Where did you go, John Pierpont Morgan?

This entry was written by Eric Hart and posted on his behalf by fellow editorial board member Drew Thomas

The legislative debate over the government bailout plan has given Congressional Republicans an opportunity to vent their long-brewing frustration with the Bush administration. Led by Rep. John Boehner (R-OH), they have bucked the President’s plan to purchase distressed assets with taxpayer dollars. Their proposed alternative is to extend insurance coverage to all of the at-risk assets. That protection would in turn entice private investors to the table. Freed from much of the downside risk, investors with free capital would remove the distressed assets from the balance sheets of financial institutions, restoring the free flow of credit without putting taxpayer dollars at risk.

The severity of the situation has been trumpeted over recent days by the three-headed economic Cassandra of Treasury Secretary Hank Paulson, Fed Chief Ben Bernanke and SEC Chief Chris Cox. The fall of Troy goes something like this: After years of feverish growth, a speculative U.S. asset bubble bursts, resulting in rapid devaluation that slams the balance sheets of financial institutions. This causes a string of bank runs that crescendo into bank failures. Access to credit dries up, grinding the economy to a halt and throwing the nation into a recession. With domestic confidence shattered and a skeptical international community running for cover from the fallout, the U.S. recession devolves into a deep, prolonged depression.

Critics of the Republican’s proposed private sector solution point to historical parallels provided by the 1929 stock market crash. As stocks plummeted, Herbert Hoover convinced an all-star cast of Wall Street scions including J.D. Rockefeller to step in and buy stocks in an attempt to restore stability. The efforts failed and the crash went on unabated. Hoover’s further efforts to solve the crisis through private sector measures proved equally ineffective and the country eventually entered the Great Depression. If there is one person in today’s government who wishes to avoid a similar fate, it is noted Depression-era economic historian Ben Bernanke.

Yet that same discredited private-led approach was employed with some success during the crises of 1893 and 1907.. In the crisis of 1893, speculation in the rapidly expanding railroad industry led to a huge asset bubble. The collapse of the Philadelphia and Reading Railroad sparked a stock-market sell-off that turned into a bank run. By the end of the year, more than 600 banks had failed. Things got so bad that domestic and international investors began redeeming their paper dollars for gold specie, driving the U.S. Treasury below its reserve requirements in 1895. Through last ditch efforts of J.P. Morgan, the government was able to successfully float a $65 million bond issuance to a syndicate of U.S. investors and European banks. Twelve years later, a similar panic was averted when Morgan was able to assemble a syndicate private domestic investors to infuse capital into cash strapped banks.

So there is some historical precedent for a private-led bailout. There are some key differences, however. Unlike in 1893, today there are no market makers of J.P. Morgan’s stature. The closest analog in wealth and reputation is Warren Buffet. Yet at its height, the House of Morgan controlled $1.3B in assets, representing roughly 8% of the U.S. GDP in 1893. Today, Berkshire Hathaway controls only $273B in assets, a mere 2% of today’s GDP.

So financial salvation in today’s market would invariably require a group effort, but who would that group include? The remaining U.S. commercial banks? Unlikely. High-magnitude acquisitions like the BofA-Merrill Lynch and JPMorgan-WaMu mergers can only be repeated a few more times. Insurance companies? Regulators would probably object. No, most of the capital would need to come from private equity and hedge funds. The question is whether there enough capital to go around. Some quick back of the envelope math would suggest otherwise.

· In 2007, private equity funds raised roughly $300B in capital from investors. Let’s assume that they raise the same amount in 2008, and that half of that capital went to the purchase of distressed assets. Total capital raised = $150B

· Assets under management at Hedge Funds totaled $1.5 Trillion at the end of 2007. Let’s make an equally optimistic assumption that 25% of those assets could be reallocated to this effort. Total capital raised = $370B

That would still leave a shortfall of roughly $180B, which would need to be funded by the remaining domestic investor classes. This also assumes no restrictions on which kinds of funds were allowed to purchase the assets. Congress would undoubtedly enact various restrictions and qualifications to prevent malicious or unscrupulous investors from purchasing the assets, which would narrow the pool of available capital even further.

Another alternative would be to turn to the international markets. Given the size of the shortfall, any discussion of foreign investment would have to include sovereign wealth funds, which currently hold between $2-3 trillion in assets. But it is hard to comprehend political support for a plan that would gift-wrap American homes and hand them over to foreigners. Even if such a plan were approved, for sovereign wealth funds to buy any significant portion of the $700B would be unprecedented. In FY 2007 through Q12008, the total cross-border investments made by SWF’s were only $91 billion.

At the time of this writing, it appears that momentum is on the side of the Paulson-Bernanke-Cox camp, and that Congress will override the objections of House Republicans and fast-track a deal for the president to sign into law. If Republicans do manage to kill the plan to use government funds to buy distressed assets, it will be interesting to see who they manage to recruit to fill the $700B void.