Tuesday, September 30, 2008 at 8:16 am
Really good questions and some half-baked answers about the bailout
Welcome to all of you coming from the link in TIME magazine. This was my original response to a reader's questions. It was condensed and edited for the magazine, but I've left it untouched here.
I got an e-mail from a reader late last week with a bunch of very good questions about the bailout bill. I hadn't quite finished answering them when it was voted down in the House Monday. But since some version of the plan is likely to be resurrected later this week, I figured I should go ahead and finish.
Where will the $700+ billion go? What exactly will it buy and from whom?
That's the, uh, $700 billion question. Mortgage-backed securities were to be the main target, and banks the main sellers. But Hank Paulson and Ben Bernanke wanted a fund that could buy pretty much anything from anyone.
How, exactly, is this bailout supposed to 'save' credit markets?
Not entirely clear. Paulson and Bernanke described it as a way to jumpstart trading in mortgage securities for which there's no market at the moment, thus allowing banks to clean up their balance sheets and get back to lending. But a lot of economists outside government believe that the real problem is that lots and lots of financial institutions are insolvent--their losses, if they actually recognized them, are enough to wipe out their capital reserves. If that's true it would make more sense for taxpayers to give them cash outright, and take a big ownership stake in return (with the idea of selling it off a few years down the road). The Swedish solution, they call it (and longtime readers of this blog know it was being discussed here long before anybody else in the U.S. was talking about it). The version of the bailout plan voted down in the House Monday seemingly would have allowed Treasury to take such action. But it also would have allowed Treasury not to take such action.
(More after the break.)
How/why is this situation different from investors simply losing their money because of bad judgment about what to invest in? Can I get bailed out when my portfolio tanks?
It's a variant on the old saw (often attributed to J. Paul Getty, although I'm sure somebody must have said something like it before him): "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Leveraged financial institutions (banks, investment banks, hedge funds) make investments with lots of borrowed money, so when their portfolios tank they can quickly get into a situation where they can no longer make good on their debts. When that happens to a single institution, it's no big deal to let it fail. But if it's happening to a lot of them at once, you get the paradox of deleveraging: a downward spiral in which failure begets more failure and retrenchment begets more retrenchment.
Why should Wall Street be bailed out? Won't it just make them all the more eager to engage in risky practices in the future? Are we bailing out the very people who created the problem?
A lot of the people who created the problem have already lost their jobs, but yes, any bailout risks rewarding the profligate and the foolish. But we're getting to the point where financial sector problems are starting to hurt people who didn't profit from the boom. And you can design a bailout that's not so much a bailout as a new start--such as the Swedish solution outlined above.
There's also the approach favored by the late MIT economist Charles Kindleberger, who thought it was the job of governments and central banks to step in and halt panics, but felt they should “always leave it uncertain whether the rescue will arrive in time or at all, so as to instil caution.” That seems to be official U.S. government policy at the moment, actually.
If more currently outstanding mortgages default, won't the problem just keep going on and on?
Yes, that's a big part of the concern at Treasury and the Fed. That economic trouble emanating from the financial system will cause even more people to fall behind on their mortgage payments which will lead to even more trouble in the financial system.
Are we all just supposed to trust that mortgage lenders and Wall Street types have 'learned their lesson' and will not continue to exacerbate the problem (or find ways to create new ones)? What safeguards are/will be put in place so that derivatives of the type that got this mess started will not continue to be created or traded?
I think it's fair to assume that mortgage lenders and Wall Street won't make these same mistakes for another generation at least. But they will do their best to figure out new ones to make. And while bubbles and crashes will always be with us, I think a regulatory structure that is far more restrictive of financial innovation is probably a good idea. Do we have that regulatory structure in place now? No.
Is the money going to the wrong people/institutions? Why should the money go to these institutions instead of homeowners or banks who hold the sub-prime mortgages?
A lot of the money would go to banks that hold sub-prime mortgages. Getting it to homeowners is a more complicated proposition. Would you just give the money to people struggling with their mortgages? How much would you give them? For how long?
If these so-called securities are 'mortgage backed' and the mortgages are in default, would the money be better spent just buying up the mortgages themselves instead of the securities? And re-negotiating mortgage rates to make it more likely that homeowners can pay down their mortgages and hold on to their homes?
A number of economists think that buying up the mortgages themselves would make more sense. I think the reason Treasury doesn't want to do it is that it would be a far more time-consuming and labor-intensive process than simply buying securities on the open market. It was easier in the Depression, when banks held whole mortgages on their books, than it is today.
