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The Wall Street-Main Street Power Game—A Commentary by James Holdcroft and Jonathan Macey ’82

The following commentary was published in The Washington Independent on October 17, 2008.

The Wall Street-Main Street Power Game; Protecting the Haves, Ignoring the Have-Nots
By James Holdcroft and Jonathan Macey ’82

Three sound-bites led to the passage of the biggest bailout in world history. The first was that the bailout is “not just for the fat cats” on Wall Street. This, in turn, is because in this crisis “Wall Street and Main Street are joined at the hip.” Finally, anybody who challenges this is told that he/she “just doesn’t get it.” The bottom line is that if taxpayers did not acquiesce and support the trillion-dollar-plus rescue plan, and the bill failed to pass, really bad things would happen to Main Street.

Isn’t it odd that Wall Street and Main Street are never joined at the hip when Main Street is foundering? In such times “market discipline” and moral hazard are the watchwords. But the moment Wall Street firms’ balance sheets begin to falter, the relationship between Wall Street and Main Street magically transforms itself from parasitic to symbiotic.

A careful look at the $700-billion Troubled Assets Relief Program, or TARP, suggests the interests of Wall Street and Main Street are really not aligned in this bill. It seems clear that the bailout plan will do little to help Main Street. Any benefits will be marginal and indirect. On the other hand, TARP will help Wall Street firms — and it will help it a lot.

Toxic derivatives, particularly collateralized debt obligations, or CDOs, and credit default swaps dominate the balance sheets of Wall Street firms. Most regional and community banks’ balance sheets are largely free of these troubled mortgage assets. Thus bailout won’t do any good for these Main Street banks. It will just help their far riskier, far bigger Wall Street rivals.

The core feature of TARP is that it gives the Treasury Dept. hundreds of billions of dollars in U.S. taxpayer funds to buy bad mortgage assets from the (mainly) Wall Street firms that bet on these highly risky, and now deeply troubled, assets.  But, of course, the statute does not require Wall Street firms to sell assets to the government.  They only agree to sell them if the price is right.

This means that if the Treasury is actually going to buy any assets, as it surely will, the price paid for these assets inevitably will be above both the market value and the book value of these assets — otherwise no bank would unload them.

It is easy to explain why.  If the price offered by the Treasury is not above market value, then no bank would sell to the Treasury: it would sell the asset into the market at the higher market price instead.  If the price the Treasury is willing to pay is not above the value recorded for that asset on the selling bank’s books, then the bank is better off holding onto the asset — since selling would force the bank to recognize a loss and cause an immediate reduction in the bank’s capital equal to the difference between the book value and the (lower) price paid by the Treasury.

Imagine, as is probably the case, that whoever acquires Wachovia acquires a large number of questionable “pick- a-pay” mortgages that have a real economic value of only $10 billion, but were once considered to be worth $20 billion. Pick-a-pay mortgages, otherwise known as negative amortization loans, feature a low minimum payment  — usually 1 percent — and give the borrower the option to make interest-only payments, at least for a while.

Borrowers with such loans usually make only the trivial minimum payment due each month rather than the actual interest rate.  This serves only to delay the time when the borrower must pay the actual interest owed.

The unpaid interest quickly accumulates.  When the amount of principal and deferred interest hits, say, 110 percent of the original loan balance. the minimum payment option disappears, and the loan resets with a new minimum payment that will be substantially higher.

Under TARP, U.S. taxpayers or, according to Wall Street, the Treasury Dept. would pay, say $15 billion for these mortgages at Wachovia.  This would mean a gain of $5 billion. It would go directly to the bottom line — i.e. to the shareholders of Wells Fargo or Citigroup or whoever buys Wachovia.

The acquirer will immediately be financially stronger, show improved earnings and have $15 billion in new cash before taxes.  No wonder Wachovia suddenly looks like such a fantastic target.

To sweeten the pot even more, the Treasury has thrown in some additional tax breaks.  Specifically, new interest in Wachovia may have been sparked by an IRS notice issued last Tuesday that increases the tax deductions that can be taken by acquirers to off-set Wachovia’s loan losses.

The notice would remove the current strict limits on the deductions an acquirer could make for the loan losses and bad debt deductions that Wachovia sustains following the acquisition.  Some experts have estimated that for certain borrowers, including Wells Fargo, the entire cost of acquiring Wachovia could be offset with the tax savings from this rule change.

The $700-billion dollar question is what Citigroup, Morgan Stanley and the other Wall Street firms who get cash in the bailout will do with the money they get for selling toxic mortgage-backed securities to the Treasury.  It is by no means certain that the firms will use their new-found hundreds of billions to make new mortgage loans or otherwise plow the money back into Main Street.

After taking huge losses on their portfolios, these Wall Street firms are likely to be far more restrictive in their future lending practices.  As taxpayers funding the bailout, we are delighted by the banks’ newly found risk-aversion.  Borrowers on Main Street will not benefit from the cash hoarding that is the newest Wall Street fad.

Regardless of what Wall Street firms do with the money they receive, it goes directly to the bottom line of the Wall Street firms.  Main Street has to take it on blind faith that Wall Street will share some of the Treasury’s largess with them.  Wall Street is known for a lot of things — sharing is not one of them.

It is highly doubtful, then, that much, if any, of this money will actually trickle down to Main Street.  Even in the highly unlikely event that the Treasury plan jump-starts a nascent market for the toxic paper held by Wall Street, there is no reason to believe that the money generated by this new market will find its way from Wall Street to Main Street.

Bonus time is approaching on Wall Street.  Inevitably, some, if not most of the $700-billion early Christmas gift from Nancy Pelosi and Hank Paulson Jr. will find its way into the pockets of investment bankers, saving Wall Street, but not Main Street, from one of its worst years in history.

Jim Holdcroft is a partner in the private-equity firm, Landmark Partners. Jonathan Macey is the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale Law School and author of a new book “Corporate Governance: Promises Made, Promises Broken.”