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September 20, 2008

How to Make a Bad Deal
by Michael Pento

I hope those who want to sharpen their skills at the art of negotiations are watching Hank Paulson and learning exactly what not to do. Rule number one when entering into a bargaining agreement to purchase an asset is: DO NOT commit to purchasing the asset before negotiating a price. Makes sense, right?

I mean, if the counter-party knows you have committed to the purchase, you have lost your bargaining power. For example, when a prospective home buyer enters into the haggling process to purchase a home, it would be insanity to tell the seller that you must buy the property. By clearly stating to Wall Street his intentions of using the Treasury to place a bid for these distressed assets, Mr. Paulson cannot now back down without causing instant calamity in the markets.

Lo and behold, what happened to prices of mortgage-backed securities on Friday? They surged, meaning Treasury talked up the prices of the very assets it now intends to buy. This must have shocked no one, except perhaps the folks in D.C.

A much better approach would have been for Treasury to have placed very low bids for these assets and let the banks decide to what extent they would get involved in the deal. In that scenario the taxpayer would have been more protected and banks would have been compelled to sell their distressed assets at a price that would have allowed them to suffer some pain, as well.

Now, I'm very sure that Treasury has no idea what these assets are truly worth, whereas banks have a much better idea what is in their level three septic tanks. That will enable them to push for a much better deal because they will only sell to Hank what they feel they could not unload on the free market at a better price. And since the onus is on him to consummate a deal, this plan sticks the taxpayer with an overvalued asset that will be carried on the books of this new RTC for years to come.

The problem will come when the reality hits the government that the skyrocketing obligations of the Treasury outstrip their ability to tax the American public to pay off the debt. Annual deficits are already approaching $500 billion while the national debt registers an eye-popping $9.6 trillion. According to estimates made by Barclay's Capital, the annual deficit could climb to $700 billion-$1 trillion in 2009 due to the increased borrowing of the various rescue plans enacted by the government. Annual deficits of that magnitude could increase interest rates to a level that mandates the Fed purchase the debt directly from the Treasury in order to keep borrowing costs in check. The end result would be rampant inflation and soaring commodity prices.

The administration is probably unaware of the consequences of its actions. Their intentions are all well and good, but elected officials get lost in the panic to put a finger in the dyke rather than to enact a potentially painful, austere, long term fix. By replacing illiquid assets with cash, Treasury will encourage banks to make more non-performing loans to consumers who are already overburdened with debt. Since the free market was abrogated and government has prevented home prices to fall to a level that consumers can afford, the ramifications will be the formation of another even bigger bubble down the road. Only the next time it will be more pernicious because banks and the consumer will be much more leveraged and the financial condition of the country will be much more unstable.

*Please check out my podcast, The Mid-Week Reality Check

Michael Pento
Chief Economist
Delta Global Advisors, Inc.
800-485-1220

With more than 16 years of industry experience, Michael Pento acts as chief economist for Delta Global Advisors and is a contributing writer for GreenFaucet.com. He is a well-established specialist in the Austrian School of economic theory and a regular guest on CNBC and other national media outlets. Mr. Pento has worked on the floor of the N.Y.S.E. as well as serving as vice president of investments for GunnAllen Financial immediately prior to joining Delta Global.

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