Monday, September 29, 2008

The "Bailout"

Here's my understanding of why the so-called bailout is the right move.

Mortgage/lending companies made irresponsible loans to sub-prime customers and the government provided no legislation to prevent this type of risky activity. These loans, along with others, were repackaged into securities (take a small percentage of 20 mortgages and call it a security) and traded between financial institutions (changing hands several times). Financial institutions used extremely sophisticated financial models to value this new class of assets--unfortunately, they got the valuation wrong. But before they knew that, they saw the market declining, and based on the models, saw an arbitration opportunity to buy more of the assets at a lower price only to sell them later at a higher price. So they levered up (borrowed to purchase more of the assets) and bought more of this asset class, putting them in a risky financial position. The trick is that the models they used were extremely reliable based on lots of years of data, but they didn't accurately forecast the risk.

Now they have lots of assets on their books, but no one really knows how to accurately value these assets, and no one has the capital / desire to purchase the assets at the moment. What that means is that although the bank has assets, they don't have cash, and subsequently can't meet federal standards. So a bank fails, then more people get nervous and want to pull money out of banks. The capital market dries up, and then small and medium size business can't get loans to grow and/or continue doing business. This eventually hits the consumer side when people like you and me can't buy things because we're nervous for the future so we sit on our cash and/or our small and mid-size business start having problems and jobs get scarce and unemployment goes up. It's ugly.

As for the real estate market--it is in trouble because getting access to loans is harder, so that slows the market and causes housing prices to decline. Slowing the market means that the distressed assets lose even more value, so that causes more banks to fail, which causes less capital available for mortgage loans. It's a vicious cycle.

Thus, the government decides to step in and purchase $700 Billion worth of these distressed securities, knowing that they have value, but no one knows exactly how much. The government will be able to resell them at a later date, but may lose some of the $700 billion they're investing. On the other hand, that will free up capital that banks can use to start giving loans and thaw the capital freeze in the market. This will avert a lot of pain for people who had nothing to do with the problems in the first place, in my opinion. And to top it off, the banks that sold their assets to the government will cover any losses that the government has after five years.

I think that whoever called this a "bailout" was pretty smart to frame the discussion that way. It seems that Frank Luntz must have been involved (the guy who changed the argument from "Estate Tax" to "Death Tax"). No one cares about an estate tax--that's for rich people. But a death tax, on the other hand--that makes me mad because no one should be taxed just for dying! The bailout is the same issue. It should have been called the "capital infusion bill" or something like that instead.

They better pass a bill like this soon. Roughly $1 Trillion of value in the stock market was lost just today. Makes $700B seem like a bargain.

19 comments:

  1. That was a really insightful and clear explanation - you obviously have no future as a television financial pundit. Your point about the labeling of this as a "bailout" is something I hadn't thought about before, and really changed the way I look at the plan.

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  2. I completely agree! It was a huge mistake to not pass the bill today. I am not exactly sure why it didn't pass, but I know that something needs to be done. Those securities you talked about, namely "credit default swap," are a large source of our problem. It was a smart part, for most places, to enables these swaps. However, now that the loans are failing and calling up for the insurance on these securities, there is little capital left to expand. There NEEDS to be a release so that the capital on hand can be used. The question is, though, is $700 billion enough? There are estimates that these securities value near $65 trillion! AIG alone had some $500 billion in responsibilities for these securities!

    I completely trust Secretary Paulsen and Chairman Bernanke - they know what they are doing! Step aside Congress and let them do their work!

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  3. i agree kendall. the media fan the flames of ignorance amongst the lay public and shield us from a potential depression in the making. the jockeying from the politicians on the hill today was sickening.

    it is rumored that bernanke did his doctoral thesis on how the depression's roots and his assessment of how it could have been avoided. his thoughts are that the government did not through enough money at the financial markets to stabilize the run on the banks and the collapse of the credit market...worrisome.

