Build a Man a Fire…

Story Highlights:

• The controversial $700 billion aid package for "troubled" assets was approved Friday.
• Despite the much-heralded urgency, the main thrust of the plan won't tangibly ease financial woes for months.
• However, the required review (and possible subsequent suspension) of mark-to-market accounting could have a material impact much sooner.

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In recent months, government attempts to stem a worsening financial crisis remind us of the ancient Discworld proverb:*

"Build a man a fire, and he'll be warm for a day.Set a man on fire andhe'll be warm for the rest of his life."

With each successive government intervention, the crisis has worsened—lending is no looser than months ago, and stocks are markedly lower. That in itself is a statement about the true value of contemporary government efforts. Simple tools have been eschewed for overcomplicated and inconsistent policy measures. In that vein, the controversial $700 billion financial institution aid package was approved Friday. To be blunt, we don't think much of the plan. But its approval could potentially cost taxpayers far less than the so-called $700 billion price tag implies.

What's interesting and little discussed is that the plan's associated urgency—"If we don't pass this now, the whole system will melt down!"—contradicts the immediate efficacy of the actual legislation. Any large-scale government purchase of "toxic" investments from private banks requires formation of a complicated yet functional new bureaucracy. Assembling a team of specialists will take time. Even using an outside vendor to execute the plan takes weeks and months—not days.

But before we even get to the execution part, let's remember we don't yet know what that is. The details of the new bureaucracy remain hazy at best. Will it be a reverse auction? How do we minimize taxpayer liability without further harming the very firms we're trying to aid? It could be several months before any structured debt products are actually removed from balance sheets. Additionally, once organized, the impending administrative upheaval will only complicate matters. Many of those deeply involved over the next few months may be replaced by the new president's appointees. A smooth handoff will be difficult and time consuming.

Though the plan could improve investor and bank-to-bank confidence in the here and now (a good thing), its primary focus (the structured debt product purchase facility) will have little direct impact immediately. However, relatively fewer folks are talking about a part of the bill we think could have a material short-term impact. The plan requires the SEC review the effects of mark-to-market accounting and November's FASB Statement No. 157 on the crisis. A very positive short-term consequence of the bill may be the temporary or permanent suspension of an accounting rule that has, in conjunction with other government actions, severely worsened an already nasty situation.

Banks, by definition, exchange short-term, liquid, easy to value liabilities for long-term, illiquid assets, whose values are hard to gauge—this is the primary and indispensable capital markets contribution to broad economic growth. Yet, under FAS 157, bank solvency was suddenly measured by their ability to liquidate all their assets overnight to pay off liabilities. By this definition, virtually every bank—everywhere and everywhen—would be insolvent. The rule forced a spiral of asset write-downs and quickly worsening conditions.

Suspension of the rule would very likely improve confidence and bank solvency in the short term, perhaps even reducing the number of institutions needing government aid in the months to come.

Friday's markets were again erratic and volatile—up big in the morning only to end the day down. Perhaps the legislative developments were priced earlier in the week, lending credence to the old investing adage" buy on the rumor, sell on the news." Or other unseen forces could be at work—impossible to tell. What we do know is the government officially has clearance to "bail out" the financial system. To us, it looks an awful lot more like taking their pound of flesh from private enterprise.

* From British author Terry Pratchett's Discworld series.