As for renegotiating mortgages, a new program goes into effect tomorrow (it was part of the housing bill passed over the summer) that uses up to $300 billion in FHA guarantees to encourage mortgage servicers to move people out of adustable-rate subprime loans into fixed-rate loans with lower face values. And if Treasury owned a few hundred billion dollars worth of mortgage securities, it could put pressure on servicers to renegotiate loans rather than foreclose on them.
And what about the 90% of homeowners who are paying off their mortgages and dealing in good faith, who have seen their equity significantly lowered by the tanking of the real estate market?
That equity will go down more if banks continue to struggle.
Is there any chance that any of the bailout money will be recouped?
Yes. Mortgage-backed securities are still, you know, backed by mortgages. They're worth something--and in some cases more than what the feds would pay for them.
How/who will determine how much to pay for these securities?
They haven't really figured that out yet. One possibility would be to hire private managers who would get a share of any profits. And there's lots of talks about using various auction methods to price them. But I have yet to hear a really convincing explanation of how this would work.
Will every financial institution that holds mortgage-backed securities be able to sell them to the federal government? Who determines what will be bought and from whom? Will institutions be able to recover losses they have already written off?
In theory anybody could sell to the TARP (troubled asset relief program). The what and from whom would ultimately be up to the discretion of the Treasury Secretary. And if institutions were able to sell securities for more than they valued them at on their balance sheets, sure, they could reverse some losses.
What is to stop speculators from buying up these bastardized securities for pennies on the dollar anticipating enormous profit when the government buys them at higher rates?
The current owners of those securities aren't going to want to sell them for pennies on the dollar if they think the government will come in soon and buy them for dimes. That said, I think Treasury would love it if there were private vulture investors bidding for mortgage assets too.
How is the current real estate crisis different from the RE bust of the early 1990s?
1) It's bigger and more national--although it is worst in California, the Southwest, and Florida.
2) It's also (except in, say, Detroit and Cleveland) not the result of external economic factors like Texas in the 1980s or Southern California in the 1990s. It's a crash caused by the twisted dynamics of real estate finance in recent years.
3) The way mortgage-backed securities and related derivatives have acted to concentrate and transmit risk rather than diffuse it has added a whole new element to the crisis.
Who is at fault here? I have increasingly seen fingers pointed at home buyers for buying 'too much' mortgage (i.e. big eyes for big houses), who 'lied' on their mortgage applications about their ability to keep up payments. Surely significant fault lies with the mortgage lenders for approving such loans without due diligence? And greater fault with the creators of the mortgage-based derivatives?
Until 10 years ago, getting approved for a mortgage was a pretty good indication that you could afford to make the payments. So for the most part I really don't blame buyers--they were relying on a time-honored financial rule of thumb that mortgage lenders and their Wall Street backers had suddenly decided to throw out the window. I'd blame the lenders, the securitizers, the regulators and Congress first, and buyers probably last. Although I'd still blame 'em a little.
Speaking of fault, how logical (much less honorable, but we probably need not go there) was it for Wall Street to over-leverage itself? Or is it just a matter of 'because they could'?
It was logical for individual Wall Streeters because they could reap big rewards from overleveraging and not necessarily suffer from the eventual fallout. It was not logical for Wall Street firms to do so (because it put their survival at stake) but those firms are after all just collections of individuals.
Without the bailout, is it really likely that we will see the end of the world as we know it? And what, exactly would that Apocalypse look like?
Given the existence of the FDIC and the activist stance of the Federal Reserve, it's hard to envision a 1930s-style breakdown in which banks shut their doors and depositors lose all their money. I think the fear is of a situation where lending to both businesses and individuals stops almost completely, which would lead to a pretty sharp downturn. Not nearly as bad the Great Depression, but the worst we've seen since then.
What is the difference between Wall Street and a casino? (Not meant as a joke)
On Wall Street, the dealers get paid a lot more and are often allowed to bet alongside the customers. Oh, and much of the money raised on Wall Street actually goes to productive purposes. Except when markets are in bubble mode.
28 Comments to “Really good questions and some half-baked answers about the bailout”
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Tuesday, September 30, 2008 at 9:05 am
"How, exactly, is this bailout supposed to 'save' credit markets?"
I believe that Bernanke mentioned something about "price discovery" recently, namely, that the Fed & Treas believe that mortgage securities are undervalued now because of illequidity, so if the govt buys some for a "fair value" above the current market price, it will allow all the holders of these securities to mark them at that new value and thus magically increase their capital. The return of "mark to myth" accounting.