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  4. @Mark - I've got to make that Wharton education worth something...

    @Charlie - I totally agree. I hope they can get this figured out, and soon.

    @Paul - Here's a link to Bernanke's doctoral thesis at MIT: http://dspace.mit.edu/bitstream/handle/1721.1/29839/05915220.pdf?sequence=1

    I couldn't bring myself to read all 150 pages right now, especially since he co-authored my economics textbook with my econ professor at Wharton--it's just too much Bernanke in one 6-month period! :)

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  5. I disagree. Yes, something needs to be done to avert disaster, but this bailout disgusts me.

    I think it is important to look at how this happened in the first place, and to acknowledge the fact that Freddie Mac and Fannie Mae made high risk loans because they expected the government to come in and back them up in case of financial crisis. Alan Greenspan warned Congress back in 04 that the Fed Reserve was concerned that Frannie and Freddie would do exactly what they did, and exactly because of the implicit assumption that the government would basically guarantee the loss. While all other banks were pulling back on their risky loans, F and F went even further, cheered on by Democrats in Congress who praised them for making housing more widely available.

    What I see is a terrible precedent whereby we privitize gains and socialize losses, and bailout become expected every time there is a financial crisis--which will only mean that financial institutions will continue to behave in this risky manner.

    The people who lived within their means and saved to buy a home have to pay the price for those who wanted more than they could afford and the lenders who could get rich then and have the tax payers step in later.

    The incentives here are awful. The government should not be micro-managing markets. I think that Freddie and Fannie have got to go. The free market should determine housing prices, not know-nothing politicians and the self-serving lenders who have them in their pockets.

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  6. SO... this is probably the best explanation of this that I've heard. Obviously we have the wrong people making these decisions. (As if the general public didn't already know that the wrong people are doing important work.)

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  7. I'm not sure what happened to the comment I posted this morning--maybe it's still sitting open on my computer at home. I'll try to re-post after work. In the meantime, here's an article that I thought was interesting.

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  8. My understanding is that Freddie Mac and Fannie Mae expected the government to back them because that is exactly what the government agreed to do. In fact, after its inception, Fannie Mae stayed on the government books for 30 years until the Johnson administration "privatized" it in order to get its debt off the government books. In practicality, though, Fannie continued to be very much tied to the federal government as a government sponsored enterprise.

    Was it a bad idea to set up Fannie? Well, if you believe that the post-Depression market alone should have decided who did and who didn't get a loan to buy a house, then I guess Fannie was a bad idea. Is Fannie a bad idea now? Maybe. Either way, we have to deal with this. So here's my question: If it's the government that got us into this mess, shouldn't it be the government that cleans it up, especially when average Americans are bearing the losses in the form of depreciating house values, difficulty in getting loans, etc? The reality is that if we don't "bail out" the market, it's not a healthy free market that will decide housing and mortgage prices and availability--it will be widespread panic and insecurity that will decide the housing prices. Bailout plus regulation is the way to go.

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  9. Sorry, that last comment is from me, Carolina. It's the one I meant to post this morning and never actually got uploaded.

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  10. If the government got us into this mess, do we trust them to get us out? And by government, do you just mean all those congressmen and senators who kept claiming that Frannie and Freddie were perfectly stable and should be praised for "helping people buy homes" (ie making reckless subprimes loans), all the while the Fed and the Wall Street Journal warned of the crisis that has now befallen?

    If we are going to enter a major depression if nothing is done, then I would have to agree that the taxpayers must come to the rescue--to save themselves.

    Perhaps it was not a bad idea to set up Fannie originally decades and decades ago. But I stand firm (and is anyone seriously unconvinced on this?) that Franny and Freddie were mismanaged in recent years--contributing to skyrocketing housing prices (after all, if anyone can get the loans to pay for these houses, then the prices can stay high and get higher), and the people guilty of this mismanagement did not ahve to worry too much about the risk involved because they knew the government would step in and bear that risk for them. That truly is privitizing gain and socializing risk, and that is not how our economy should be working. That is why I think F and F should be phased out. If they were any other private company, they would have already collapsed. And it would serve them absolutely right. If half our economy were not entangled with them, I would be glad to see it happen now.

