Why the Bail-Out Won't Work

Might it be churlish to wonder just how exactly the US banking bail-out can hope to succeed...?

SEVEN HUNDRED BILLION DOLLARS will flush through the US banking system faster than [insert preferred metaphor here], writes Dan Denning for The Daily Reckoning Australia.

In other words; the bailout won't work.

The crux of the US bailout is that it's designed to keep banks from failing by recapitalizing them. It's like a massive financial organ donor program where the Treasury, like a live organ donor, replaces the malignant guts of the current system with its own, healthy ones.

But of course, live organ donors don't usually swap their healthy organs for failing ones. The Treasury is breaking new ground here.

Even if Treasury secretary Hank Paulson can come up with the full $700 billion from Congress, many of the banks are going to fail anyway. They borrowed money short term to buy long-term assets (mortgage backed securities and collateralized debt obligations). Now, the money must be paid back, but no one wants to lend short term.

Why? Because the assets are falling in value. And when assets fall in value, it wipes out equity capital. You have a small amount of capital controlling a large amount of assets. If you take a write-off on those assets, it wipes out your capital. You're insolvent.

Here's the thing...$700 billion is not going to be enough to remove the troubled assets from bank balance sheets. But then, Paulson must know that. He's hoping that the Treasury's buying kick starts the market by establishing a price for the stuff.

Then, he also hopes, private equity, hedge funds, and others with cash come in from the sidelines to make deals with the banks and get the assets off the balance sheet so the banks don't fail. Trouble is, the price Paulson wants to pay for the assets seems likely to be higher than what the market is willing to pay. Kick-starting the banking system won't work if the first bidder (the government) comes in and pays a price the market has already said no to.

The financial markets may believe, for a day or two, that the passage of Paulson's bailout plan fundamentally alters the dynamics of the US financial system. But it does not. Not one jot.

Borrowed money has to be paid back. Assets that were bought with that borrowed money are falling. That is how all credit bubbles end. This one is no different.

The new Senate version of the bailout bill has some bells and whistles not included in the version that failed to pass the House. Two of the main measures added seem aimed more at shoring up political support for the bill, rather than improving the chances that the plan will actually work. But let's take a look at them anyway.

First, the Senate wants to temporarily increase Federal insurance on deposits in US commercial banks from $100,000 to $250,000. You might wonder what an increase in Federal deposit insurance does to improve the quality of assets on bank balance sheets.

The answer is, "It doesn't."

But the increase in what the FDIC can offer was designed to make the Paulson plan more difficult to oppose in the House. Who could be against providing ordinary savers more insurance for their life savings? No one looking for re-election.

There is also the question of confidence. By increasing FDIC insurance to $250,000 you reassure (hopefully) people that there's no need to remove their money from the bank. Here the Feds aim to prevent a run on banks by depositors that leads the bank to fail. This is what happened first at Indy Mac in July and at Washington Mutual early last week. Depositors took out a whopping $16.5 billion from WaMu between September 15th and the end of the month. That kind of run is a serious drain on a bank's capital. It's a scenario the Congress wants to avoid by increasing FDIC insurance. But it does nothing to improve bank balance sheets, unless, by restoring confidence, it prevents a huge drawdown in a bank's assets (its deposits).

Meanwhile, to address the value of those damaged assets that Henry Paulson can't wait to get his hands on, the SEC clarified its stance with regard to mark-to-market accounting rules. This is where an asset is valued on a balance-sheet at the actual price it would currently fetch in the market. Toxic mortgage-backed securities, however, currently hold no value – and no one seems willing to pay any more for them just because they 'might' one day rise towards their initial price as home-buyers repay their loans.

The SEC's move towards clarifying its mark-to-market plans for the bail-out cash is designed to give banks some wiggle room when it comes to valuing their damaged assets. The higher the banks can value the assets, the less likely the banks are to have to take losses on those assets, or to sell them to meet capital requirements. They can stay in the game. So in essence, the new dispensation permits financial institutions to legally inflate the real-world values of many balance-sheet assets.

The new ruling provides a delicious array of valuation metrics that will enable financial firms to elevate the stated value of their troubled mortgage-backed securities far above what any actual human being would pay.

Granting these new powers of deception is good, we are told, because telling the truth would be too darn painful and would put many banks out of business. This process is a little bit like providing a trophy from Little League as collateral for a $1 million loan. No one actually believes that the trophy is worth $1 million, but since the borrower may legally assert that the "fair value" of his trophy is $1 million, the lender cannot foreclose. Everyone is happy, right?

No bailout plan in the world is going to convert a Little League trophy into a $1 million asset...or a defaulted mortgage into a AAA security. And no bailout plan in the world is going to reverse the fall in American house prices (or even arrest it). Therefore, no bailout plan in the world is going to force banks to lend, if the assets on their balance sheets are both overvalued AND falling in value.

Until someone comes along with a plan that severs the connection between residential American real estate and the banking system, the system itself remains on the edge of crisis.