[Oe List ...] You broke it, we own it

[Herman Greene]

Fair Game
Your Money at Work, Fixing Others' Mistakes


By GRETCHEN MORGENSON
Published: September 20, 2008

It looks as if we may get through this weekend without another scramble to
save a troubled financial firm with a trillion-dollar balance sheet.

But that doesn't mean taxpayers are out of danger. No, sir. No, ma'am.
Because lawmakers are at work on a bailout fund that would buy the kind of
distressed assets (defaulted mortgages, for example) that have ignited this
firestorm.

Treasury Secretary Henry M. Paulson Jr. has called the fund the "troubled
asset relief program." I'll just call it TARP for short (you know, the kind
of thing they spread over muddy fields so you don't soil your Guccis).

And depending on how TARP is operated, and how the assets are valued before
taxpayers are forced to buy them, it could bloat our final bill for this
mess while benefiting the very institutions that got us into it.

Yes, we need a smart plan and a concerted effort to get the frozen credit
markets up and running. But we also have to be certain that the types of
conflicts of interest that riddle Wall Street aren't visited upon TARP.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a
pile of stinky mortgage securities that it currently values at 60 cents on
the dollar. Let's assume that the most recent actual trade between market
participants for similar assets was struck at 30 cents on the dollar.

So what's a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate,
we would most likely face a loss. The bank, however, would be much better
off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up
making a profit on the purchase if the assets performed better than expected
over time. But the bank would have to write down the value of the assets as
a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working
their Hill contacts right this very minute to ensure that the TARP
valuations are rigged in their favor?

You know the answer to that.

And you also know that we should steel ourselves for heavy losses as the
TARP gets pulled over our eyes. Never mind that it was the banks, with their
reckless lending and monumental leverage, that drove us into this ditch.

Such is our lot today: They break it. We own it.

Taxpayers deserve better than this, of course. But we have no lobbyists, so
we get skinned.

IF federal regulators and political leaders want to earn back some trust,
they could do two things. First, they could provide us with some
transparency about whom precisely we are backing in the recent bailouts.

Take, for example, the rescue on Tuesday of the American International
Group, once the world's largest insurance company. It was pretty
breathtaking. Since when do insurance companies, whose business models seem
to consist of taking in premiums and stonewalling claims, deserve rescues
from beleaguered taxpayers?

Answer: Ever since the world became so intertwined that the failure of one
company can topple a host of others. And ever since credit default swaps,
those unregulated derivative contracts that allow investors to bet on a debt
issuer's financial prospects, loomed so big on balance sheets that they now
drive every bailout decision.

The deal to save A.I.G. involves a two-year, $85 billion loan from
taxpayers. In exchange, the new owners - us - get 80 percent of the company.
If enough of A.I.G.'s assets are sold for good prices, we may get our money
back.

Credit default swaps, which operate like insurance policies against the
possibility that an issuer of debt will not pay on its obligations, were the
single biggest motivator behind the A.I.G. deal.

A.I.G. had written $441 billion in credit insurance on mortgage-related
securities whose values have declined; if A.I.G. were to fail, all the
institutions that bought the insurance would have been subject to enormous
losses. The ripple effect could have turned into a tsunami.

So, the $85 billion loan to A.I.G. was really a bailout of the company's
counterparties or trading partners.

Now, inquiring minds want to know, whom did we rescue? Which large, wealthy
financial institutions - counterparties to A.I.G.'s derivatives contracts -
benefited from the taxpayers' $85 billion loan? Were their representatives
involved in the talks that resulted in the last-minute loan?

And did Lehman Brothers not get bailed out because those favored
institutions were not on the hook if it failed?

We'll probably never know the answers to these troubling questions. But by
keeping taxpayers in the dark, regulators continue to earn our mistrust. As
long as we are not told whom we have bailed out, we will be justified in
suspecting that a favored few are making gains on our dimes.

A.I.G.'s financial statements provided a clue to the identities of some of
its credit default swap counterparties. The company said that almost
three-quarters of the $441 billion it had written on soured mortgage
securities was bought by European banks. The banks bought the insurance to
reduce the amounts of capital they were required by regulators to set aside
to cover future losses.

Enjoy the absurdity: Billions in unregulated derivatives that were about to
take down the insurance company that sold them were bought by banks to get
around their regulatory capital requirements intended to rein in risk.

Got that?

Which brings us to Item 2 for policy makers. Stop pretending that the $62
trillion market for credit default swaps does not need regulatory oversight.
Warren E. Buffett was not engaging in hyperbole when he called these things
financial weapons of mass destruction.

"The last eight years have been about permitting derivatives to explode,
knowing they were unregulated," said Eric R. Dinallo, New York's
superintendent of insurance. "It's about what the government chose not to
regulate, measured in dollars. And that is what shook the world."

And it will continue.





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