Financial Crisis Primer, Part II

In my previous article, "Financial Crisis Primer," I gave a very brief explanation of why there is a financial crisis in the first place.

What I failed to mention, was a solution. While I would love to take credit, I didn't come up with this, and sadly I don't remember the name of the guest on CNBC who mentioned it.

What the Treasury should do, and it appears as though they will, is ask the banks what they need in terms of recapitalization. For example, Neel Kashkari (Cash-Carry, right? Love it) pictured above, calls Citi and asks how much they need to cover existing losses on mortgages, as well as capital necessary for lending. Citi responds with a number like $15 billion (twice what they got from Abu Dhabi Investment Authority). The government in turn, gets $15 billion in prefered stock, warrants, and other financial instruments of value.

I think this is a good model. It is very similar to what Warren Buffett did with Goldman Sachs. Goldman needed some quick cash and Warren put down a cool $5 billion. In exchange, (from MSNBC):

"(Buffett got)...$5 billion worth of perpetual preferred stock getting a 10% dividend and warrants to buy $5 billion of common stock with a strike price of $115 a share. He'll be able to exercise the warrants at any time over five years."

Imagine if the Treasury could spend $120 billion, $15 billion over 8 banks, and voila, much of the financial crisis is solved. The banks get fresh capital and the US taxpayer gets a profitable investment. Unfortunately for the existing shareholder, the infusion will dillute existing shares. Oh well, caveat emptor.

In the end, I think Bernake and Paulson are trying to shorten the duration of this mess by offering US taxpayer money to purchase the worst of the worst assets as well as providing plenty of cash at the Federal Reserve Discount Window.

Many argue that the government shouldn't be spreading around taxpayer dollars. While I agree in principle, the overall market for money indicates that banks are hoarding cash and investors are fleeing for quality. For the global financial system to function smoothly, capital has to get moving again, and I think that is the plan.

Ken Lewis Cleans Up

Its good to be the king, or CEO of a major bank. Ken Lewis, the CEO of Bank of America, is looking quite smart.

Forbes did an article about the whole Freddie/Fannie mess call "BofA's Bailout Benefit" on September 8th.

The article calls out how Mr. Lewis was panned for his purchase of Country Wide, the large and failing mortgage company. Many thought BofA was chasing good money after bad. However, with the bailout of Freddie Mac and Fannie Mae, he is looking crazy like a fox.

From the article: "The Ladenburg Thalman analyst (Dick Bove) argues that Bank of America, and Countrywide, have the existing infrastructure to start buying and securitizing loans on a large scale. He even said in a phone interview that Bank of America's capital levels would allow it to guarantee mortgage payments. This promise to pay has been Freddie and Fannie's traditional role in the U.S. housing market."

Naturally, one questions if a company like BofA can handle the securitization and guarantee of mortgage payments, do we really need Freddie and Fannie anyway?? Arguably, the answer is "No." In my previous post "Taxpayers Cover Freddie's Fannie," I state the bailout is a done deal, but what to do with the Freddie and Fannie is an open question.

It would seem that a market solution may be the best solution after all. Yes, you can hear me grinning, as that is a common theme of mine. Although widespread home ownership is valid policy objective, let's keep the government out of it to the greatest extent.

Again, from the article: "“I would be shocked if Bank of America isn’t happy about how this worked out. For years, banks have been asking for Fannie and Freddie to be cut back in size because they have they an unfair advantage," said Bove.“The government says Fannie and Freddie handled 80.0% of the market this year and someone has to handle that market share.”

There you have it, companies such as BofA are well positioned to handle a piece of the hopefully dismantled Freddie and Fannie. The next question is whether other banks of similar size have enough capital to do the same. If Citi, JPMorgan Chase, and Wachovia can get their capital coffers refilled, then maybe this will be a reality. However, if they can't get their collective acts together, expect to see more Barney Frank (D-MA) and government intervention.