    Meanwhile, the families who only dream of affording a home of their own rather than renting (likely from a home speculator who will be benefitting from this bailout) will help to make sure that the greedy homebuyers who bought beyond their means and the reckless lenders who profited from the high-risk loans and the politicians who enabled it for political purposes don't ruin our entire economy. And still we renters cannot afford to get into the market.

    It isnt about sticking it to the rich guy. It is about fiscal responsibility. F and F behaved the way they did bc it is easy to take big chances when you have everything to gain and someone else will hedge your bets. My biggest concern is that it is only going to happen again.

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  11. The government in fact does not guarantee Freddie and Fannie. They are hybrid institutions that are free from the laws and regulatory controls that apply to other financial institutions, and they enjoyed the implicit assumption of federal backing. That is why this bail out is a big deal: the government is making the decision now to guarantee the loss. But even assuming that the govt had explicitly agreed to guarantee losses, it all comes to the same. F and F were reckless because this kind of arrangement is just and invitation to the very risky behavior that created the crisis.

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  12. @Alexandra - I totally agree that F & F were poorly managed in terms of allowing too risky (poor) loans. They are, however, practically extensions of the government. In fact, many people consider them to be quasi-government entities. If you looked at their bond ratings before this whole mess broke, for example, you'd notice that they were higher than they should have been based on fundamentals. The bond ratings were high because people knew that F & F were government backed. I don't know enough about F & F to have a very informed point of view on their current benefit and cost to society, but I do know that the government was almost compelled to stabilize them because of their ties.

    As for feeling the consequences of bad decisions - I totally agree with you that it would be ideal if they could, but I think that this is one where it's better for them to avoid the full consequences of the problem for all of our sakes. It truly is the taxpayers saving themselves.

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  13. Alexandra, you are absolutely right, the federal guarantee that Fannie and Freddie enjoy was not explicit in the entities' "charters" (I'll call it that since I don't know what a GSE's founding docs are called). However, there clearly was an expectation on all sides (Fannie, Freddie, Feds, taxpayers, economists) that the government was backing them. In fact, commentators and economists have been calling these entities implicitly fed-backed entities for years. Sure, it was stupid for the feds to acquiesce (and likely explicitly make statements off the record to those in control of Fannie), but it is a result of their not ever really cutting the cord. And I imagine that Fannie and Freddie don't have as much importance now as they did after the Depression (unless of course, we have another great depression, and then their viability depends on whether we, as a society, view home ownership as a vital part of our economy).

    As far as privatized gains and socialized losses, that is exactly what will occur one way or the other at this point. The average American will bear the losses in the form of a stagnating economy. Those that were high on the corporate ladder in all of these failing institutions have made a great deal of money and have no risk of losing it. That's not going to change. The only thing we can do is control our losses by buying some of these assets, however difficult it is to value them. Then, we need to put regulations in place that don't allow this to happen again.

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  14. I am totally opposed to this “Bail Out/Rescue” plan for five reasons:

    First, I agree with Alexandra that this “this bailout disgusts me.” It goes against everything I believe philosophically, lacking even a shred of accountability. When Enron and WorldCom went belly-up, there was no talk of a bail out. Instead people went to jail. Why in this case do we want taxpayers to foot the bill, when Wall Street last year received $69 billion in total compensation - $38-39 billion of which were bonuses paid to executives?

