It's The Insolvency, Stupid

Shoot first, ask questions later. In the wake of last week's financial nightmare, this philosophy was remarkably popular. Many observers pressed the US Congress to quickly approve a $700b bailout plan to buy up distressed assets and restore confidence to the American economy. From this perspective, the federal government could not afford to get bogged down in legislative details as markets entered a negative spiral. In reality, measured deliberations are the only way in which the federal government can literally afford to fix the crisis.

Earlier this week, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke rolled out a plan for the US Treasury to purchase huge numbers of distressed assets from various financial institutions, at a premium. Effectively the federal government would create a latter-day Resolution Trust Corporation (RTC) to liquidate bad debt, as it did in the Savings and Loans crisis of 1989. These assets would be purchased at above-market value and transferred onto the taxpayers' balance sheet.

In theory, the bailout would relieve a huge credit burden that has frozen interbank lending and commercial paper markets. With distressed assets burdening all the major financials, banks have been uncomfortable making valuations in a very volatile market. According to the Treasury's plan, financial institutions would be able to clear their balance sheets of toxic paper and begin lending once again. 

Upon closer review, however, such a plan addresses only one side of the current economic crisis: illiquidity. Firms are constrained by mortgage backed securities (MBS) which they cannot sell and cannot borrow against. As a result, financials are unwilling to provide short- and even long-term cash without spectacular interest rates. The fundamental market loses its fundamental lubricant: liquidity.

The Treasury's plan would likely ease the credit squeeze temporarily. Unfortunately, it has already experimented with MBS bailouts and seen very limited success. In March of 2008, the Treasury unveiled its Term Security Lending Facility (TSLF) program, which was designed to buy investment-grade debt securities from financial institutions and unfreeze the credit market. Banks effectively blew out the allocated funding, as they attempted to unload depreciated collateral. There was a voracious appetite for cash, and yet the economy has only accelerated towards its breaking point.

These events would indicate that the markets are also suffering from a solvency crisis. Simply put, there is not enough cash available to cover the debt in the economy. The US total debt-to-GDP ratio (including government, private, individual debts) is above 300%, and the bailout will only exacerbate that figure. In many respects, the US must now confront the harsh realities of its FIRE (Finance, Insurance, Real Estate) economy. Unlike the speculative dot-com bubble in 2000, the complex financial instruments related to mortgage payments have left no usable infrastructure. Instead, the country is awash in big consumer durables: vacant houses.

Even as Congress battles in vain to limit golden parachutes (deferred payments and legal loopholes will ensure C-level executives get their millions), it looks as though some form of the rescue bill is sure to pass. Will the market unwind favorable, or will the US resemble Russia in 1998 and Argentina in 2001? One thing seems for sure, however, Wall Street is forever changed.

For a handful of brilliant individuals, it has been a fantastic party. Unfortunately, it looks like taxpayers will be picking up the tab.