Thomson: Comment

Thomson: Comment

Opposition to massive bailouts

A former FDIC chairman who now lives on the Gulf Coast has been instrumental in leading the charge against the bailout. He has an alternative.

By Rod Thomson

Bill Isaac is a frustrated man, and for good reason. He saw the market crash coming on the heels of the vaunted bailout plan, and he knows what should have been done - and what still could be done, but probably won't be.

The former chairman of the Federal Deposit Insurance Corp. understands with economic and legislative precision what Main Street America understands instinctively: The bailout was doomed to fail from the beginning because it did not fix any actual problems.

Bailing out the people and companies who made significant mistakes was hardly a solution, and Wall Street knew it.

"The market is behaving rationally. It knows we have not fixed anything with this bill," Isaac said early last week when the New York Stock Exchange posted record drops within hours of the bailout that was trumpeted as the nation's economic salvation.

Isaac, who now lives in Sarasota, knows a thing or two about a financial crisis. As head of the FDIC, he was instrumental in putting together the savings-and-loan bailout plan in the late 1980s that is generally credited with resolving that situation.

He says he told bailout opponents and proponents alike the markets would tank on the bailout news, and they did from the time it was passed Oct. 3, rippling through European and Asian markets also and forcing the federal government to scramble for another plan within days. He was one of the few not surprised.

"Everyone was surprised because of the way the (Bush) administration hyped the bill," he says. "If it did not pass, there would be blood in the streets."

So Americans were set up by a credulous and largely business-ignorant media to believe that with the vote in the House, the bailout bill would fix everything and stabilize the markets. Instead, there was a 1,100-point drop Friday to Monday in about six hours of trading.

A small problem

Isaac contends that the original problem of subprime loans was a small one and eminently fixable at little cost or risk to taxpayers.

He also says that the government played only a small role in the subprime disaster. It did pass the Community Reinvestment Act, which urged such loans. But banks eagerly made the loans and more as real estate entered the hyper-growth bubble.

When that bubble burst, it put a lot of people with those loans upside down on their homes. Some lost jobs, some gave up and walked away. It resulted in a sharp increase in non-performing loans on banks' books.

A little more than a trillion dollars are in subprime loans. The amount that is in arrears is about 30%, meaning that 70% of even the worst loans are still active. So the subprime problem was about $300 billion, Isaac says.

Then, among the worst government interventions came into play: the infamous "mark to market" for fair value accounting rule. This is an arcane accounting rule implemented last year by the Securities and Exchange Commission at arguably the worst moment.

The idea was to avoid Japan-style situation where companies kept assets on their books in grossly overstated value. So the rule, known as FAS 157, requires companies to "mark" the value of their assets at the estimated current market value based on what similar assets are selling for on the open market.

However, when some weak financial institutions began a fire sale of their assets, the mark-to-market accounting rule required stronger institutions to drastically cut the value of their assets, even though that may not have been true value. That meant that banks and investment firms had to go hunting for more capital, which was drying up. And that began a panic.

Isaac uses Merrill Lynch as an example. He says many of its assets quickly dropped to 22 cents on the dollar, which he considered ridiculously low. But it froze the company and made it unable to obtain financing or make investments, causing it to sell itself in a shotgun marriage to Bank of America.

The scenario was repeated over and over so that in a matter of months, these financial companies lost about $500 billion of capital on paper. Because banks need to hold back 10% for customers' access, Isaac says this effectively took $5 trillion worth of loans off the table and preceded the liquidity crunch causing the credit freeze. "That's insane, at best," he says.

The bailout bill did nothing to fix that or restore any kind of investor confidence, which the markets amply illustrated.

"The bill is an extravagant waste of taxpayers' money," Isaac says.

Alternative vision

After writing columns in the Wall Street Journal and the Washington Post, Isaac became a rallying point for members of Congress who originally voted against the bailout in hopes of getting to the core of the problem.

