficient capital.  In fact, they might start to report record profits as the balance sheet marks flowed through the income statement as "one-time gains."  

While Paulson's plan was clever, it didn't really solve anything.  It was a way to spend $700 billion to get around an accounting convention and boost the earnings of banks.  It did nothing to stabilize the housing market or ensure that banks would have sufficient capital to start lending again.  The stock market eventually sees through accounting tricks.  After an initial relief move higher, the market would have started on its downward decent once again. 

Paulson was essentially just trying to buy time.  But Jamie Dimon hit the "time's up" buzzer on Friday.  The mark to market losses will have to be taken.   Paulson ran out of time because the price tag on his plan was too high and the Congress and American people balked.  I would be amazed if the plan, as it stands, gets passed at all.  The voter is rioting in the streets during an election year.  No politician will stick their neck out to get lopped off by the angry electorate.  

A more reasonable solution would be to set up two government entities – one would be a buyer of last resort and one would be an investor of last resort.  The first entity would buy bad mortgage paper at fair market value.  Fair market value would not be much for many of the worst mortgages, but again, many banks would be willing to just get the paper off their books.  This government entity would then partner with private buyers to work out these mortgages.  At the end of the day, the entity would receive a percentage of monies left over after the properties had been sold and the loans re-paid.  The entity would probably end up breaking even after ten years of difficult work. 

The second government entity would infuse capital into failing institutions in return for a senior preferred security.  Banks which sold bad loans could shore up their capital base from this entity.  As it currently stands, the private market is closed for new investments.  No investor wants to be the next TPG, which lost $7 billion in in five months through its investment in Washington Mutual.  Therefore, this second entity is needed to be an investor of last resort.  It would stop the spiral of bank failures we are now experiencing, provide a government backstop and give the taxpayer upside in any recovery that takes place. 

I think this solution would be easy for even Paulson to explain and sell to the American public.  However, his attempts to hoodwink everyone will leave him with so little credibility that I'm not sure any plan, good or bad, will get passed this year.