If you are having a bit of trouble understanding the goings-on in the financial market, it may help to remember that all the government’s plans, manipulations and machinations are directed toward one primary goal: the rescue of the money center banks from a disastrous outcome.

For example: the Financial Accounting Standards Board had earlier ruled that a bank’s Tier 3 assets (those for which no ready market value can be determined) must be ”marked to market” (evaluated for what they are currently worth) and transferred to the lender’s balance statement. The day of reckoning was scheduled for Nov. 15, 2007.

But you will also recall that when two of the SIVs organized by Bears Sterns got in trouble in July ‘07, the SIVs began to sell the assets, thereby establishing a market value for the underlying collateral which consisted in large part of subprime mortgages and other collateralized debt obligations (CDOs) of less than AAA quality. The price obtained by BS in early sales was reported to be about 50¢ on the dollar.

Other major lenders, such as Citigroup, Lehman Brothers, JP Morgan Chase and B of A, rose to the occasion, prevailing on BS not to sell assets which would establish a market value for the less-than-sterling collateral carried by these large bank centers. BS relented and sales were curtailed.

Treasury Sec. Paulson arranged (but did not sponsor) the establishment of the Master-Liquidity Enhancement Conduit (M-LEC), an entity created to provide access to funds for major banks which could experience a “run on funds.” (Recall GB’s Northern Rock.) The idea is that by creating such a fund ($85B), banks under duress would have a ready source of re-financing short-term commercial paper rollovers rather than a sale of assets – and in so doing inadvertently establish a market value for these debt obligations. The final outcome of the M-LEC is still to be decided, but optimists anticipate full funding by 1Q08.

Which brings us back to FASB 157 which mandated a mark-to-market of Tier 3 assets by Nov. 15, 2007. Had this been done on schedule, the effect would have been the same – a drastic, if not calamitous, reduction in the value of collateral held by major banks. No wonder, then, that the relevant provisions of FASB 157 have been “postponed” for one year.

But the cascade of failing subprime mortgages continues unabated. The financial collapse of millions of these high-risk mortgages over the next 18 months could undermine the solvency of even our “strongest” bank centers. Consider, for example, that Citi (Citigroup) holds an estimated $64.7B in troubled mortgages. Citi just got outside help from the Abu Dhabi Investment Authority’s (the United Arab Emirates sovereign investment vehicle) $7.5B cash infusion in return for 4.9% convertible bonds bearing an 11% coupon.

Now Paulson’s Copper Bullet

Secretary Paulson has been careful to emphasize that the latest device to delay the recognition of big bank losses will not be a “silver bullet.” His effort is to obtain an agreement among loan servicers, loan investors and lenders to arrest the scheduled rise in Adjustable Rate Mortgage rates and impending defaults. This is a herculean task made more difficult by the fact that the investors who now own these less-that-desirable debt obligations are diffused throughout the world.

Sec. Paulson envisages dividing the subprime borrowers into three groups:

  • Those who cannot sustain their mortgage payments even if the payments were frozen at the teaser    rate.
  • Those who are well qualified and can sustain increased payments without help.
  • Those who cannot sustain their payments at an increased interest level but who can make the payments at the lower teaser rate.

Since many of the subprime borrowers were Ninjas (No income, no job, no assets), this group (1) would be most likely not to receive help and would be allowed to proceed to foreclosure. But of the remaining two groups, Paulson’s plan would subsidize group (3) but not group (2.) All of which creates an advantage for one group at the expense of the other.

The Paulson Plan assumes no direct help using government funds but it does depend on the willingness of investors to absorb losses on mortgage contracts which they bought. Case in point: Florida’s state-run Retirement Pool which invested heavily in SIVs. A run on the Pool within the last 2 weeks reduced assets from $27B to $14B before the administration group (Fla’s Governor, CFO and Atty. Gen) halted withdrawals. The case has captured national attention since so many other pension plans are in the same financial soup.

But Rep. Charles Rangle’s (D. MA, Chairman of the House Financial Committee) pending bill would not only give federal judges the right to modify mortgage contracts (an action prohibited by Article 10 of the U.S. Constitution) but would also forgive any tax due from a borrower who sold his home for less than the balance of the mortgage (a “short sale”), thereby realizing (ala IRS) “taxable income.” It would also reset the Fannie Mae and Freddie Mac lending limit much higher than its current $417,000. Countrywide Financial’s CEO Mozilo likes this idea and has recommended a 50% increase in the limit to $650,000. This would allow the GSE’s to purchase mortgages from lenders thereby transferring the risk from owning entities (pension funds, banks, investors,) to agencies which have the implicit guarantee of the U.S. government. This would be a transfer of private debt to public debt.

There is no simple solution to the current subprime problem. If the subprime problem were left to market forces, the market would purge bad loans and bad borrowers in relatively short order. This would be painful and would undoubtedly accelerate the coming recession. But we would be through with it rather than prolong the inevitable, as did Japan for the decade of the ’90s.

And the millions of potential real estate buyers who are now waiting for the bottom of the market would become active buyers. And the nation would recover. And perhaps learn something about easy credit.

But come Dec. 11th, alas, we expect another rate cut, higher inflation, a weaker dollar and more kicking the can down the road. Our coming recession is likely to be deeper and more protracted that just a few quarters. We don’t expect a ‘silver bullet’ from the government; we just wish that it would get out of the business of trying to manage the economy. They do a lousy job of it.

Everyone of voting age should read Daniel Yergin’s "The Commanding Heights."