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Sunday, September 28, 2008

The Bailout: Many Devils in the Details

Momentum is building behind the weekend revisions made to the financial bailout bill which may allow it to be enacted and signed into law within days. What follows below are quick comments that come to mind from a first reading of the entire 106 page bill, now officially termed the Emergency Economic Stabilization Act of 2008. Even from a single cursory reading, it seems clear the bill lacks any material clarity required to prevent abuse of the sweeping powers it grants. It also seems clear the bill fails to include any economic and regulatory incentives to alter the market behaviors that produced the need for such a bailout in the first place.

The full text of the September 28 version of the act is available at:


Text from the act is shown in bold letters with my commentary in normal text.

(3) Designating financial institutions as financial agents of the Federal Government, and such institutions shall perform all such reasonable duties related to this Act as financial agents of the Federal Government as may be required.

Before the earlier of the end of the 2-business-day period beginning on the date of the first purchase of troubled assets pursuant to the authority under this section or the end of the 45-day period beginning on the date of enactment of this Act, the Secretary shall publish program guidelines,

At the rate institutions are imploding, all allocated money could be committed before a single explanation of the mechanisms by which the money was committed would be communicated to the public. Even after splitting the authority of the program into phases, that's still $350 billion of unaccountable spending of public dollars.

(e) PREVENTING UNJUST ENRICHMENT.—In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the resale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset.
This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code.

This really provides no defense at all when one of the ways the Treasury is "solving" problems is by allowing instant mergers of collapsing institutions into other banks with zero Congressional or Justice Department review.

REPORTS.—The Secretary shall report to the appropriate committees of Congress on the program established under subsection (a). Such report shall be submitted prior to any increase in the authority to purchase troubled assets in accordance with section 115.

Mechanisms for insuring assets created by the Secretary do not have to be explained until the first funding allocation is exhausted and the Secretary requests additional authorization to purchases assets. Again, that allows vast amounts of dollars to be spent and commitments made before the public has any clarity on how the mechanisms work (or don't work). In item (2) of this clause, it says the Secretary shall publish the methods used to set premiums based on risk but provides no implicitly or explicit requirement of WHEN such publication will be produced.

(3) PAYMENTS FROM FUND.—The Secretary shall make payments from amounts deposited in the Troubled Assets Insurance Fund to fulfill obligations of the guarantees provided to financial institutions under subsection (a).

Looks legal-like and official huh? This means the Secretary of the Treasury shall make payments when situations warrant paying out guarantees against defaulting instruments. Much of the document reads like this --- very obvious statements to help fill out the structure while obfuscating other content that ISN'T in the document but should be.

(5) ensuring that all financial institutions are eligible to participate in the program, without discrimination based on size, geography, form of organization, or the size, type, and number of assets eligible for purchase under this Act;

This is nonsense. The amount of funds committed by Congress is likely to be FAR less than the total value of mortgages and instruments at risk. BY DEFINITION, the effort needs to focus on institutions big enough to trigger a cascading failure if they fail. Even though a dollar is a dollar is a dollar, WHERE that dollar exists in the system (or more accurately, where it NO LONGER exists in the system) is key to the risk posed to the system. A small regional banks with $1 billion of trouble poses far less risk to the entire systemw than $1 billion of trouble at a megabank that is $1 billion away from insolvency. The Treasury's own actions to date make it clear they are willing to let small players fail while protecting the big players.

(8) that nothing in this Act prevents the Secretary from protecting the retirement security of Americans by purchasing troubled assets held by or on behalf of an eligible retirement plan other than a plan described in section 409A of the Internal Revenue Code of 1986; and

This translates to: Nothing in this act prevents the Secretary from using the funds to also attempt to backstop public and private pension plans -- other than unqualified deferred compensation plans for executives subject to 409A tax code rules. This clause essentially pulls in another class of financial institutions under the supposed protective umbrella, subjecting whatever financial limit is approved for the plan to many more competing interests.

(9) the utility of purchasing other real estate owned and instruments backed by mortgages on multifamily properties.

The secretary shall also consider the value of directly bailing out developers of overbuilt condominium and apartment complexes in the most bubble-prone areas, thus assuring Florida will remain a source of electoral shenanigans as politicians lobby to "help the most" by lobbying the Treasury to help their allies.

(c) REGULATORY MODERNIZATION REPORT.—The Secretary shall review the current state of the financial markets and the regulatory system and submit a written report to the appropriate committees of Congress not later than April 30, 2009, analyzing the current state of the regulatory system and its effectiveness at overseeing the participants in the financial markets, including the over-the-counter swaps market and government-sponsored enterprises, and providing recommendations for improvement, including—

April 30, 2009 provides roughly three months of time for players in a new Administration to take their seats and dig through the blizzard of paper left from the outgoing team. Ideally, a report from CURRENT players should be required by 12/31/2008 just to put them on the record about what happened and what they did with follow-up reports to be issued by the new Administration after they find the bathroom and nearest emergency exit by their office.

(a) STREAMLINED PROCESS.—For purposes of this Act, the Secretary may waive specific provisions of the Federal Acquisition Regulation upon a determination that urgent and compelling circumstances make compliance with such provisions contrary to the public interest. Any such determination, and the justification for such determination, shall be submitted to the Committees on Oversight and Government Reform and Financial Services of the House of Representatives and the Committees on Homeland Security and Governmental Affairs and Banking, Housing, and Urban Affairs of the Senate within 7 days.

