Dear Congressman Tierney,

I have written to you daily since this administration has proposed a massive government bailout for Wall Street banks.

I write today to offer you an alternative solution that creates no moral hazard and can be implemented in a ‘pay-as-you-go’ manner.

The real reason that financial companies cannot raise capital is a lack of trust. No one can read the financial statements of these companies and tell you if they are well capitalized. No one can tell you how big the problem is because today’s accounting rules allow them to hide their problems either off balance sheet or allow them to use Level 3 accounting rules. Level 3 accounting allows them to assign whatever value they like to their assets with little justification. This is why I stated earlier that no one can read the financial statements of any of these companies and decide whether they are going concerns. This is why they won’t lend money to each other. They are all liars.

If you had complete transparency in financial statements and accounting, two things would occur:
1. Companies that are truly insolvent (i.e. bankrupt) would be exposed and they would fail immediately.
2. Companies that are solvent, but illiquid, would be able to readily access private capital because trust would be restored by transparency. Investors would invest.

The solution is to accelerate rather than defer ‘mark-to-market’ accounting rules and also to make illegal the practice of burying bad assets off-balance-sheet like Enron.

This will cost a lot of money because the troubled banks and companies that are exposed as insolvent will fail and the federal government has an important role to play through the FDIC and SIPC insurance guarantees. These companies should pass through government receivership. The government should make individual accounts whole up to the insurance limits. Interested parties can offer to take over the branch offices of the failed companies. They won’t be recapitalized so much as they will be merged into a stronger surviving company. This alone could cost you $500 billion, but not all at once, and certainly not in the form of a bailout that would create a moral hazard.

A second element of a true solution will put an end to the ticking time bombs known as credit default swaps (CDS). These are unregulated derivatives that have added an element of mutually assured destruction to this whole mess. Throwing $700 billion at a problem without defusing this time bomb only means that in 3 to 6 months when all the money is gone and the problem persists that you will have to make a choice of whether to throw good money after bad. CDS is an insurance contract and should be regulated as such. There should be limits on who can participate in CDS contracts and how much insurance can be taken out on any given debt issue. Today these function more like side bets and Wall Street in general has a casino feel due to the complete lack of regulation in the derivatives market.

A third element of a true solution would limit leverage to reasonable limits. Let’s say 10:1. All of the failed companies to date have been using excessive leverage where one wrong move wipes them out. You should set a limit and give them all one year to get below that limit and measure their progress quarterly when they report financial statements.

A fourth element of a true solution is liquidity for Main Street. The fallacy of the proposal you are being asked to vote on is that the administration has implied that if you bailout these institutions that money will flow freely again. It won’t. Following the Bear Stearns bailout we created moral hazard where institutions felt that the ‘Fed has our backs’ and they began to take risks. But instead of writing mortgages or consumer loans or even lending money to each other, they began to speculate in the commodities markets and drove the cost of oil sky high and we all suffered $4 a gallon for gas. You can expect more of the same if you bailout Wall Street without taking the following measures:
1. Require financial transparency to restore trust
2. Regulate derivatives, specifically CDS
3. Limit leverage

So where will liquidity come from? The federal government. Make money available in tranches through existing government agencies for mortgages, student loans, car loans, or whatever you wish. You could expand GNMA or direct either Fannie Mae or Freddie Mac to extend credit on whatever terms you think are required. This is the ‘pay-as-you-go’ part whereby you can allocate $50 billion at a time to specific markets to get things moving and then check back in 3 to 6 months. Eventually the private sector will begin to take over and the government as lender of last resort can step back.

--mike