Where Do We Go From Here?

"Is there any reason why the American people should be taxed to guarantee the debts of banks, any more than they should be taxed to guarantee the debts of other institutions, including merchants, industries and mills of the country?" -- Senator Carter Glass, author of the Banking Act of 1933

With that act, US Senator Carter Glass put his imprimatur on one of the most important pieces of financial legislation, the Glass-Steagall Act of 1933, a bill that was knocked to smithereens and destroyed in 1999 by Republicans and Democrats alike.

The bill was crafted to put a firewall between staid deposit-taking banks and more dicey Wall Street activities such as selling stocks, bonds and later speculative derivatives that has all of Wall Street, and now the US government, staring morosely at this moldering pile of decaying tissue paper.

A pile that the US taxpayer now owns via the US government's bailout of Fannie Mae, Freddie Mac, American International Group, and the $700 bn rescue of Wall Street's mortgage-backed securities.

It's a mountain of dust that still threatens to smother Citigroup (C), JPMorgan Chase (JPM) and Bank of America (BAC), which has bought Merrill Lynch (MER), the recipient and repackager of all things Countrywide. Derivatives that proved the downfall of Bear Stearns and Lehman Brothers.

Derivatives that proved not just Wall Street, but Congress, with its terrible lack of regulatory oversight on the part of Democrats and Republicans alike, have no more sense than a flock of pheasants.

And it's a pile that now threatens to swamp the US budget with record deficits never before seen in the history of this country and slam the already ailing US dollar.

We must put up the guardrails once and for all.

I urge you to read through to the bottom to see what is at stake and what must be done now to protect the financial system--and U.S. taxpayers.

The Country's Mega-Dumpster

Now we have the $700 bn bailout, the mega-bailout creating the mega-dumpster of all to buy that rotting paper that was crafted by habitually self-deceiving, hubristic hustlers on Wall Street, who, unburdened by conscience, felt entitled to follow their own codes of conduct as they went berserk enriching themselves.

Readers, who I so appreciate, know I've been saying since last fall that the free market has turned into a free-for-all, that in the process Wall Streeters have now sewaraged the once white-shoe reputation of finance with a kind of thinking that exists only on the margins of the Bell Curve.

It is their unfathomable stupidity, and the fact that these exotic derivatives that so enriched Wall Street but now have the same rights to the US Treasury as plain vanilla Treasurys, that is already engendering a voter outrage hot enough to melt platinum.

And now we have come full circle, as with a great thundering thump, the Federal Reserve took the unthinkable step of converting the last two major investment banks standing, Morgan Stanley (MS) and Goldman Sachs (GS), into traditional bank holding companies.

It's the end of Wall Street as we've known it.

Are you being protected now?

The clear as rain answer is no. There are positives and negatives though. "Nobody wants to swallow a bitter pill, especially a $700 bn one," says Jill Schlesinger, president of Strategic Point Advisors. "But we know for certain that doing nothing will result in financial calamity."

Schlesinger adds: "In other words a fence at the top of a cliff is better than an ambulance at the bottom."

*Government's coolants will start to take effect on the market. The insurer of last resort, the backstop of last resort, the US government, one of the last triple-A rated borrowers left standing, as well the temporary ban on short sales, will calm the markets starting this week. Watch out when the 10-day ban on short sales is lifted, as volatility will come storming back;

*Don't expect interest rate cuts for now. The central banks' coordinated massive liquidity injection will cause interbank, overnight rates to drop, helping ease lending. The Federal Reserve may have temporarily lost control of the Federal Funds rate, which has risen above and below its set rate for some time now since last August when the central banks first intervened mightily with huge liquidity injections. Inflation will remain an enduring problem.;

But Where Do We Go From Here?

The US taxpayer will now buy distressed mortgage-backed securities not at fair market value but at the value hashed out after much arm-twisting between the Treasury and Wall Street, who wants to sell at above market prices. The brief two-pager on the plan purposely doesn't say that the government will buy this junk at distressed, fair market values.

What Should We Do Now?

*Keep Mark to Market Accounting. If market watchers who know anything about accounting thought this through, they'd know to stop pressuring the accounting rule makers to suspend fair value accounting because the taxpayer is now on the hook for these assets.

Fair value accounting, called mark to market accounting, says companies must book values on their financial statements for their assets as if they were going to sell them today in the market place. Since hundreds of billions of dollars of mortgage-backed securities, $500 bn on Wall Street alone, can't be sold because no one wants to buy them, that means Wall Street must record these assets at lower and lower values, triggering record writedowns and losses, $514 bn and counting.

