McCain and Obama Take Back Seat To Financial Market Crisis

Does anyone remember that the first Presidential Debate is on Friday? I forgot. I’ve been a little busy watching both candidates flail in the wind, trying to find a position on the current state of our financial markets. Fortunately for them, the first debate is on foreign policy so they will not have to perfect their messages just yet. Since both candidates have been running for President since George W. Bush’s 2nd term began, it is easy to forget that both are sitting US Senators with a real role to play in bringing stability to Wall Street. Absolutely no one, perhaps not even John McCain, still believes that fundamentals of our economy are still strong.

It is hard to find any good things to say about the 2nd term of the Bush Administration, but I believe either by chance or dumb luck, President Bush deserves credit for the astute hiring of Henry Paulson to lead the Treasury Department at this particular time. There are very few people in the country today with sufficient grasp of the magnitude of this looming slate of economic problems. The former CEO of Goldman Sachs, one of a handful of investment banks that appear likely to survive this current meltdown, not only knows the issues but also has a personal stake in resolving the matter, the value of his own Goldman Sachs stock options having fallen from $809.5M when he went to Treasury to $523.5M at Friday’s closing bell.

A brief history lesson- the current crisis can be traced to government policy in the 1990’s to expand access to homeownership by reducing lending standards. Fannie Mae and Freddie Mac have always provided liquidity to banks by buying conforming loans with the implicit guarantee of the Federal government. Wall Street banks got in on the action in the early '90s by buying up packaged up subprime and/or non-conforming loans and selling them as mortgage backed securities (MBS) with the actual properties providing collateral. The Federal Reserve reduced interest rates. This combination of low interest rates, relaxed lending standards and new loan financing products offered by banks sent property values through the roof.

Home values increased at a rate disproportionate to increases in wages which took first time home buyers out of the market. Without first time buyers, existing homeowners had no one to sell their properties to. A new wave of fraudulent loan applications, 100% financing programs and pencil whipped home appraisals provided a way to keep home sales up. But as increasing mortgage payments became a burden for homeowners who had obtained loans for dollar amounts unsupported by their incomes, foreclosures rose. Banks became increasingly stuck with properties not actually worth their appraised value as homeowners began walking away from the now unaffordable mortgage payments, in many cases, with no money lost.

The result of the housing crisis was paralysis in the credit markets which spilled over into the stock market. Banks became afraid to lend money because they were busy trying to shore up their own balance sheets, forced to write down bad debt associated with faulty MBS. Today, banks still have no idea what the intrinsic value of these MBS is. Given this, short sellers began betting the house that the collective value of this debt was nil and driving the stock prices down on all of these firms, destroying their values. Ultimately, this is what killed Bear Stearns, Lehman Brothers and what was about to off AIG and Merrell Lynch before the government stepped in.

Secretary Paulson’s fix is to provide a government agency that can purchase shaky MBS at a discount from Wall Street investment firms with taxpayer dollars and provide an orderly sale of those securities to obtain the best price available. This is not a free market response but rather injects government further into the private sector. However, while inexcusably late to the party, this is a sound financial response, recognizing that traders have apparently lost all confidence in the balance sheets of most of our country’s financial institutions and had become content to profit from destroying all of them.

Purchasing an asset for the purpose of selling it is not exactly the same as going into unsecured debt. The mortgages which back these securities do have value, just not the value stated. The orderly sale of these MBS, under Paulson’s plan, provides the best opportunity to obtain a fair market value for them. Also, the government will improve the balance sheets of remaining financial institutions to restore trader confidence in the market and sell off the MBS at a price that recoups as much of the planned borrowed dollars as well as the hope of possible profit. The government may buy and sell repeatedly. What remains to be seen is if the $700B the Treasury wants to borrow will secure $600B of MBS or $800B of MBS, in terms of actual value.

$600B bad. $800B good.

In any case, make no mistake about it, to prevent financial Armageddon, we are about to see the largest bailout in US history. Now, in an election year, the focus shifts to Congress where Democrats want any bailout to include many new and expansive Federal regulations and oversight powers over Wall Street. Republicans, especially those in the Senate not up for re-election, see a bailout as a socialist response to a free market problem and are not yet onboard. The White House’s position is that this is a potentially lethal fire that needs to be extinguished immediately and the time for blame and new rules should come later. The potential for this legislation to get bogged down by political add-ons is very high. Hopefully the market does not collapse during negotiations.

While opening up the credit markets on their own would help all Americans who have or need mortgages, credit cards, auto loans etc. as well as those looking at dwindling 401(K) and IRA balances, it is unlikely that legislation will pass without some help aimed directly at homeowners at present risk of foreclosure. Let’s look at the bright side though. At least one American dream will come true. Under Paulson’s plan, finally everyone will become a homeowner. Sort of.

Stay tuned.