what i learned today

I was a bit caught up the past two weeks and did not get a chance to write about everything I wanted to, so bear with me as we go through some week-olds. The first, what the heck is this bailout? What will it do? Why did the first one get voted down? What’s the difference between the first and the second plan? And WHY oh why isn’t it working yet?!!

What is this bailout?
The bailout was intended to inject confidence back into the market so that everyone would start trading again. See, much of our market rev up was due to the trading of mortgages, which lost their value and are unable to be sold now. This “bailout” would jumpstart that market again. Or so they hoped. Later, they’d use the $700B to buy up distressed mortgage securities (not the mortgages themselves, but the Mortgage Backed Securities that got us into this mess – remember the ones where they bundle up all of the mortgages and then sell that bundle off like a stock. These are CMOs, CDOs, CDSs, ABSs.).

Why this plan? Interestingly enough, many thought the reason the Great Depression was so great was because the government did not act fast enough. In their book A Monetary History of the United States: 1867-1960, Milton Friedman and Anna Jacobson Schwartz argued the Fed could have mitigated the financial crisis of the 30s by cutting rates, buying bonds, and making loans. Instead, the Fed reduced its credit to the banking system, causing about 1,860 banks to fail. Luckily for us, Bernanke is a Great Depression expert (really, he studied the G.D. intensively.. perhaps they had a bit of foresight when they brought him on in early 2006).

What’s the difference between the first and second plan?
The initial draft was 3 pages. Here’s the initial draft proposal. But many thought the first plan gave Paulson too much power and that the government wasn’t going to get enough ownership stake in the companies so that we, the taxpayers, could benefit if the plan worked.

That got reworked into about 110 pages for Bailout Plan #1. The first plan gave the Secretary of the Treasury (Paulson) the right to buy up any mortgage related assets. It proposed disbursement of the $700 billion in stages. The first $250 billion would be issued when the legislation is enacted while another $100 billion could be spent if the president decided it was needed. The remaining $350 billion would be subject to congressional review. In an attempt to protect taxpayers, the banks selling the assets would issue stock warrants – which gives us an opportunity to take an equity stake and therefore make profits.

But it was voted down on September 29 in the House, 228 to 205. The majority of nay sayers were the House Republicans, but it received nays from both sides.

Back to the drawing board. The Senate then reworked the plan and had a new draft ready October 1. On October 3, the House approved the plan, 263 to 171. What was the difference? The second plan, a 450 pager,saw a few changes – it requires the Treasury to set up an insurance-based alternative. That is, instead of buying up the mortgage securities (MBSs), the Treasury will act as an insurer to the banks holding MBSs and the bank will, in return, pay the Treasury a premium. It also temporarily raises the FDIC insurance limit from $100,000 to $250,000. It also allows for the purchase of MBS’s through a reverse auction, where the banks will compete to sell their assets to the Treasury. The Treasury sets a price (usually a higher one to ensure good participation) and then allows the institutions to offer lower prices. It also allows the Fed to pay interest on the money that banks must leave in the Central Bank – this will hopefully provide some more liquidity into the financial system and to our ailing banks.

It’s also stuffed with what people like to call PORK. $150 BILLION worth of tax provisions for some rather random parties. Here’s the list of recipients:

• Wind Power
• Solar Power
• Disaster Victims
• College Students
• Teachers
• NASCAR Racetrack Owners - $128 million
• Small- to Medium-budget Film and Television Productions - $10 million
• Bicycle Commuters
• Makers of Virgin Islands Rum & Puerto Rican Rum $192 million.
• Owner of Plug-In Electrical Vehicles
• Corporations Operating in American Samoa - $33 million
• Mine Rescuers
• Worsted Wool Fabric Producers
• Alaskan Fisherman whose livelihoods suffered as a result of the 1989 Exxon Valdez oil spill - $223 million
• Makers of Wooden Arrows for Use by Children - $6 million

So with all that The Emergency Economic Stabilization Act aka the Wall Street Bailout Plan was passed by the House 263 to 171 and was signed October 3. Huzzah!

Huzzah? But it’s not even working!
No, it’s not working. At least the confidence part, since the actual implementation of the plan hasn’t begun yet. Despite all the attempts at assuaging our fears, fear levels among investors are high, fear levels among the banks are high, since they’re not lending each other money as they usually do, and fear levels among the rest of us are high. And it’s showing in the market.