Tuesday, September 30, 2008 at 9:39 am
Good stuff, Justin. Now, if you owe the bank $1 trillion, it's the government's problem.
Tuesday, September 30, 2008 at 10:51 am
"I think it's fair to assume that mortgage lenders and Wall Street won't make these same mistakes for another generation at least. But they will do their best to figure out new ones to make. "
Haha so true. You have a significant financial meltdown roughly every 3-5 years, one for each new batch of mba'rs rushing through the system. (94/95 fed rate surprises, 97 russia default/ltcm, 00/01 dot com busterone, 07 credit crunch start).
Tuesday, September 30, 2008 at 11:00 am
Where will the $700+ billion go? What exactly will it buy and from whom?
Because mortgage backed securities was only the start of the all things securitized, I think folks will be mighty surprised to find out everything else that has been as well. The derivatives of these securities has literally taken over like Bermuda grass in a rainy Spring.
Tuesday, September 30, 2008 at 11:25 am
Overall, I really appreciate your taking the time to post these questions and answers. But, I think your answers make it clear to that many have a fundamental disagreement with this plan and I realize my disagreement because of your answer to the Are we all supposed to trust that bankers have learned their lesson? question. I do not like this plan because it does not make banks change their business practices. I really disagree with the idea that banks have learned their lesson and are changing their ways. While this may be true in some regards, I believe they are shifting their past practices into other areas in order to try to recover their losses. We have a basic problem in that we cannot grow our way out of this financial crisis because we have exhausted and/or given away all our methods of growth. Banks are desperate and looking for ways to make lots of money fast. They cannot do this through selling assets and now investors are going to avoid buying bank stocks or bonds. So, I think they are continuing to look for the next big score and still trying to figure out how to game the system out of this mess. I believe that the Paulson plan is just a massive subsidy for these bankers to try to prop up their current system, not to safely dismantle it. To me, that's why the public reaction is so extremely against the idea. If we are going to spend this money to pursue these types of policies, then I think we need a concurrent and very strong regulatory framework to force the bankers into looking for a whole new type of business model going forward (and I think it cannot include securitizaton or derivatives in any substantial amounts). To those who dismiss the public's belief that this $700 billion is just the start of giving money to friends of the Administration, I say those fears are real and justified based on the past actions of this President, Vice-President and others in his administration. Those who say Paulson and Bernanke don't have a credibility problem with the American people don't understand that we feel we have been lied to repeatedly by both of them, just like the others, and have no reason to trust them. I have seen all of this before and agreeing to this Administration's "solutions" has been catastrophic for all of us. I think the most patriotic thing this Administration could do was to step down and let who ever wins in November take over right away. One of my big fears is this Administration wants to "fireproof" its current members (this was the documented purpose of the Patraeus promotion) and so I don't want this administration forcing us to have to live with Paulson/Bernanke for the coming years. That is why I oppose this plan and will continue to oppose it until I really feel that it can accomplish something good.
Tuesday, September 30, 2008 at 11:55 am
Great info Justin. You kind of touched on this and maybe I just don't understand. These Mortgage-backed securities that the Gov would buy, who determines the price the government would buy them for? I mean, you mention that the owners probably wouldn't sell for pennies on the dollar to others if they expect that the Gov would buy for dimes. Why wouldn't the Gov ask them for pennies too? I mean, its a buyers market right and if the sellers don't want to sell for what the Gov asks, then let them keep that security. Basically, I think what I'm really asking, is the government gonna get screwed over here and buy up securities from various friends of government officals for tens of dollars on the dollar instead of dimes or pennies? Kind of like the contracts with Halliburton in Iraq?
Tuesday, September 30, 2008 at 12:22 pm
Have the bankers (and ex-bankers) learned a lesson? Yes. However, I have a couple of degrees in behavioral psychology, and I have to ask just what lesson, in fact, have they learned. Here's a couple of possibilities:
1. Get out while the getting is good.
2. Don't use the junk you are selling.
3. Lie 'til they buy.
4. It's different this time.
Tuesday, September 30, 2008 at 12:49 pm
I keep reading that there are $62 trillion of credit default swaps out there. I have been unable to get a clear explanation of how that number is determined (especially confusing since the US GDP is $14 trillion). What is the relationship of the CDS's value to the value of defaulted mortgages or the derived securities? What is the relationship, for that matter, between the securities and the actual mortgages? Should they not be the same number? What is the actual value of those defaults in aggregate? (In other words - how was the $700 billion figure arrived at - it's obviously a whole lot less than $62 trillion). And finally - what is the total thus far which the Fed and Treasury have ponied up prior to any "bailout" or "rescue" plan (and therefore why are they now asking for permission to do what they have already been doing?)
