What the bailout will, won't do
Once the system stabilizes, fixing overleveraging is next
By Howard Newman
October 13, 2008

Will the $700 billion Emergency Economic Stabilization Act work? It all depends on what problem you want the financial market rescue act — signed into law by President Bush on Oct. 3 after frantic debate — to solve, and how the Department of the Treasury will implement the authority it has been given.

If you want the bailout package to end the fall in real estate prices, it will not work. The distress in the real estate market reflects the fact that housing became too expensive and, to a lesser extent, that many markets became overbuilt. Those problems can be solved only by housing prices falling to affordable levels and housing starts being dramatically reduced. Fortunately, much of the required adjustment in housing prices has taken place, and the current low level of builder activity will bring excess inventories into line, though probably not for at least two years.

If you want the rescue to prevent lenders from foreclosing on delinquent loans, it will not work, and it might do some harm. Once prices have fallen to affordable levels, there is a tremendous incentive to avoid the foreclosure process and work to keep a homeowner in a property. However, when prices are still falling, there is an incentive to repossess and sell as soon as possible. The provisions in the act that are designed to slow the foreclosure process and address the housing crisis are counterproductive and will just prolong the crisis. It would be better to deal with them directly.

If you want the bailout to punish those lenders who made foolish loans and own real estate paper based on inflated prices, it is unnecessary. That punishment already has been inflicted by the market. While the act does facilitate the realization of those losses, including those not recognized through mark-to-market accounting, it will not increase them.

If you want the bailout to end the process of deleveraging, you will be sorely disappointed. The laundry list of factors that allowed the U.S. financial system to become overleveraged is large, and includes financial innovation outpacing regulation, a desire by investors to offset declining returns through leverage, accounting rules that did not require financial institutions to reflect their true leverage, mark-to-market accounting that assumed markets would always be liquid, trade surpluses created by developing countries that added to demand for liquid investment products, and the separation of origination and ownership implicit in the rise of securitization. The act does not — and should not — attempt to solve these structural problems. That will take much more time and thought than was available to solve the liquidity squeeze in the market.

However, if you want the rescue to unclog the financial system, end the run on the capital markets, and allow the recapitalization of the banking system, it will work if the Treasury is allowed to be guided by economic principles.

But if you want the rescue package to prevent the U.S. or global economies from slipping into recession, look elsewhere. Stabilizing the capital structure of the banking system will make it possible for lending to take place, but won't make it happen. Credit is restricted because of concerns over repayment, not because of a shortage of funds. Thoughtful economic policies — both fiscal and monetary — are the solution to the slowdown, not more reckless lending.

What we have seen in the past few weeks can only be described as a run on the capital markets. That run is the problem the act is designed to solve, and solving it is a proper function of government. The steady downpour of bad news has badly shaken investors' faith in the value of their investments and they want out. As has been the case in every financial panic in the past, the stampede to liquidity causes otherwise solvent institutions to fail. The only thing that is new in this crisis is that it encompasses a wider group of institutions than panics in the past.

The bailout will allow institutions to sell distressed paper to the Treasury at fair-market value without an additional discount for illiquidity. If the Treasury uses its authority wisely, this value should reflect the decline of real estate values to affordable levels.

If the Treasury offers to buy mortgage paper at fair-market value, it will accomplish a number of important objectives. First, traders and investors will be able to buy knowing that only economic factors, as opposed to liquidity issues, will determine its future value. Too many investors are sitting out the market because everything they buy is going down.

Once the illiquid assets have been sold, healthy banks will be able to attract capital and refinance themselves. The Treasury is being given authority to do “good bank/bad bank” deals by taking the bad assets and financing them. If done properly, what is left is a good bank that can be assessed and valued by investors.

Once the system is stabilized, the Treasury and the Federal Reserve will be able to move to the much more important task of modernizing the regulatory framework that allowed this situation to develop in the first place. Recent advances in financial technology essentially allowed an end-run around the capital requirements upon which the system is built, and the leverage that crept into the system over the past 20 years allowed risk premiums to be artificially reduced.

The need for the bailout legislation underscores the fact that liquidity is a property of markets, not of instruments, and that markets are a product of psychology. The traditional remedy for illiquidity in the banking system was to flood the system with reserves, driving down borrowing costs and creating opportunities to profit on these spreads. This approach works only if the system has time to reap the profits that result, and it did not stop the run on the capital markets this time. The bailout, by fixing the value of the assets in the system and providing term financing for them, directly addressed the pathology of the current environment and was the only possible solution.

Howard Newman is president and chief executive officer of Pine Brook Road Partners LLC, New York, a private equity firm investing in financial service and energy companies.

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