This translates into: The Secretary doesn't have to follow existing federal laws for government contracts and purchases with regards to minority-owned or female-owned business and simply has to notify Congress it is ignoring the law when it sees fit. This is fundamentally a reflection that few of the major players benefitting from this bailout are minority- or female-owned businesses and as such, those players have no recourse with the government for the billions spent.

(c) CONSENT TO REASONABLE LOAN MODIFICATION REQUESTS.—Upon any request arising under existing investment contracts, the Secretary shall consent, where appropriate, and considering net present value to the taxpayer, to reasonable requests for loss mitigation measures, including term extensions, rate reductions, principal write downs, increases in the proportion of loans within a trust or other structure allowed to be modified, or removal of other limitation on modifications.

This provides the Secretary the ability to alter interest rates, terms or principle amounts of any mortgage assets acquired under the program. However, it doesn't explicitly tie it to any conditions applied to the entity benefiting from the change. You can bet we will be hearing stories for the next 10 years about well-connected parties having terms renegotiated while the un-connected are left with original terms that force them out of their home into bankruptcy.

(A) limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity position in the financial institution;

The section on Executive compensation for firms involved with assets acquired by the program is a key addition to the updated bailout plan. Unfortunately, the language above is so poorly worded that it might wind up being useless. It should have read:

(A) Limits specified in both percentage terms and dollar values shall be applied to all executive compensation including options, deferred compensation and performance based bonuses to prevent undue risks from being taken by firms while the Secretary owns or insures assets originated by the firms.

SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES AND CENTRAL BANKS. The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.

The Secretary will encourage the central banks of foreign countries to create similar boondoggles, but, in the event they demur, the Secretary shall have the authority to buy up their trash as well under the assumption it will aid stabilization for foreign banks doing significant business in the US.

(E) EXERCISE PRICE.—The exercise price for any warrant issued pursuant to this subsection shall be set by the Secretary, in the interest of the taxpayers.

This clause is included in the conditions on how the Secretary will act to acquire and later sell any senior debt positions or warrants in firms requiring assistance. The phrase in the interest of the taxpayers or phrases like it are scattered throughout the document. Unfortunately, most have exactly the same amount of detail to describe the "interest of the taxpayer" as that shown here. NONE. Without reference to specific formulas or existing publicly understood methods for valuation, these clauses all leave open the possibility (likelihood?) of corruption by the Secretary setting an artificially low value to be paid back, allowing troubled firms to enjoy more of the upside if they turn-around without paying back the dollars that took taxpayers to the low point of the firm's meltdown.

(b) DISCLOSURE.—For each type of financial institutions that is authorized to use the program established under this Act, the Secretary shall determine whether the public disclosure required for such financial institutions with respect to off-balance sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure is adequate to provide to the public sufficient information as to the true financial position of the institutions. If such disclosure is not adequate for that purpose, the Secretary shall make recommendations for additional disclosure requirements to the relevant regulators.

If, upon reviewing the books of an institution requesting assistance under the program, the Secretary cannot make heads or tails of said books for the purposes of supporting an arm's length valuation of assets to be acquired, the Secretary shall make recommendations to appropriate regulatory agencies for additional disclosures. What this should say is that if the firm's books cannot support any reasonable determination of the value of the assets being acquired, the firm shall be required to suspend quarterly SEC filings and review / restate earnings for prior quarters appropriately before any assistance will be provided. There is no justification in allowing the firm to continue filing quarterly earnings reports pretending all is well when a floor cannot be found for assets requiring taxpayer assistance.


The new version of the bailout defines the requirements for the "magic resolution" which must be approved by Congress to essentially halt the program in its tracks if the Congress decides it doesn't like the results of the program after reviewing the many reports its operators are required to produce. These sections define a variety of parliamentary rules which must be satisfied in the House or Senate (whichever body initiates the resolution). It isn't clear whether these terms were added by House or Senate members. I'm sure proponents claimed these were required so that any public concern by Congress about the continuance of the program would be (relatively) quickly resolved to avoid spooking markets. However, the inclusion of such arcane parliamentary rules to control a bill's future fate within the bill itself seems very odd.

(1) ANNUAL AUDIT.—The TARP shall annually prepare and issue to the appropriate committees of Congress and the public audited financial statements prepared in accordance with generally accepted accounting principles, and the Comptroller General shall annually audit such statements in accordance with generally accepted auditing standards.

This might be the funniest clause in the entire text of the plan. Exactly HOW is the auditing of ANY of this program going to comply with Generally Accepted Accounting Principles? If GAAP had applied, these firms would have figured out five years ago that these financial instruments should have been avoided. If GAAP were applied right now, many of these assets would be marked down to zero since, by definition, we are IN this predicament because the market for these securities has completely disappeared. If no market exists to assign a value for an asset you hold, the only legitimate value to impute is ZERO.

(a) AUTHORITY.—The Securities and Exchange Commission shall have the authority under securities laws (as such term is defined under section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.

This will make producing those annual audits according to GAAP principles much easier -- by simply invoking superpower privileges to waive normal mark-to-market accounting rules to avoid recognizing reality and ignore the parts of GAAP that prevent the numbers from adding up.