A golden parachute is a clause in an executive’s employment contract that specifies he will receive benefits in the event the company is taken over and the executive is let go. A golden parachute can come in the form of severance pay in cash, stock options, bonuses, etc. The term more loosely refers to an executive’s  severance package - regardless of takeover. Golden parachutes are designed to protect the executive from job loss and to hinder unwanted takeovers.

The origin of the “golden parachute” comes from TWA and Howard Hughes. Shareholders wanted to decrease Hughes’ control of TWA and so appointed Charles Tillinghurst as chariman of TWA. They guaranteed Tillinghurst financial protection (a severance package) if Hughes were to retain control and fire him.

Below is a list of various egregious compensation packages and golden parachutes awarded to Wall Street’s best. They’re listed in chronological order of bank failure. (Numbers may be disputed based upon which CEO pay calculator you use. Some include cash, pension, benefits, accelerated stock and options and other compensation, while some do not. Either way - you get the point.)

Countrywide - Angelo Mozilo was supposed to receive a $37.5 million severance package when Countrywide was acquired by BofA in January, though he declined it. He did, however, cash in on his stock options to make about $122 million.

Bear Stearns - James Cayne sold his stake of Bear shares for $61 million just before the company completely collapsed and was sold off to JPMorgan.

Indymac – Michael Perry, Indy’s CEO & Chairman, was dealt something more like a golden anvil. He’s under investigation for misleading the investing public about IndyMac Bank’s risk profile and financial condition from April 26, 07 until May 12, 2008.

Fannie Mae - Daniel Mudd earned $11.6 million last year and was expected to receive $8 million in a severance package after Fannie was rescued. The Federal Housing Finance Agency (FHFA) denied him that golden parachute.

Freddie Mac - Richard Syron earned $18.3 million last year and was expected to receive $16 million when Freddie went down. Again, the FHFA, which Congress gave the power to limit severance packages of departing executives, said no.

Merrill Lynch - Stanley O’Neal received a $161 million retirement package when we was let go last year after the bank saw huge losses. When Thain came on board, he said he wouldn’t accept any cash severance.  Instead, he took restricted stock, giving him a nice $9 million parachute to fly away from the sale of Merrill to BofA.

Lehman Brothers - Richard Fuld, Lehman’s CEO, received about $22 million in exit packages and earned $354 million in his last 4 years as CEO. He also sold about $490 million worth of LEH stock before it collapsed. Not a bad retirement plan.

AIG - Robert Willumstad was supposed to receive a $22 million exit package when AIG was rescued by the Treasury, but he voluntarily declined. His predecessor, however, was not as humble. Martin Sullivan, who was forced out of AIG in June 2008 received $15 million in severance package.

Washington Mutual - Kerry Killinger, WaMu’s former CEO received $44 million upon his departure on September 8.  He was succeeded by Alan Fishman, who was on the job for 17 days before WaMu went down, but received $20 million.

Goldman Sachs - Lloyd Blankfein, Goldman’s CEO, made $70 million last year.

Morgan Stanley – Mack the Knife received over $1.6 million in stock last year.

Wachovia - Ken Thompson received package worth $5 million when he was ousted in June (after making a nice salary of $20 million in 2007). Bob Steel, his predecessor brought on in July, was set to receive $1 million salary plus a $12 million bonus, but we’ll see what he really gets after the dust settles in Wachovia’s sale to Citigroup.

Citigroup - Chuck Prince left Citi last year with a $22 million severance package. Mind you that was after Citi announced far greater than expected losses.

JP Morgan Chase – CEO James Dimon earned about $28 million in 2007.

Other Refs and Reading

• Give every person in the US $2,300 or give every household $6,200.
• Pay the income taxes of every American who makes $500,000 or less a year.
• Fully fund the Defense, Treasury, Education, State Veterans Affairs and Interior departments next year, as well as NASA.
• Buy gasoline for every car in the US for 16 months.
• Buy every NFL, NBA, and MLB team and build each one a new stadium - and pay your players $191 million a piece for a year
• Create the 17th largest economy in the world - roughly equal to that of the Netherlands.
• Or you could pay off just 7% of the $9.8 trillion national debt. (via Time)

OR you could nationalize some mortgage related debt (aka “impaired assets”) that banks, credit unions, and pension funds hold. Using our tax dollars, of course.

