I think Congress and Bush should tell us the truth. This bail out package will not fix the credit market. The function of this bailout package is to keep the Over Counter Credit Market solvent. (See: http://www.occ.treas.gov/deriv/deriv.htm) There has always been a debate about there is enough capital to withstand crises in this market. I wish to note this:
Credit risk is a significant risk in bank derivatives trading activities. The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. The credit risk in a derivative contract is a function of a number of variables, such as whether counterparties exchange notional principal, the volatility of the underlying market factors (interest rate, currency, commodity, equity or corporate reference entity), the maturity and liquidity of contracts, and the creditworthiness of the counterparties.
Credit risk in derivatives differs from credit risk in loans due to the more uncertain nature of the potential credit exposure. With a funded loan, the amount at risk is the amount advanced to the borrower. The credit risk is unilateral; the bank faces the credit exposure of the borrower. However, in most derivatives transactions, such as swaps (which make up the bulk of bank derivatives contracts), the credit exposure is bilateral. Each party to the contract may (and, if the contract has a long enough tenor, probably will) have a current credit exposure to the other party at various points in time over the contract’s life. Moreover, because the credit exposure is a function of movements in market rates, banks do not know, and can only estimate, how much the value of the derivative contract might be at various points of time in the future.
The bailout package is targeted to the tier 2 capital requirement: subordinated debt. A firm can go to the financial market to replace its tier 1 capital.
You can get public support if Congress lowers expectations. This package is a business loss.
A note on the connection between monetary policy and the cost of credit. Recent events have shown the old path of short term interest rates: Monetary Policy ->> Primary Broker ->> Banks ->> Us is changed.
It is more like:
Monetary Policy ->> Primary Broker ->> Intermediate Financial Instruments ->> Us
->> Banks ->> Us
->> Other users
As one can see the “distance” between the Federal Reserve and the Real Economy is longer. The reality is the fact the market sets the value of credit. The result of this mechanism dictates a recession (business cycle) can not be stopped. The nonsense about the short term interest rates and trying to make this a V shape turn around has to be stopped.
Also, the nonsense about U$ Dollar weakness and closing the trade gap has also got to be stopped. The truth is there is a lack of confidence in the US Governments leadership. If you can show to the investment public you understand the real cause behind the housing market you can “jaw bone” the currency market toward U$ Dollar strength.
Here are some facts:
- IRS data show that the median tax filer’s income - half earn less than the median, half earn more - fell 2% between 2000 and 2005 when adjusted for inflation, to US$30,881.
- There is no mystery why housing prices are declining. All one has to do is to read; Income, Poverty and … for 2006 (http://www.census.gov/prod/2007pubs/p60-233.PDF) released Aug 28, 2007. Real wages dropped by 1.1%. One should expect real household income to decrease in the 2007 report. All the definitions used are given as http links in the report.
- Let’s take a look at the user cost of capital. From Housing and the Monetary Transmission Mechanism (http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.PDF) (all terms are defined in the paper) Fraud invalidates the after tax real interest rates. This went on for years.
- The implosions, in the sub-prime housing market, CAN NOT stay in the sub-prime mortgage market. One of the reasons given by those sub-prime loan originators was their expectation of housing price appreciation, not a decline. I believe this attitude was wide spread. In Fannie Mae’s 2004 10K PDF page 99. (http://www.ofheo.gov/media/pdf/f10k03152004.PDF) Assessing the sensitivity of the profitability of the single-family mortgage credit book of business to changes in composition and the economic environment sub-section, one will note that Fannie Mae never consider the possibility of a nation wide price decline. It should be also noted in the same section Fannie Mae stated credit risk was based on the asset value of the home, not the income of the home owner. This assumption was removed in 2005. Fannie’s Mae 2006 10K PDF page 151 (http://www.ofheo.gov/media/pdf/form10k120606.PDF) assumes a modest price decline. The housing bubble was based on fraud NOT on economic fundamentals. The mortgage meltdown started in 2005 when the “smart money” pulled out of these securities. The free market sells first and asks questions later when fraud is discover.
It is not the function of the US Government to guarantee a minimum return on investment capital (in most cases. ex student loans can be a good payoff). The notion of using private equity is a bunch of cow patties. If private equity can calculate the discounted vale of an asset they would have done so. Let’s also look at the mechanism of private equity. Private equity does not keep asset forever. They sell at a profit. In other words, the use of private equity inserted a middle man in the transaction between the US Government and the end client. This increases the cost to the US Tax payer. Private Equity wants to make a profit. They want too much. Again, this increases the cost to the US Tax payer.
If US Tax payer goes on the hook then we insist pay is reasonable. Debt must be renegotiated. On one extreme, it may be impossible for the original mortgage to be repaid. The other extreme is one in which a refinancing agreement can be reached (cheaper and easier).
Viva La Résistance Toward Government Bailout!!!
Bush and Congress must point out the fact this bailout package buys time. If you do not calm down the panic, the voter will insist on changing the global financial plumbing, a Smoot-Hartley bill. We need the global financial system to solve our healthcare problem. Jobs and wealth is created by the return of investment capital. I understand the use of the US Government’s lower borrowing cost however, in the long run, return of investment capital is creates more wealth. The use of credit risk instruments can be used to control healthcare cost. Interest rate movements are well model and can be hedge against. The global financial system is independent of the ultimate structure of our healthcare system (public vs. private). Voters will decide which method is to be used.
Known facts: One can not stop a business cycle.
One can not stop voters from going from one end of the political spectrum to the other. In this election season from right to left.
Viva La Revolucion!