Yes, governments affected by the Latin American debt crisis temporarily suspended mark-to-market accounting, where companies price-tagged their assets based on prevailing market prices (meaning these things were bottoming fast because no one wanted them). At that time, they let companies under their purview use historic pricing.

Marking to Taxpayers

Suspending it temporarily over the past year prior to government intervention might have made sense.

But now that the government has stepped in with massive bailout money, marking this Kryptonite to market now is the right thing for taxpayers as it will keep costs down. Wall Street and banks who will take the profit hits can access the expanded Fed discount window--or merge. Enough is enough.

Doing otherwise, letting Treasury buy at any price, should make foreign funding sources look askance at the country's balance sheet--and think twice about buying our Treasurys, (what analyst Brad Setser rightfully calls "the quiet bailout"), a shunning which is already happening by China.

The valuation swings between these assets at companies are huge. In the most recent quarter, for example, A.I.G. had $20 bn of subprime mortgages marked at 69 cents on the dollar and $24 bn in Alt-A securities valued at 67 cents on the dollar.

But Lehman officials on one of its last conference calls with investors said it was valuing similar subprime mortgage securities to those held by A.I.G. at 34 cents on the dollar; its mark on the Alt-A holdings was 39 cents.

Why should you care about this? Again keeping mark-to-market accounting will save taxpayers money as housing continues to bottom.

Meredith Whitney, a top Oppenheimer bank analyst, has already reported that major banks are understating the severity of the house price declines in their assumptions, which means they could be overstating the value of their mortgage-backed securities (see blog "Top Analyst Warns Banks Too Optimistic About Housing").

Futures markets have priced a peak-to-trough decline of 33%.  We are now about 20 percentage points off the peak of July 2006. I say 35% to 40% is more reasonable. We have a long way to go.

Bank of America (BAC) and JPMorgan Chase (JPM), through 2008, are using 25% to 30% and 24% peak-to-trough declines, respectively. Citigroup is using just a 23% peak-to-trough assumption.

Will the Treasury Do the Right Thing?

Watch out.

The new bailout provision says explicitly that: "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."

This puts the Treasury's actions beyond the rule of law, which means the Treasury can at will buy this Kryptonite at any price it deems fit with no accountability.

All Treasury has to do is make a report to Congress twice a year on its progress. I can see the conflicts of interest looming from lobbyists who want their consultants to get a piece of this action.

So....

*Protect the Fire Sale. There will be political pressure from financial companies on the new government mega-dumpster, a bum's rush, "me first" arm wringing. The Democrats are right to call on the Office of the Comptroller of the Currency to conduct oversight and to keep the bankers' mitts off the new entity. It happened during Sweden's credit crisis in the ‘90s--the Swedish government shelled out 4% of GDP to recast problem credits.

But politicians in Sweden mucked it up, delaying the end game. That 4% by the way in our case would equate to a $552 bn burden to taxpayers, but it ended up being much less eventually in Sweden because the government sold off assets at a profit--once meddling politicians got out of the way.

Also, just by way of comparison, the Resolution Trust Corp. in the early '90s restructured 750 insolvent thrifts, took on about $225 bn in bad S&L assets and sold them for $140 bn.

*Dial down Freddie and Fannie. Now. The new law forces the two behemoths, which taxpayers now own, to start winding down their book of business starting in 2010. But they only have to do so after they, by a new law, get to ratchet up their book of businesses to a total of $1.7 tn to help with the housing crisis.

The new law says they must dial back, starting in 2010, by 10% a year until they hit $250 bn each, down from $850 bn each.

Do you think future Congresses will have the intestinal fortitude to see this through?

*Do More Bank Mergers. Now. Pre-emptive, bazookanomics policy is the order of the day. Why not with bank mergers? Some 1,187 banks and S&Ls went under in the ‘90s thrift crisis, equal to more than $454 bn in assets. So far there have been 11 failures this year equal to about $40 bn. There are now 117 banks on the FDIC's problem watch list, up fm 90 in the prior quarter and 60 a year earlier. Washington Mutual's (WM) $170 bn in deposits would give a shock to the FDIC claimant pool of about $43 bn or so (much of those deposits have been lent out in the form of loans).

*Force Wall Street to Ante Up. Force a new FDIC style insurance premium pool that investment banks must pay in to back their businesses. Taxpayers, who have bailed it out, deserve no less.

And the Federal Reserve should force publicly traded investment banks and force their parents too, to have capital cushions at these units equal to 15% of net assets, with no debt nonsense in it or junk like credit defaults swaps or preferred shares in Freddie Mac or Fannie Mae. I mean true, liquid assets.

It is nonsense of the highest order to let these teenagers gear themselves up 40 to 1, for example, (Merrill Lynch) with no adult supervision from the Securities and Exchange Commission.