Tuesday - September 23, 2008 at 07:35 PM in

Wall Street Bailout

What an amazing couple of weeks.

It looks like right now we may be in the middle of the climax of the financial mess which has been building for the past 18 months. At least I hope this is the climax: if there's another act to follow, it will be a doozy. On the other hand, I've been saying since the beginning of the year that I thought we were at or close to the bottom.

Foolish me.

What scriptwriter can resist the natural drama of a $700 billion bailout of the financial system juxtaposed with what was going to be a historic election anyway? I have a bad feeling, though, that when the inevitable movie versions are made my reaction will be the same as often happens when my favorite books are put up on the big screen: "It was OK, but the original was better written."

There's been considerable media coverage and analysis, but not every question has been answered. Here's a little bit of my own analysis:

What Happened?
Since the Great Depression, large chunks of our financial system have been regulated by the government to ensure stability. The tradeoff was basically that banks would have their deposits insured by the FDIC, preventing a run on the bank, in exchange for strict oversight and somewhat reduced profits.

The regulations are designed to help in bad times by ensuring that most banks have enough money to weather most storms. In good times, of course, bank failure isn't so much of an issue.

Over time, however, more and more of the financial system has migrated from the regulated banking world to the unregulated world of money market mutual funds, commercial paper, hedge funds, CDO's, and so forth. That's because it's easier to make money on the unregulated side (no pesky regulations, after all). To feed the appetite for more investment, higher returns, and greater fees, the unregulated side gobbled up more and more of the financial acitivity which used to be handled by regulated banks.

If you're a consumer in the U.S., chances are that at least some of the money you owed to someone was bought, repackaged, sliced, sold, repackaged, etc. Not just mortgages, but credit card payments, student loans, auto loans, etc. all got fed into the machine.

Investors and bankers made so much money so fast that the demand for these investment vehcles was nearly insatiable. It helped that the economy was doing great, and default rates were at historically low levels. Because of that demand, it became really easy to borrow money for almost anything, on almost any terms. That easy credit masked the fact that the value of the collateral (the mortgaged house) was perhaps not as solid as everyone assumed.

When the party ended and default rates started going up, the value of all these investment vehicles inevitably started to drop. In a normal recession, that wouldn't be such a problem, since banks are required to have enough reserves to buffer against a certain level of defaults from the people they loaned money to.

Two things are different this time: first, many of the loans this time around are held by unregulated institutions, whcih are not legally required to hold any particular cushion. The hedge funds and investment banks which own all these slices of mortgages only needed to have enough assets on hand to convince their trading partners that they would be solvent in the near term. Second, house prices went up so far so fast that they came crashing down much faster than anyone thought possible, wreaking havoc on everyone's risk models.

The net result is that, among the institutions who were active in the market for packaged debt, nobody's sure that anyone else has enough assets to cover their obligations, or that they'll have enough assets tomorrow. Confidence is gone, and nobody is willing to do business with anyone else.

How Will $700 Billion Help?
Simple: The governmet steps in, buys a bunch of these investment vehicles which nobody knows the value of (presumably at pennies on the dollar), and takes them off the hands of whoever owns them. Then that hedge fund, investment bank, or insurance agency knows exactly the value of its assets, having replaced hard-to-value distressed debt with easy-to-value cash. Confidence is restored, the system unfreezes, and life goes back to mostly-normal.

The fly in the ointment is setting a price at which the government will buy these distressed securities. If the government (that is, you and me as taxpayers) pays too much, then it takes a loss and winds up subsidizing a bunch of money-grubbing hedge funds. Pay too little and the taxpayers make a profit (which is the American Way after all), but the seller may go bankrupt anyway.

I'm actually not too worried about the government paying too little: presumably nobody is going to be forced to sell us these toxic assets, so they have the option of walkng away if the price is too low. If a few banks and hedge funds go bankrupt despite unloading their bad holdings, then they almost certainly would have gone under anyway. We're no worse off in that scenario, and maybe a little better since at least the dregs of the bankrupt firm will be easy to value.

Won't This Cause Inflation?
One of my first worries when I heard about this plan was the inflationary effect of pumping $700 billion of money into the economy (which is essentially what will happen, in a roundabout way).

I'm not as worried about inflation on further reflection. One of the big effects of the housing bubble was to create vast amounts of wealth from thin air as home prices went up, and many people spent a lot of that wealth through cash-out refinancing. Now that housing prices are dropping and investors are deleveraging (reducing the ratio of debt to assets), huge amounts of money are being sucked out of the economy. This $700 billion bailout will serve to replace some of the money which is being vaporized through deleveraging and declining asset prices.

It's also worth pointing out that the government isn't going to just hand out dollar bills. We will get assets in return, in the form of these mortgage-backed securities, and at a discount. As the underlying mortgages are paid off, the government gets to pay off whatever money it borrowed to facilitate the bailout in the first place. If we play our cards right, there might even be a small profit.

Who Are the Winners and Losers?
Winners

• Anyone who sold a house in the past five years and didn't buy a new one (or bought a less expensive house)
• Anyone who did a cash-out refinncing and was foreclosed on or did a short sale (*these people probably don't feel like winners, since they lost their homes, but they essentially got free money from the bank without having to repay it. This let them live at a higher standard than they otherwise would have been able to for at least a few years.)
• Anyone who did a cash-out refinancing and manages to keep the house, since they got a bigger line of credit than they would have qualified for otherwise, for at least a few years.
• Anone in the real-estate or mortgage-broker business in the past five years.
• Any investor who owned mortgage-backed investment vehicles before 2007

Losers

• Anyone who bought a house in the past five years, unless that house was bought from the proceeds of sellng another house. These people probably overpaid and are now stuck with the debt.
• Anyone in the real-estate or mortgage-broker business in the past five years. Most of these people are now unemployed or in new carreers.
• Any investor who owned mortgage-backed investment vehicles during or after 2007. These investors lost their shirts, and many have gone bankrupt.

The interesting thing is that in many cases, the winners and losers are the same people. Hmmm.

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