Tuesday, September 30, 2008 at 1:56 pm
@bob weisberger: The $62 trillion is the "notional value" of the swaps, which overstates the actual sums at stake. On an interest-rate swap, for example, where you agree to pay a floating rate on $100 million and your counterparty pays a fixed rate, the notional value is $100 million even though the amount of money actually at risk is much smaller.
I've got to say I don't fully understand how all that works with credit-default swaps, though. I have plans to educate myself, but market chaos keeps getting in the way.
So far, by my counting, the Fed and Treasury have extended $314 billion in guarantees in bailing out Bear Stearns, Fannie, Freddie, and AIG. And the FDIC just extended a $270 billion guarantee to Citi to get it to buy Wachovia, although that's with some significant protections (Citi agrees to take the first $42 billion in losses on a $312 billion portfolio, and gives FDIC an equity stake). Treasury wants approval from Congress so it doesn't have to wait until institutions are on the brink of failure to step in.
Tuesday, September 30, 2008 at 1:59 pm
I would like to hear an open discussion on inflation when we print $700bn. If there is more money in the system, then every dollar is worth less. That would make everything more expensive. The value of the dollar was the only thing that went up when this bill was rejected (against the Euro and against the Yen).
Tuesday, September 30, 2008 at 1:59 pm
I think giving money to homeowners in trouble is a mistake and unfair. What about the people who DID get mortgages they could afford.. and also got fixed rate mortgages?? If we give bailout money to people.. it should be to all of those with mortgages...
Has anyone considered fining the high-paid executives and recovering some of their salary??
Tuesday, September 30, 2008 at 2:03 pm
One of the biggest problems I see with this bailout bill is that the "oversight" board would consist of 5 Bush appointees: Bernanke, Paulson, Chris Cox (SEC Chairman), Steve Preston (HUD Secretary), and James Lockhart (Director of the FHFA, created to oversee Fanny Mae/Freddy Mac). Paulson is going to oversee Paulson with $700 billion dollars? And three of those guys will remain no matter how the elections go, retaining control of the process with Republican appointees.
Tuesday, September 30, 2008 at 2:09 pm
The market system has been influenced by fear tactic of the Bush administration. Our capitalist system is "Laissez-faire" meaning free itselt, free trade...If there is someone that can show me in an economic book, finance book or accounting book that the action of the gorvenment is appropriate, I will support the bill; until then I will vote against ANYONE of my district who don't take a stand against it. No matter how much I like him/her.
Paulson,Bernanke and all the CEO of those failure institutions should be fired, what are we waiting for, Stand up for your right.
Tuesday, September 30, 2008 at 2:11 pm
Your first question asks where the $700 billion will go, but more importantly does not ask where it will come from; to be sure, more Treasury debt will be monetized by the Fed, money will be printed, devaluing the dollar and confiscating the wealth of the people through an invisible infation tax. Even Ben Bernanke admitted that inflation is a tax! This legislation would alos raise our debt ceiling to ~$12 Trillion dollars! great plan indeed!
Secondly, the notion that the money will actually be recouped is as absurd as it is idiotic. If you're operating under the assupmtion that a profit could be made from these toxic securities, why doesn't the private market invest in these securities? Why wouldn't they want to make money? They are 'toxic' for a reason. To pretend they'll magically become sound investments once the Fed/Tres. buys them is stupid. They need to be liquidated at a market determine price.
Also, F.A. Hayek won the Noebl prize for demonstrating that the Great Depression lasted for 12 years (vs. a possible 18 months), due to the interventionist policies of the governement by injecting credit into the market, artificially propping up prices and controlling wages.
Lastly, blame lies directly with congress and the government for creating this mess. The Community Reivestment Act of the Carter administration forced banks to make bad loans. Furthermore, the Clinton administrations push for "homeownership" further reduced the requirements and verifications for sub-prime loans. It was our current regulatory structure that allowed this housing bubble to occur, coupled with the end of Breton-Woods, and the loose credit policies of the Greenspan/Bernanke Fed. We need less regulation not more. Every state has fraud laws; these were used successfully to prosecute crimes in the Enron debacle. The resulting 'regualtion' from that was Sarbanes-Oxaley, which is no agreed upon in the financial world as one of the greatest hinderences to the industry.
And, even without the bailout from congress, the Fed still pumped about $630 Billion into the markets through its Term Lending Facility.
