The Crash

News of Wall Street’s tumult has dominated my reading list for the last week or so. It’s a crazy time.

My understanding of the crisis might not be complete, but I find it easiest to explain with a grocery story analogy. I wrote the following to an e-mail to Mikey back in March: Our “biggest problem is that there isn't any money in the tills— people are hesitant to buy, because there isn't enough change (liquidity and capital) to go around. A secondary problem could be devastating. None of the products on the shelves have price stickers. So, customers (financial institutions) don't really know what the products (assets) are worth, so they are hesitant to make any decisions. Finally, it's unclear what anybody's money is worth. (The dollar is in the tank).”

That was March.

I didn’t understand then the now-obvious implications of questionable asset values — dubious balance sheets mean lowered credit ratings which require higher capitalization ratios. And if you, as an investment bank, hold assets that cannot be capitalized, you are worthless. You are Lehman Brothers. You are done.

It is largely irrelevant if your day-to-day operations are successful. It means nothing that Lehman Brothers have posted something like 100 straight years of profit. Lehman was leveraged out the ass. Between 2004 and 2007, Lehman added $300B worth of assets to its balance sheet, but only $6B in cash. When Lehman discovered that $300B was worth significantly less, it was screwed.

Lehman was not alone.

Now, officials are wrestling with how best to fix the crisis.

The thrust of the Bush administration’s $700B plan is this: The government will buy all your crazy, questionable mortgage-related assets. The government will buy your bad debt. You, bank folk, please go about your business. The plan is simple. It is clean. It is only 840 words long. Literally.

Of course, the administration cannot implement its plan without congressional approval, so the politics have begun. The Democrats will try and make sure the banks aren’t the only winners.

Paul Krugman argues that instead of helping Wall Street sell (capitalize) its assets, the government should simply provide the companies with capital. Give Wall Street money, take an ownership share in the banks, but insist that Wall Street keep its own debts.

He writes:

"'Clean,' in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review 'by any court of law or any administrative agency,' and this adds up to an unacceptable proposal."

Not everybody agrees.

Over at the Wall Street Journal, for instance, Evan Newmark says this is the sort of crisis that requires bold leadership and not committee solutions.

Newmark says Americans are lucky Hank Paulson is the best man for a difficult job. Newmark calls Paulson “an honest broker between the banks and the taxpayers – between Wall Street and Washington.”

Newmark also writes, interestingly, that since the $700B will be spent in purchase negotiations, Paulson needs all the authority and latitude he can amass:

"And that is all this $700 billion bailout is–a negotiation between the Treasury and the banks over who picks up the tab for $2 trillion of bad mortgages.

"There is a lot of money at stake, so it will be almost impossible to produce a plan that makes everyone happy. But the plan has to produce winners on both sides. Push the banks too far–and the Treasury may get more bankruptcies than the system can handle. Don’t push the banks hard enough–and they will get rich at the expense of the taxpayer. It is a balancing act, but who better to find that balance than an honest broker like Paulson?"

I love the debate. It will be interesting to see, many months down the line, to see how it plays out. Here’s hoping things stay “interesting,” and do not turn "devastating."