Who Killed Capitalism?

“Capitalism is dead,” said Steven Brant of the Huffington Post. If it isn’t, it is certainly badly injured. Financial markets are frozen. Credit has evaporated. It seems our economic system is teetering on the brink of collapse. Jeremy Siegel, finance professor at the University of Pennsylvania´s Wharton School of Finance commented, “Two weeks ago was the first time in my life that I was worried about the very stability of the United States financial system.” So what does the EESA propose to do, and who is ultimately to blame for this crisis?

EESA: WHAT IS IT?

Recently U.S. legislators approved the Emergency Economic Stabilization Act of 2008 (EESA). EESA is the successor to the Troubled Asset Relief Program (TARP), a simpler version of the same bill which was rejected by the House of Representatives days earlier. In addition to pledging $700 billion to procure illiquid mortgage-backed securities and distressed real estate loans, the expanded legislation also:

•Encourages federal agencies to modify residential mortgages to help stave-off foreclosures. •Demands that the United States government receive an equity stake in firms that benefit from the bail-out funds, in order that taxpayers may participate in potential profits. •Caps compensation and termination packages for executives of rescued firms. •Extends a variety of tax relief provisions to individuals and special interest groups. •Temporarily increases the FDIC deposit insurance limit from $100,000 to $250,000 (until December 31, 2009) and provides the FDIC with unlimited borrowing authority from the Treasury.

Funding is promised in three stages: $250 billion released immediately; an additional $100 billion released with unilateral Presidential approval; and a final $350 billion subject to Congressional disapproval.

Pricing and procedures are left to the discretion of the Treasury, but three primary acquisition mechanisms are anticipated.

Of these, the primary mechanism for purchase is through reverse auction, whereby institutions bid on RFPs and the Treasury fills the order with the most attractively priced collateral. The bill also allows direct purchase of assets in situations where a market auction mechanism is not feasible or appropriate, such as time-sensitive circumstances or esoteric asset classes. In addition, the Treasury is also provided the option to guarantee principal and interest payments of assets held by participating institutions, in return for a risk-based premium.

Eligible institutions include banks, broker dealers and insurance companies. These institutions hold the majority of non-agency mortgage debt. Hedge funds and mutual funds are excluded. According to Goldman Sachs’ October 3rd US Economics Analyst Issue Number 08/40, “US subsidiaries of foreign institutions are eligible, but foreign holding companies are not. Non-qualifying firms may sell assets to qualifying firms, but sales to the Treasury may not be for a higher price than the price paid for the asset.”

America is conflicted about the government’s role in the crisis, and about EESA in particular. Some say it unfairly transfers the financial costs of Wall Street’s avarice to work-a-day citizens. Representative Marcy Kaptur of Ohio’s 9th District states that “Wall Street game masters have kept billions of dollars of their gains and shifted their losses to American tax payers.” Senator Jim Bunning (R-Kentucky) warned that “[EESA] is financial socialism, and it is un-American.”

Others argue that EESA wisely allocates community resources to avert the collapse of our financial system. Jonathan Laing wrote in a recent Barron’s cover article: “There’s no question that the Bush Administration’s $700 billion bailout plan is necessary.” Siegel adds, “We were on the verge of falling into an abyss, which was only averted when news leaked out of the bailout plan.” And Yale economics professor Robert Shiller reports in the Washington Post, “Today’s federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles.”

Some see government intervention as the origin of the whole debacle. The Chicago Tribune recently editorialized that the economy is in trouble because of “too much government. Not too little.” In a September 29, 2008, article titled “In Times of Crisis, Trust Capitalism” and published on Real Clear Markets, investment officer Joseph Calhoun argues that the housing bubble stemmed from government interference in the form of artificially low interest rates, legislation encouraging home loans for low credit borrowers, and subsidized mortgages from quasi-governmental agencies FNMA and FHLMC.

Others cite a lack of government oversight and urge tighter regulatory controls and more intervention as the only way to resolve the problem. “Capitalism require[s] checks and balances to ensure that [it] work[s] properly,” wrote Robert S. McElvaine in the Washington Post. “One of the most prominent dangers of capitalism is that income will become too concentrated at the top, undermining the functioning of a consumer-based economy.”

FINDING BALANCE

Clearly, policies like EESA are polarizing. We like clarity, not grey areas, so in the face of complexity we tend to make ideological biased judgments. Moreover, we want someone to blame, whether “gluttonous financial tycoons” or “pig-headed politicians.” So we take a stand and point fingers.

But if there’s one truth that emerges from this economic carnage, it is that “irrational exuberance” is costly; temperance and prudence in the recent boom would have been a desirable alternative. Why then, would we not apply that same lesson to the bust?

Our current financial crisis was created by greed—in overreaching home buyers and insatiable bankers alike. All enjoyed the benefits of hyper-liquidity. The bubble grew incrementally, and none of us wanted it to contract. Like frogs in a warming pot, we collectively failed to recognize an overheating economy in the form of unsustainable expansion.

But as always, the dam broke. And it broke hard. At the point of inflexion, the financial markets flipped from unrestrained greed to unrestrained panic. Irrational pessimism replaced irrational exuberance seemingly overnight. We called it “flight to quality,” “risk aversion” or “unwillingness to catch a falling knife.” Those who were able chased profits through short trading, credit default swaps and other bearish wagers that punished the weak. Like greed in a bull market, fear in a bear market is a self-fulfilling prophecy. Thus, self-preservation has contributed as much to this financial crisis as the self-indulgence that seeded it.

