TARP in Trouble

Our Salesman-in-Chief is pushing this latest bailout plan hard, but Congressional leaders may not be able to bring along the rank-and-file, who are getting bombarded with messages of outrage from constituents. With the general election just five weeks away, congressmen running for re-election are going to have a hard time ignoring those messages. Voters have short memories, but not that short.

The proposed "Emergency Economic Stabilization Act of 2008" will require an initial outlay of $250 billion (with another $100 billion at the President's immediate disposal) to fund a Troubled Asset Relief Program (TARP). Once the Treasury Secretary burns through that, he has access to another $350 billion unless Congress votes to withhold it. TARP funds will be used to buy impaired securities for future resale, hopefully at higher prices. Only when TARP has sold all its inventory will taxpayers know the true cost of the program.

It's not like Congress actually has the money. One provision of the new bill is to raise the Statutory Limit on the Public Debt (the so-called debt ceiling) to $11.315 trillion. This will make it legal for us to borrow and spend even more. And it's not like the $700 billion of borrowed money is going to be enough, either, with tens of trillions of dollars worth of illiquid assets looking for a home. So what's the point?

According to erstwhile presidential candidate Ron Paul, the mission is "to prevent the liquidation of bad debt and worthless assets at market prices, and instead [to] try to prop up those markets and keep those assets trading at prices far in excess of what any buyer would be willing to pay." In other words, government will be in the price-fixing business, last attempted with little success during the Nixon Administration. Distressed securities for which there are no bids will be marked to maturity. (I call it marked-to-mandate.) Recent regulations requiring mark-to-market accounting by investment firms may be rolled back: "The Securities and Exchange Commission shall have the authority under the securities laws...to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board."

Recalcitrant lawmakers on Capitol Hill have formed a "Skeptics Caucus" out of concern that the government will overpay for troubled assets. Convening the caucus a week ago, Rep. Brad Sherman (D-Calif.) proclaimed, “this is greatest shift of power to the imperial presidency and the greatest shift of wealth to a still wealthy Wall Street that anyone could imagine.” The Skeptics cannot be reassured by the present bill, which leaves it to Treasury Secretary Hank Paulson to develop TARP guidelines, including "methods for pricing and valuing troubled assets" and "criteria for identifying troubled assets for purchase." The Secretary is furthermore authorized to make "direct purchases" of assets where "use of a market mechanism...is not feasible or appropriate."

The Secretary's new job, thus, is to create a market where none exists and a price structure that fortifies financial-sector balance sheets under severe pressure since marking to Merrill. And he needs to broadcast the results with all the gusto of a carnival barker. "To facilitate market transparency," the bill reads, "the Secretary shall make available to the public, in electronic form, a description, amounts, and pricing of assets acquired under this Act, within 2 business days of purchase, trade, or other disposition." The goal is to alter perception in the marketplace, to entice private bidders back into the pool.

If private capital remains on the sidelines, the Paulson Plan will go up in smoke.

Merrill, Lehman Are Goners

While most of us got to watch football this weekend, government officials and bank executives had to work overtime in the Big Apple to address the ongoing, ongrowing credit crisis. For those folks, seven-day work weeks are now the norm. Their task is to shuffle assets in a way that will assure investors that (a) they know what they're doing and (b) what they're doing will work. If the answer to either question is "no," financial markets will crash.

Last week came the announcement that Fannie Mae and Freddie Mac will be bailed out by U.S. taxpayers. The news this morning is that Merrill Lynch and Lehman Brothers will cease to exist: Merrill is being taken over by Bank of America, while Lehman is filing for Chapter 11 bankruptcy protection to allow more time for liquidating assets. Treasury Secretary Hank Paulson, apparently of the opinion that taxpayers have done their part, is holding firm for a private-sector workout. Meanwhile, the Federal Reserve (privately capitalized, remember) stands ready to lend funds to other troubled firms (think AIG). Trouble is, the Fed's firepower has already been cut in half year-to-date.

Merrill's demise is no surprise, as vultures have been circling since February. What is a surprise is the price that Bank of America is paying: $29 a share, or 70% higher than Merrill's stock price at the close of Friday's trading. (Too high, traders are saying this morning, as BAC is down five in the pre-market.) In a similar move last March, JPMorgan Chase got Bear Stearns at a substantial discount. So why the premium now for Merrill? In all likelihood, the Fed forced the deal. It remains to be seen whether BAC shareholders can be forced to approve the deal.

A stock-market rout is a distinct possibility today, but it is the price that must be paid for future economic recovery. The bad actors in the false prosperity of the past decade must be allowed to fail. Unfortunately, we will all share the pain in the years ahead. As market strategist Mike O'Rourke observes, "The problems will be the reverberation throughout the economy as access to capital becomes even tighter than it already is. It appears that the amount of de-levering the market is about to encounter in coming months will likely outweigh the benefits of last week's GSE program."

[update, Sept. 17--]
With Merrill Lynch saved from bankruptcy, will the firm satisfy Maine's claim to funds invested last year in MainSail II? A check of the Maine Treasurer's website reveals that the issue was resolved three weeks ago. Merrill has agreed to pay back the $20 million.

Latest on Lehman

After yesterday's bloodbath, in which the common stock of Lehman Brothers declined in value by 45% in a single day, company executives feverishly accelerated their quarterly report by a week. Originally scheduled for next Wednesday, third-quarter earnings were released this morning instead. The news was worse than expected: a loss of nearly $4 billion and a mark-to-Merrill write-down of twice that on its inventory of mortgage-backed securities.

Lehman announced several steps to repair its balance sheet. It cut its quarterly dividend from 68 cents to a nickel (should have been done a year ago) and disclosed plans to sell a majority stake in its investment-management business (good luck--the Koreans just walked away from a possible deal). There was also talk of spinning off its commercial real-estate portfolio into a separate, publicly traded company, but that's just a shell game, no value added. All this is to "reposition" the firm, according to the CEO, who must not be comfortable with the current position of prostrate and tire-marked.

The hastily arranged conference call was meant to prop up the stock price, which briefly exceeded $9 a share in the pre-market as short sellers cashed in. An hour into the regular trading session, the stock has settled back to 8, down 85% in the past year. If the Mac'n'Mae takeover by the U.S. Treasury earlier this week is any indication, the shares are on their way to zero. Another bad omen: the yield on Lehman's two-year paper is going through the roof. The firm will be unable to roll over its debt as a stand-alone entity.

[update, Sept. 11, 8:15 a.m.--]
LEH is getting crushed in today's pre-market, trading near 5.

[update, 15 minutes later--]
Make that 4. Sounds like a launch-pad countdown!

[update, Sept. 12, 8:15 a.m.--]
Now trading with a 3 handle.

[update, Sept. 15, 7:00 a.m.--]
Now less than a buck, as the company files for Chapter 11 bankruptcy protection.