Landing Safely in the New World of Finance

The financial crisis is very confusing, even to those in the industry, or so it seems given the variety of analyses we have seen. But I pass along what ever I think seems especially insightful (emphasis on seems).

First, what we have always known as "Wall Street" is no more. A Wall Street Journal editorial, "The End of Wall Street," Sept. 23, 2008) announces it.

And so, in a single week, the era of the independent investment bank has ended. Wall Street as we've known it for decades has ceased to exist. Six months ago there were five major investment banks. Two -- Lehman Brothers and Bear Stearns -- have failed, Merrill Lynch is selling itself to Bank of America, and now the last two are becoming commercial banks.

What has replaced it? David Brooks calls it "The New Establishment" (New York Times, Sept. 22, 2008). He helps us understand it with a short historical retrospective on the old establishment and what intervened. The Paulson plan "is a pure establishment play."

[The Paulson Plan] would assign nearly unlimited authority to a small coterie of policy makers. It does not rely on any system of checks and balances, but on the wisdom and public spiritedness of those in charge. It offers succor to the investment banks that contributed to this mess and will burn through large piles of taxpayer money. But in exchange, it promises to restore confidence. Somebody, amid all the turmoil, will occupy the commanding heights. Somebody will have the power to absorb debt and establish stability.

Here are two different views of the Paulson bailout plan. Andy Kessler, a former hedge fund manager, says that "The Paulson Plan Will Make Money for Taxpayers" (Wall Street Journal, Sept. 25, 2008). He predicts a $1-2 trillion dollar windfall for the public treasury. The political reality of this is, however, that even if it is true, while the public would pay the bill up front for the $700 billion bailout, Congress would go on a drunken spending spree as the profits roll in. Net losers: generations of taxpayers.

In today's Journal, John Paulson, a New York money guy, argues that "The Public Deserves a Better Deal." Under what he calls the "Preferred Plan," because he thinks we should prefer it, we would "[i]nvest the $700 billion of taxpayer money in senior preferred stock of the troubled financial institutions that pose systemic risks." The Fannie Mae and Freddie Mac deal serves as a model, and it is also the deal Warren Buffett has worked out with Goldman Sacks.

He argues that the most important feature of this plan is that it protects taxpayers while stabilizing the system.

Shareholders had their dividends blocked and remain first in line to bear losses, as they should have been. Taxpayers came both first and last -- first to get paid back, as the new preferred stock is senior to all shareholders; and last in realizing losses, as common and other preferred equity would be extinguished before the taxpayers would be at risk."
This mechanism -- purchases of senior preferred stock with warrants in troubled institutions -- addresses the problems with the Treasury plan. The financial market is stabilized, companies get recapitalized, failures are avoided, debt securities are supported, and time is gained for illiquid assets to mature.
The institutions continue to function, their cost of funding will decline as equity capital increases, and innocent third parties like bank depositors, broker/dealer clients and insurance-policy holders are all protected. The only difference is that potential losses are kept with the shareholders where they belong.

I suspect that the answers are fairly obvious to anyone who is informed and public-spirited. Thus, I suspect that the wrangling and disagreement on Capitol Hill between Treasury and Congressional Democrats (Barney Frank et al.) has more to do with securing power and prosperity for themselves and their friends than with the public good.

We should beware of the establishment protecting itself and enriching itself at public expense. Given that Washington players are lucratively connected with them, voters must judge for themselves who is dealing honestly and who is snowing us.