If you haven’t heard, the “mother of all bailouts” may soon take place in the US. The Federal Reserve plans to spend $700 billion to buy up mortgage related debt from our ailing banks so the banks will be able to lend again. Credit is, after all, what America runs on. As Bernanke put it, it’s “the last wrench in the toolbox” to fix our financial crisis. But how did we get here? Here’s where the blame game leads us…

Greenspan
He had interest rates too low for too long, which resulted in the housing bubble. But what is too low too long? You can’t blame the guy for thinking “innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means.”

Consolidated Supervised Entities Program
In 2004 the SEC changed the rules under which banks with at least $5-billion of capital calculate their gross leverage ratios. It basically raised the leverage ratio to 30, from about half that. A gross leverage ratio measures the amount of debt a company has compared to its net capital. There are different ways to calculate a leverage ratio - this law governed the comparison of debt to net capital (which is basically your total capital minus anything that can’t be easily converted into cash (like debt)). A leverage ratio of 30 basically means there was 30 times as much debt (bad stuff) as there is equity (good stuff). Under the law, the banks could take on more debt, which was good when times were good because it allowed them to make more transactions. However, high levels of debt means it takes only a small decline in the value of the firm for the bank to go bankrupt.

Five investment banks fell under the program: Goldman, Merrill, Lehman, Bear, and Morgan Stanley. It is noted that at the time of decline, Merrill had a leverage ratio of about 40, Lehman of 36.

Goodbye Uptick Rule
In 2007, the SEC eliminated the “uptick rule”, which prohibited sellers from shorting a share when the stock was selling for lower than the previous trade. This rule was instituted after the Crash of 1929, as shorting was alleged to be the culprit of the crash. After research and assessment of the rule, the SEC suggested the uptick didn’t matter and lifted the ban. Now, shorting has been blamed for today’s crisis and has been put on a temporary ban.

Hedge Funds
Hedge funds aren’t as highly levered as ibanks, but do they do a lot of shorting. Perhaps their ubiquity spurred the financial decline. They’ll pay whether or not that is the case. About 90% of hedge funds are currently losing money and that’s sure to increase with the advent of the short selling ban.

Ratings Agencies
It’s not the Fed’s job to allocate or assess risk, so we can’t truly blame Greenspan. But the job is someone’s responsibility. Whose? The ratings agencies, these government sanction oligopolies like Moody’s, S&P, and Fitch. See, the ratings agencies slapped high ratings on all of the Mortgage Backed Securities. An MBS is a bundle of a bunch of loans, some dodgy, some not, that are all rolled into one tradable security, like a stock. The Ratings Agencies rate all securities based on their level of risk. Again, the ratings are a lot like school grades, A  good, B okay/bad, C junk. The Ratings Agencies aren’t regulated by the SEC, and so were not really watched throughout this whole game. So they were able to slap high ratings on risky MBS’ last year, and then downgrade AIG last week, putting the onus of bailing them out on you and me.

The SEC
The SEC was created in 1933 to protect small investors against securities fraud. It doesn’t have robust oversight over all financial entities, ratings agencies included, and is not really equipped for our financial world.

The Deregulatory Financial Modernization Act of 1999
In 1933, Congress established a set of banking regulations under the Glass Steagall Act. Thinking commercial banks (ones that take deposits from everyday citizens) caused the Crash of 1929, the act separated the commercial banks and the investment banks. This way investment banks would take on risky investments, and commercial banks could protect its members by not. Before 1933, there were few investment banks and the Glass Steagall Act spurred Wall Street as we know (ahem, I mean knew) it.

The Glass Steagall Act was repealed, however, in 1999 under the Deregulatory Financial Modernization (Gramm-Leach-Bliley Act) Act. This allowed the commercial banks to take on the same risky bets that ibanks did. A commercial bank (one that sells to you and me, like Citigroup or WaMU) could trade Mortgage Backed Securities, Collateralized Debt Obligations, and other SIVs, Structured Investment Vehicles. So basically, it allowed the guys that are usually safe and who hold my life savings to take on risky investments and get all mixed up in the mess too.

The Glass Steagall Act of 1933
Or you could blame the Glass Steagall Act of 1933 (mentioned above) itself, for really creating the stand alone investment bank in the US.