Rather than stampeding over a cliff like lemmings, perhaps we would be better served by taking stock of the situation, accepting personal responsibility, modifying our behaviors and moving forward. EESA has been approved by the legislators elected to make such decisions. How might we expect it to help?

EESA: HOW DOES IT WORK?

Illiquid debt assets on the balance sheets of our financial institutions are the heart of the problem; there is no meaningful market for afflicted institutions to sell these troubled assets. Consequently, value is in a vortex. Laing comments “A negative feed-back loop has developed for the banks in their pell-mell rush to deleverage, raise capital and remain liquid. The more mortgage securities they sell, the weaker the prices get, which, in turn, forces even more security sales at ever lower prices in a futile attempt to outrun the credit tsunami.”

EESA intends to establish a value for these assets, accelerate recognition of appropriate losses, rebalance the capital ratios of participating institutions, increase confidence in short-term interbank lending, and (it is hoped) clear the log jam in our capital markets. Essentially, the Treasury will attempt to leverage the largest balance sheet in the world (the U.S. government’s) to break the negative feedback loop that is destroying liquidity.

Some are concerned that $700 billion in asset purchases may not be sufficient to absorb all of the troubled assets. According to Goldman Sachs in its October 3 US Economics Analyst report, approximately $11.3 trillion in face-value residential mortgage debt is currently outstanding. Of this, roughly $1 trillion is delinquent or in foreclosure as of the second quarter 2008. Another $150 billion in commercial loans are delinquent or in foreclosure. Given that the Treasury will buy assets at a substantial discount to face value (Bill Gross of PIMCO estimates 65 cents on the dollar), it is likely that the $700-billion-capitalization yields buying power approximately equivalent to the face value of bad real estate debt.

It is not yet clear how the assets to be purchased will be valued. The Treasury is required to provide guidance within 45 days of enactment (mid-November) or two days after the first auction is held. Goldman Sachs expects the first purchases in the first week of November. A major purpose of EESA is to establish a value for troubled mortgage assets that is greater than the current “fire-sale” pricing. According to Goldman Sachs however, congressional testimony and legislative discussions imply that the program should not attempt to artificially infuse capital into troubled institutions by paying inflated prices to buy bad assets. Instead, the Treasury is likely to estimate the intrinsic “hold-to-maturity” value of the securities, and use this price as a benchmark in auctions.

The program will probably focus on helping major money-center banks on Wall Street, which hold the majority of the illiquid securities being targeted. However the balance sheets of main street institutions, such as regional banks, are equally troubled by bad residential loans (primarily land and construction debt). It is yet unclear how EESA may benefit or ignore thousands of small banks. However, enhanced liquidity at the top of the food chain should flow throughout the system and relieve pressure everywhere.

Laing dismisses the notion that U.S. tax payers will get stuck with the bill. His analysis (and that of Warren Buffet among others) suggests that the whole endeavor could turn a tidy profit. The Treasury is taking advantage of an extraordinarily low cost of funds (3 percent to 4 percent T-Bills) to “invest” in assets at a historic benchmark low; even with draconian default and recovery assumptions, the Treasury stands to make a positive 7 percent to 8 percent yield spread on the purchase. What’s more, the Treasury is unhampered by balance sheet ratio requirements or shareholder return expectations that could force untimely liquidation.

The sheer volume of the investment may reverse pricing. Jeffrey Gundlach, Chief Investment Officer at TCW Group, an important mortgage fund managing firm, sees this as a distinct possibility. “Essentially this secondary effect would do much to lift housing out of its funk and actually improve the performance of the securities that Treasury ends up buying,” he says. “Thus, I think that there’s a good chance that the bailout plan will be a win-win for both the taxpayer and the financial system.” If the Treasury buys right and holds these assets long enough, prospects for the U.S. taxpayers are good.

PERSONAL RESPONSIBILITY

So who killed capitalism? We all did. Everyone played a role in creating this crisis—admittedly some more than others. So there’s little point bickering now.

Opinions on how best to prevent further problems—or worse, a recurrence—will vary. Tighter regulation and legislation will no doubt play a role, to the dismay of some and the relief of others. But we cannot regulate away this problem because capitalism, like democracy, is imperfect, as is our ability to legislate human nature.

Leadership blogger Michael McKinney notes on LeadershipNow.com, “You can’t regulate greed out of existence. Regulation just improves creativity. Greed is regulated by character. Character is built at home, in our schools, in our churches, and yes, in our businesses.”

I was taught that challenging experiences build character. This is just such an experience. And character is exactly what we need; calm, steady, individual leadership, and commitment to move forward. We must resolve to be prudent and measured, but unafraid. Panic and profiteering at this sensitive moment can do great harm. I’m not recommending any fool hardy charges on “business as usual”; A little confidence and common sense will do. Our currency is, after all, only a symbol of the value we imbue to our economic and political systems. Besides, what is that nice phrase we print on the front of our coins? Here’s to temperance, character, and a little faith during this (and the next) economic cycle.

Steven Orchard is an SVP with George Smith Partners Inc.