Intrade has opened a new market on whether the proposed bill (”TARP”, an acronym for Troubled Asset Relief Program) to bail out financial firms will pass Congress by the end of the month. The contract trades as BAILOUT.APPROVE.SEP08. Open for the past couple of days, the market has already gained significant trading volumes, and an early verdict: the bill looks about as close to a sure thing as you can imagine (90% at the time of writing).

Why, is not hard to fathom: Now that the White House, and the Fed and Treasury are finally owning up to the scale of the issues that need to be dealt with, they are desperate to demonstrate that they are in control and have all of the answers. They have pulled out every stop, including , not surprisingly, the use of scare tactics to strong-arm legislators into swallowing the TARP package whole.

Whereas a few quarters ago there was no “problem” requiring intervention according to the Administration; now the problem is of such a magnitude that unless the TARP gets passed before the end of September the world as we know it will end.

Red Herrings such as the debate on executive compensation are being thrown about to divert attention from the fact that the proposal arguably represents the biggest usurpation of Congressional accountability, oversight and responsibility to the voters in the history of the Republic.

In our view a rescue plan must satisfy several basic criteria if it is to be successful and contribute to a lasting betterment of the situation:

• The Plan must recognize that the first step in any troubled asset remediation  – if one’s objective is to avoid bankruptcy and liquidation – is first and foremost, to Stabilize the situation and then to Triage the zombies.
• The Plan must conserve precious financial resources.
• The Plan must be transparent and allow for performance benchmarking and accountability.
• The Plan must recognize that the process of remediation will take a long time and that not all problems are presently fully in view.
• The Plan must offer a reasonable probability of success to the American public.

Sadly, the proposed TARP legislation falls short in all of these key respects. Looking at this by the numbers:

There is nothing in this plan that suggests a normal stabilization process to remediate bad assets will feature prominently in the process of buying out the cratered paper. There does not seem to be a triage process defined in the legislation. As a consequence some institutions requiring help may not get it and others may receive more assistance than they need. The proposal leaves the entire process open to bad decisions and misappropriation. Wall Street houses are already now lining up to offer their services in helping to administer various parts of the proposal – to earn fees from problems they or their friends helped to create.

In his remarks to Congressional leaders earlier this week, Paulson signalled that it was time to move away from a case-by-case approach to a taxpayer funded  “carpet bombing” of the problem. The proposal to undertake a bond-financed USD 700 Billion buyout of bad assets could be not more ill-advised, as it is open to fiduciary malfeasance and inefficiency, and it further and unnecessarily encumbers the Government Balance Sheet. Because it is far from clear that this is as big as it is going to get, the strategy furthers pushes the envelope on the country’s solvency and significantly heightens the risk that the eventual bailout will be financed by printing money.

The draft of the TARP reads in part: “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.” It goes on further to state…..”The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this act without regard to any other provision of law regarding public contracts.” No wonder Congressional leaders are rightly up in arms, there is no accountability and no transparency.

There is a real risk that the proposed legislation will prove inadequate because it does not address the other areas of concern that could lead to additional problems for financial institutions, Main Street, and the economy generally. These include now-latent problems in commercial real estate, brewing issues in the derivatives markets, the growing risk of a sell-off in the bond markets, and  the impact of rising prices and a slowing economy on corporate profitability and creditworthiness.

As a consequence of the forgoing, the probability of the proposal as announced and being discussed as leading to a durable solution are extremely remote – whether or not some of the features of the plan are amended. It is flawed in its essence. The markets will not buy into this for very long.

A Different Proposal

Here we suggest a solution that starts off with the premise that Stabilization and Triage are key. In order to help ease the gridlock in the credit markets we propose that the Treasury extend a specific guarantee over the liabilities of all US Financial institutions that apply for inclusion in the remediation program. The guarantee would be secured by the equity of the companies and a priority claim on their assets in the event of default. To apply, financial companies need to have assets above a minimum threshold of materiality, own a threshold percentage bad assets out of total assets, and be participants in the interbank markets.

Inclusion in the remediation program will also require that each of these institutions provide an accurate accounting of its financial position and a register of all impaired and defaulted assets on their books to the Treasury; and that each senior officer and the board directors of such applicant institutions provide representations and warranties for the accuracy of those submissions that would be irrevocably secured by a high percentage of their personal assets.

This would be a one time “Get Out of Jail for Free” card for the zombie institutions and their managers.

This strategy also suggests that the holding action to supply adequate liquidity to the markets to keep the credit wheels turning is continued by the Fed and other global central banks. As banks begin to trade with each other in the interbank again – the US Institutions with the benefit the guarantee from the Treasury – the central bank sources of liquidity could be gradually scaled back. The stabilizing actions (and other tactics not herein discussed) will provide the necessary breathing room to properly assess the situation and run a triage exercise.

In this phase, and using the information supplied by the applicant institutions, the Government would conduct a parallel process to assess and value all of the cratered assets in order to evaluate the sick and dying institutions and measure the actual scale of the problem. Valuations should rightly feature a distinction between OLV (Orderly Liquidation Value) and FLV (Forced Liquidation Value) to determine the scale of the buyout funding.

The weaker institutions could then be merged off with stronger players and bad assets would be hived off into a Bad Bank Vehicle (in the Remediation stage of the process). At each stage Treasury managers of this exercise would report to Congress through a public mechanism. Funding would be doled out on an as needed basis and subject to strict oversight.

As such the legislation to deal with the issues needn’t be rammed through in one go. There could be separate, less overarching, legislation for the Stabilisation operation, and additional legislation to cover offer the Triage and Remediation stages of the plan. This would give Congress and the public time to properly consider the proposals.

Moreover, the immediate Operating and Balance Sheet impact of this proposal would do far more to bolster confidence, buoy the markets and the support value of the US dollar than the idea to appropriate USD 700 billion of bond finance for a quickie buyout. At a minimum, there would be no immediate need to raise this vast sum of money on top of already otherwise ballooning fiscal requirements.

The actual “cost” would be limited to the government taking on a contingent liability relating to the solvency of companies that it knows it will rescue with certainty, but only after appropriate due diligence has been conducted and after the size of the problem at the various companies has been soberly determined. As the guarantee would only cover the “Loss Given Default” of the liabilities, the size of the contingent liability at this stage is probably in the range of USD200 billion at most, and would not need to be financed. This is vastly more financially efficient than the TARP.

The Reality

Whilst we believe that other solutions such as ours outlined above merit consideration and that this is no time to be making significant decisions under artificial pressure and with still limited information, we also agree with the market’s political assessment of the legislative situation as outlined above. The package will pass.

Therefore we believe that ultimately this will all end in more tears. In our view, the combination of bumbling and incompetence represented by the lurch into these financial difficulties, the constraints on future action imposed by previous rescue measures, and now the $700 Billion TARP “Bond Aid” response is setting the stage for even worse problems yet to come.

This entry was posted on Thursday, September 25th, 2008 at 3:16 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.