He provided them with meaty arguments and relatively easy alternatives that would not put taxpayer money at peril or unduly expand the scope of government into the private markets. With the political pressure that was brought to bear, he was inspired at the members of congressmen who voted "no" that Monday.

"The 228 members of Congress who voted against it are true heroes," Isaac says without reservation.

But after the initial rejection by Congress, the pressure to pass the bill became too intense. In addition to fear-mongering whipped up among constituents, members of Congress running for re-election were threatened with no money from their respective parties to help run their campaigns and were told that if they did still get re-elected, they would not get any decent committee assignments.

It was the worst kind of inside Washington strong-arm tactics, and Isaac does not condemn those who flipped in the face of it.

But he also believes that the bailout will, at best, be a monumental waste. At worst, it will further hurt the economy by falsely raising hopes.

With the debilitating mark-to-market accounting rule, flooding the market with easy money from the Fed and other counterproductive moves by the government, he points the finger squarely in one direction for the escalation of the crisis.

"Everything (since the subprime bust) has been brought to us by our government - the administration and leadership in Congress, both sides of the aisle," he says. "I'm so aggravated. This should have been a relatively small problem."

Still some hope

Isaac eschews fatalism over the economic state of America.

"We can fix it this week," Isaac says, and lays out a specific plan. He has pitched his alternative plan to Vice President Dick Cheney's economic advisers, but as of the bailout week, it went nowhere.

His fix does not, however, include in his proposals the risk of billions more in taxpayer money to buy short-term commercial paper under a Depression-era law - the most recent federal attempt to right the economic ship.

"It is a Band-Aid, not a cure. I do not believe it is healthy for the Federal Reserve and Treasury to play such a huge role in our lending markets," Isaac said in an e-mail shortly after the newest plan was announced.

His plan involves using FDIC emergency rules to calm market fears; raise bank capital by canning the fair-value rule; create a "net worth certificate" program; restricting short-selling and creating an economic stimulus package.

Without the right moves by the government, which does not include more of the same, Isaac loses his optimism: "All of our fortunes are at stake."

Rod Thomson is executive editor of the Gulf Coast Business Review and can be reached at [email protected].

The Bill Isaac Solution

Here is former FDIC Chairman Bill Isaac's prescription for unlocking the credit markets and restoring consumer and investor confidence:

• Eliminate fear. This can be done by the FDIC invoking its emergency authority, with the approval of the FDIC board and the Fed. The authority, already in statute, says that the FDIC and thereby the federal government will stand behind all deposits, whether they are insured or not. Everyone is protected.

"That will stop the freeze-up of the financial markets worldwide," he says. "Ireland has already done this." Germany did it a week later.

• Raise bank capital. Ditch the mark-to-market accounting rule. It may have been well-intentioned, but obviously the law of unintended consequences went into hyper-space with it. The fix is stunningly easy.

The SEC pushed this rule on companies and the SEC can un-do. "It bears no relation to reality," Isaac says. "The SEC destroyed $500 billion in bank capital" with the rule.

• More bank capital. Isaac also recommends the creation of a "net worth certificate" program similar to what Congress enacted in the 1980s as part of handling the savings and loan crisis.

The FDIC under Isaac purchased net worth certificates in troubled banks that his agency had determined could be viable with more access to capital and more time. The purchase was accomplished through FDIC senior notes, eliminating the need for cash. It was voluntary and the institutions had to agree to FDIC oversight, which included getting rid of bad managers and limiting executive pay. The program solved a $100 billion insolvency crisis in the industry for about $2 billion, Isaac says.

• Economic stimulus. Further, Isaac suggests that any taxpayer money should be used as a financial stimulus for the economy and as a help to homeowners in danger of losing their homes. However, with the $700 billion expenditure on the bailout, and who knows how much more on commercial paper, a general stimulus package that spits out more debt for future taxpayers appears unlikely.

The first two steps require no action by Congress and can be accomplished with the proverbial stroke of a pen. The congressional members who opposed the bailout wanted these steps included in a "sense of the House" non-binding resolution. But their party leadership would not allow it.