    Second, this deal will be portrayed as the government coming to the rescue of the free market which couldn’t survive without help and regulation. The facts, however, are that the government made this mess in the first place by incentivizing F and F to make “irresponsible loans to sub-prime customers.” Of course “government provided no legislation to prevent this type of risky activity” because it was the government (i.e. the Clinton administration, Barney Frank, Joe Biden and friends) that was sponsoring it. Maybe that’s why there’s no talk of jail time for the executives of these companies now…

    Third, to rephrase Kendall’s words: “no one knows exactly how much these distressed securities are worth.” Analysts, in fact, suggest that the proposed $700 Billion bailout could balloon to $5 Trillion. There is a very real fear that this current bailout plan will prove to be just a drop in the bucket, leaving the economy in a disaster and leaving the taxpayers with the bill.

    Fourth, a bailout allows banks to continue their bad behavior, doing nothing to correct it. What’s to stop this problem from becoming even worse because of the bailout? What’s needed is not government intervention, but an end to the excessive leveraging which is what created this problem. Housing prices will decline (not a bad thing considering the wild rise in home prices in recent years) and irresponsible banks will fail. Loans will be harder to qualify for (after all, homeownership is not a right, Carolina’s and House Democrats’ protests, notwithstanding), but QUALIFIED buyers will still be able to enter the housing market.

    Will the whole economy feel the effects of this Wall Street crisis? Absolutely, which is why those responsible should be punished, starting with the CEOs of F and F, and all the rest. I only wish we could throw the Democrats in Congress in jail along with the rest of them for forcing this down our throats for the past 15 years.

    Fifth, this bailout puts a major portion of our economy into the hands of the government, dealing a serious blow to capitalism and paving our way toward socialism. I would far rather deal with a short-term recession than put my economic future (as far as one can see) into the hands of politicians who had to be given a glossary of terms in their meetings discussing this crisis. They don’t even know what the words mean, let alone have an idea of what’s needed for a “healthy” market.

    Looking back on the Great Depression of the early 1930s, economists today both liberal (e.g. Galbraith) and conservative (e.g. Friedman) consider the government’s involvement in the economy misguided and counterproductive, taking what began as a relatively minor recession in to the worst economic crisis in our history. I for one hope we don’t make that mistake again.

    As a final comment, (it pains me to disagree with Alexandra since I agreed so heartily with everything else she wrote, but) I don’t believe “the taxpayers [can] come to the rescue--to save themselves” from this crisis with a bailout any more than you can borrow yourself out of debt. There is only one answer to this crisis: “To get our houses in order.” A man I respect, Gordon B. Hinckley, cautioned us in 1998, “There is a portent of stormy weather ahead to which we had better give heed.” He warned that “So many of our people are living on the very edge of their incomes. In fact, some are living on borrowings.” He counseled us “to live within our means, … to be free of debt, [and] to have a little money against a day of emergency put away where it can be retrieved when necessary.” For those leveraged and in debt, the medicine will be bitter. But I prefer the bitter medicine to a bailout disaster.

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  15. Last Monday they hadn't passed the bailout bill and the Dow lost 700 points. They'd better pass it soon, said some. Well, they passed it and this Monday (today) the Dow lost almost 900 points. I'm sure glad the bailout is working...

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  16. Actually, the market rebounded and the Dow closed today with a loss of about 400 points. Just think what could have happened if they hadn't passed the bill! :)

    Only time will tell whether the "bailout" will work.

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  17. This is a very interesting discussion. It's definitely not clear what the correct answer is, but my general feeling is something had to be done. The housing market is really only the tip of the iceberg in my opinion. The whole economy, from the largest financial firms down to individuals, is over leveraged. The only thing that is clear to me is that going forward if something is "too big" to fail it has to be regulated. I'm not a huge fan of government intervention, but there is a place for it.

