Congressional Testimony Answers Critical Questions

By Markos N. Kaminis - Economy & Markets:

We addressed the meat of the bailout on Tuesday, but a few of our lingering and critical questions were answered during Wednesday's testimony of Paulson and Bernanke.

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Bernanke's Testimony to House Committee

Federal Reserve Chairman Bernanke offered insight on Wednesday morning beyond that shared in Tuesday's testimony to the Senate Banking Committee. For starters, he offered some important economic forecasts, noting that he sees GDP in the second half of the year "falling well off its potential." Now, he stopped short of predicting recession, and left himself quite a cushion at that. Between the economic forecasts and his notation that he is neither part of the executive nor legislative branch of government, and therefore has no legal authority to negotiate law, specifically the bailout, Bernanke showed an impressive political prowess. Regarding GDP, he especially made note of global economic softness and the recently strengthening dollar, and how exports should therefore lose some of their recent robustness.

While giving most acclaim to Paulson on the big bailout, Bernanke offered strong support for it, noting that any lending constraints should be removed to allow banks to promote economic activity and normal business fluidity.

Greek Not On Board with Schumer

As questioning began, we again found ourselves disagreeing with NY Senator Chuck Schumer. The Senator offered a variation of the bill that I found myself pounding the desk against. He asked Bernanke why the $700 billion could not be broken up into installments. Then, as he detailed his own research on the subject, he pretty much answered his own question. He noted that some experts he had queried indicated that this could offer a noisy message to the market, disturbing the psychological impact that the original $700 billion clearance would provide. However, he offset this critical statement by focusing on the likelihood that the Treasury would not need more than $150 billion for starters, to which he noted experts agreed.

Schumer made case for installments by stating that in this manner Congress might have more assured oversight, since they would be required to again approve further capital. However, what this really does my friends is install uncertainty into the picture, and the market hates uncertainty. The market wants to know that Paulson has his bazooka, and the bullets as well. Of course oversight is a necessity and will be a part of the final deal, as Senator Dodd made clear.

I also disagreed with Schumer on the subject of funding the bailout. With a noble goal to reduce the burden on taxpayers, since we decide if he has a job or not, Schumer offered the idea of having the banks help fund this bailout themselves. I agree that it would be nice if the those costing us the money could pay for it. But, we again shoot ourselves in the foot and damage market psychology if we require capital constrained banks to pay up for their own bailout. The idea Bernanke responded with, and we were thinking of as well, was that you might extend the funding burden to the banks, but on different time frame. We might create a special tax for banks that would begin perhaps a year or two from now, and in that way not offset the goal of the bailout, which is freeing financial intermediaries of constraints.

While Bernanke was a bit soft on the possibility of plan alteration, noting that this was a topic for psychologists, he did strongly address another important question. Regarding "fire sale pricing," Bernanke indicated that fire sale pricing is what exists now, and that this is why the government needs to step in. He also stated that it was of course the goal of the Treasury to purchase these assets at best competitive price, and this would occur by allowing broad participation in the reverse auction. He also smartly noted that he thought there was a decent chance the federal government could make money before things were all said and done.

Bernanke also addressed Congress' concerns regarding some of the plan changes that have developed. Congress is troubled that foreign based institutions are now eligible, and that the Treasury also wants authority to purchase other impaired assets if necessary, beyond subprime loan securities. Bernanke's spot on answer here along with our own opinion mixed in was that, allowing foreign based institutions to participate would broaden the scope of bidders and allow for true price discovery, thus better pricing for the feds, and it would simply be fair to our trading partners, since these assets are American originated after all. He and Paulson noted later that they had been encouraging foreign governments to take similar steps as well. There clearly is rightful concern that taxpayer money might help foreign institutions. We still need to find some solution here, or better justification. One might be that these foreign institutions also promote American economic activity, as evident by their ownership of illiquid assets, and so by freeing them up as well, we further drive the wheels of economic growth.

Regarding non-subprime loans, Bernanke believes that other loans that are not as difficult to market as subprime MBS, are increasingly running into trouble as well. This goes for consumer credits, commercial real estate, etc., so he believed it would be wise to not limit these government purchases. Also, this further broadens the bidders in auction, and these assets are already causing problems with some institutions and look to be tomorrow's issue. The goal is to free financial intermediaries to go about their business, which is greasing the wheels of the American economy.

Inflation Fear Resolved

The biggest news came when Senator Dole (I believe) asked about inflation, specifically whether Bernanke foresaw these proposed steps as driver of inflation. Bernanke's response was critical in my view. It was doubly satisfying since he had just fielded some tough questions from Representative Paul, and rather well I might add. He corrected Paul on a couple things regarding the Great Depression. Most importantly, Chairman Bernanke went on record saying that he foresaw no impact to inflation.

Increasing money supply would be an inflation driver, but we suspect Bernanke's point is that the Treasury will be purchasing an asset, and one that he expects to return value potentially equal to cost. We're buying assets, not issuing capital blankly. Happy happy! Joy joy!, all the Congressmen cheered! Actually, they demanded the President address the nation so that they could blame this whole thing on him if it goes awry. It seems Congressmen are fielding significantly more calls opposed to this deal than for it. I'll have something to say about this later this week, and why I believe the consensus of popular opinion is wrong this time regarding the terms "bailout" and "Wall Street" when describing this action. I believe we should pass this proposal into law, and move past this period of economic troubled waters.

Please see our disclosures at the Wall Street Greek website and author bio pages found there.