US toxic debt rescue package is smoke and mirrors

Private investors give money to investment banks and "hedge funds" which buy packages of debt which has been bundled into an "asset backed security." The value of those securities is, in many cases, not just dubious but arguably fictitious. Worse, they were given credibility by self-appointed "ratings agencies" - which are not agencies at all, but simple independent commercial consultants who use a set of criteria they designed but do not make available to assess what they perceive as the credibility of all manner of things - including the asset backed securities.

What is clear is that the underlying assets were not, in many cases, properly valued and the risks were not properly assessed.

Someone, somewhere made a huge mistake of principle.

And now, the Obama / Geithner rescue package is recreating exactly the same situation.

The plan, to inject USD1,000,000,000,000 into buying up bad debt in an effort to clean up the balance sheets of banks is based on one idea: use private money to buy the debt.

But that is precisely what happened before. It did not create the mortgage loan crisis: that was due to bad management of the financial sector and the Government must take a significant share of the blame for that. But it did magnify the problem and lead to a threat to the financial sector in all countries. It's a global problem created by globalisation but the mechanisms to correct it are national - leading to countries falling into line behind the ill-conceived plans of the UK and the USA to buy their way out of the crisis.

But the US Taxpayer is rebelling - and as a Democrat, Obama is already tarnished with the brush of high-tax and spend even before distorting the budget for decades to come as he follows the Bush plans to bail out financial institutions.

The plan is to package bad debt - and to sell it at a discount. The value of the loan books has already been written down in the books of most US financial institutions. And so what the packages will sell for will be a further discount against current values (to take account of impending falls) and because buying up future income and gains is always discounted against the optimum gains to be had. Part of that is credit risk, and part of it is so that the seller does not gain too much from getting the money now rather than waiting for it to come in over time.

But there is now another factor: credit risk has been so severely miscalculated that the past value of that debt cannot be accurately estimated. And as jobs continue to be lost at near-record levels the overall capacity of the US borrower to service his loans is equally uncertain. If no-one's job is safe, nor is his mortgage.

So the packages will have to be priced to assume an extraordinary failure rate - or to assume that the property market will recover in sufficient time for repossessed properties to be sold before they become too dilapidated to interest anyone except the renovator.

So who will pick up these packages? If Obama's plan works, it will be private equity. Note this: when the market was turning bad, there was no mention of private equity. Disparaging comments were made about "hedge funds" and "investment banks." But now there is a plan for recovery, the term "private equity" is in use as a positive term.

So how is private equity channelled into the purchase of assets? Answer: through "hedge funds" and "investment banks."

So, exactly the same people that have been pilloried for investing in packaged assets of uncertain value are now being asked to invest in, er, packaged assets of uncertain value.

And who will be trying to assess the value? The "ratings agencies" - and the same property valuers and auditors who so patently got it wrong last time.

Can we assume they have learned their lesson?

If so, then perhaps there is cause for optimism.

But if not, then this looks like a cop-out.

Looking at the proposal and taking out all issues of sentiment, this looks suspiciously like a re-run of precisely the circumstances that compounded what should have been a simple problem of overlending by US banks, confined to them.

Instead, international funds were applied to these assets.

As fund managers around the world queue up this morning to tell international news organisations that they plan to take part in this scheme, it all seems a little too close to deja vu for comfort.

If this is true, then the financial earthquake the world has seen in the past 18 months will be followed by a devastating aftershock.

And that one will be far too big for governments to paper over with newly printed banknotes.