    I know people are upset at the CEOs who "let" this happen, but I can't get too upset at them. They were just acting in their own self interest. At the end of the day that's how most people act especially business men. That's why monitoring, efficient contracts and when necessary government regulation are important. Problem is that when everything is going well (everyone's making lots of money), people are poor at assessing the probabilities and risk associated with a downturn in the economy. Thus, monitoring goes by the wayside, contracts become less efficient and no one dares to regulate. This is the same thing we saw with the last bust. Problem is that the financial markets have become so complex and interconnected that this has spread like a cancer throughout the whole system. There may have been some illegal behavior at the mortgage underwriting level, but it doesn't appear that most banks did anything illegal in the market that is really killing us, the credit default swap market. There is no regulation in this market, which always tends to make it more difficult to engage in illegal behavior :). We find ourselves in a rather unique situation. When I saw the numbers on the credit default swap market, I was stunned. The nominal value of the market is about $60 trillion. The total size of the market that the swaps have been written on is approximately 1/10 that size. Talk about an enormous amount of speculation going on. Crazy times. These are the times that make me think I made a good career choice :).

    The best/simplest explanation I've heard on this whole situation is the most recent episode of "This American Life." Take a listen. It's extremely well done and informative. You can download the mp3 at www.thisamericanlife.org, or of course the Itunes store. I know it's public radio, so Chris might be opposed to listening, but it really is good. Give it a shot :).

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  18. Chad: This is what I don’t understand … if the problem is that “The whole economy, from the largest financial firms down to individuals, is over leveraged,” then how is further leveraging going to solve the problem? The success of this whole bailout (which consists of government borrowing/leveraging to infuse money into the economy) depends on continued consumer debt/leveraging and spending. But if want to stop compounding the problem, we’ve got to stop borrowing and start saving. That means spending slows. That means the economy slows … and then what happens to the bailout plan? I honestly hope I’m wrong, but it seems to me this bailout can’t be a long term solution, and from the looks of the market so far this week, it’s not even a short term fix.

    One more question regarding regulation: I agree that most banks did nothing illegal. In fact, many banks were all but forced by the government to make sub-prime mortgage loans to unqualified borrowers to achieve the political goal of an “Ownership Society.” So who would have regulated this activity? It was government sponsored.

    Politicians created this mess for the last fifteen years (the Clinton administration, the Bush administration, a Democratic, a Republican, then another Democratic Congress). For them to say now that they could have prevented this if only they’d had more regulatory control is the biggest lie ever. This was government intervention at its worst. Do we trust the problem to be the solution?

    And seriously folks … am I that easy to peg? Who told this guy I don’t listen to NPR?

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  19. I know, I know… I’ve got to let go of this topic… right after this last comment.

    I understand that we’re buying “assets” with the $700B bailout money, but where are we getting the $700B? We’re borrowing it, or in other words, we’re leveraging. It’s not so different than what some now failing banks did when they leveraged themselves to buy these very same “assets.” The crisis came when these “assets” were worth far less than had been hoped for. I’m somewhat concerned about the value still since nobody really knows what they’re worth.

    So how would I fix it? Rather than encouraging more borrowing (which is what it seems this bailout plan is meant to do), I would incentivize savings. Before the bailout we were afraid there wouldn’t be the liquidity needed for the banks to make loans. But that should have resulted in higher interest rates (because if money is scarce it’s going to be more expensive), and higher interest rates would in turn reward and incentivize savings. The resultant deposits into savings accounts would then provide the liquidity needed by the banks.

    I would also lower the capital gains tax. Why “punish” people for investing by taxing them more? Especially when we need more liquidity in the market? What’s interesting is that capital gains tax revenues actually increase when the tax rate goes down because, when you let people earn more on their investment by reducing the tax rate, more people actually invest and pay the tax. In short, when it pays to save and invest, people save and invest.

    One final note, the government has got to control inflation which is completely in its control. Inflation destroys any incentive to save as money becomes worth less the longer you hold it. Yet this bailout is going to add inflationary pressure on the economy. I don’t want to make the case here, but I can’t think of a better way to stabilize our dollar than a return to the gold standard.

    In summary, I would let the market work. That means some short term pain, but it looks like we’re going to experience that anyway.

    OK. I’m done… I promise.

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