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.

Winners and Losers

It is very easy to consider the free market as nothing but a vehicle to decide winners and losers. However, it is more than that. It is a vehicle to restore order and balance, insuring that the fundamental principles of economics are obeyed.

In the events of the past weeks, we have seen stalwarts such as Merrill Lynch and Co., Lehman Brothers, Bear Sterns, Freddie Mac and Fannie Mae all begin to fade into obscurity.

As this is the political silly season in the U.S., politicians are quick to point blame at each other, some of which is well deserved. However, the current troubles are the result of violating basic economic principles. Yes, I repeated the phrase, because it bears repeating.

Companies in the U.S. can safely take on debt (leverage), if their cash flow permits it. Additionally, debt can be used to lessen taxes. However, with debt comes risk. Failure to properly evaluate risk can result in being over leveraged and unable to pay back the debt. That is exactly what we have seen in this current economic situation.

Individuals took out mortgages well in excess of their ability to pay. These mortgages were bundled, chopped into pieces (tranches), and sold. Lehman, Merrill, etc., bought these seemingly low-risk securities and then used them as collateral for new debt. In both the individual and corporate cases, they were over-leveraged. People have been missing mortgage payments. The tranches with bad mortgages have lost value. That value which was used as collateral is now insufficient to pay back corporate loans. Badda bing, badda boom, companies go out of business.

Let this be a lesson, conservative risk management rewards in the long run. Bank of America, JPMorgan and Goldman Sachs, while taking it on the chin in the short run, are well positioned to weather this storm. The market is correcting the excesses and that's exactly what it is supposed to do.