We have been living beyond our means for too long and need a corrective recession; more government intervention will only prolong the pain. Easy credit got us here, and that's the solution we're being told again. And this administration is warning again (not dissimilar to the time of Iraq), that action is needed. Let the market sort through the bankruptcies.
Tuesday, September 30, 2008 at 2:21 pm
FYI, we haven't had a free market since the creation of the Fed in 1913. Even before then, we had government subsidies (think railroads) and 'antitrust' laws (think standard oil). sidebar: the myth the standard oil was a monopoly has been thoroughly discredited here: http://mises.org/story/2317
So, $314 billion in bailouts, $270 Billion to FDIC, and $630 Billion in Term Lending = $1.214 TRILLION!!! Remind me why we need a congressional bailout again? Oh right, we don't.
Tuesday, September 30, 2008 at 2:31 pm
We can stop the Great Bailout!
Paulson, Bernanke, and Bush (Paulnankebush) as well as McCain and Obama are still pushing for passage of the Great Bailout.
I'm mad as hell and I'm not going to take this anymore!
If you also want to stop the Great Bailout, please visit http://ImMad.net to sign a petition, right now!
Then email/tell as many people as you can to visit http://ImMad.net to do so too, right away!
This may be our last chance to speak up.
p.s. To learn about, and discuss, alternatives to the Great Bailout, visit http://AmericaIs.OurCreation.info .
Tuesday, September 30, 2008 at 2:36 pm
I still don't understand how the $700b will make an ultimate profit for the taxpayers. The fact that these mortgage backed securities are "toxic" is because nobody wants them. How on earth a prudent and decent businessman will buy these securities that nobody wants?! If they can be sold at a profit "eventually", why don't these financial institutes keep them? Rather than asking for $700b, Paulson should perhaps convince these people to keep these "profit-making" securities forever.
Tuesday, September 30, 2008 at 2:58 pm
I'm so impressed with this breath of fresh air forum.
I started with instinct to just say no to bailout, however the more I read and learn the more I am convinced it is a big mistake to give this sum of money to our (The Peoples') Treasury for a bailout. Does not even sound as though they will treat it as a deposit.
Among many questions I have is the means that investment banks leveraged (x30) CDO's and derivatives, who did they borrow from? Along with this I do not believe there are enough defaulted mortgages to warrant $700BLN bailout.
I also ask if the mortgage backed securities were being traded on face value of amount borrowed or tied to total repayment amount over life of mortgage?
Finally I ask about AIG and the fact that their failed investments consisted mainly of European holdings, so why did Paulson give AIG our money?
Tuesday, September 30, 2008 at 3:04 pm
Almost there folks...just keep asking the questions. Sooner or later you'll be bound to ask why we have a Federal Reserve Bank (a private enitity, not a government branch) and why we have a fiat currency (backed in nothing but broken promises). Study history; fiat currencies and the empires they fund do not last. We need to return to sound monetary policy, fiscal responsibility and a drastically limited government. Stopping the bailout is the first step to prosperity. We need to live once again within our means and not on credit. The credit markets need to freeze up so that lending requirements are tighter, so loans are more secure, with less risk.
Tuesday, September 30, 2008 at 3:17 pm
Eli,
In a government with a fiat currency, all roads lead to inflation.
Tuesday, September 30, 2008 at 3:29 pm
Yes Bryan, you are correct; not to mention hyperinflation. Just ask Zimbabawee how that's going for them. $100 Billion of their dollars buys 3 eggs. Or maybe Weimar Germans have a better understanding.
Karl Marx would be proud: "Centralization of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly" 5th measure in eliminating capitalism
Tuesday, September 30, 2008 at 4:11 pm
I've noticed that TIME's sister, CNN, has dropped the 'bailout bill' title and switched to calling it a 'rescue bill'. And, to think, John McCain says the media doesn't give him any help. It sounds like someone at CNN decided (as some of your writings here have indicated) that the media didn't 'sell' the bill properly to Americans. As in the 'breaking news' headline that the market rallied on the hopes lawmakers will pass a 'rescue' bill. Maybe the market rallied because people realized the sky wasn't falling and the emperor has no clothes.
Tuesday, September 30, 2008 at 5:55 pm
f the Treasury owned these mortgage securities, it would greatly skew the market in ways we cannot begin to predict. It certainly wouldn't allow for a normal return to market equilibrium. The idea that any institution could sell to the TARP, only complicates this further by encouraging banks to sell to the government for easy money, rather then to put in the hard work necessary to work out a solution, through write-downs or other methods, with home owners who are on the verge of foreclosure. The likely result is that the housing market will be flooded with foreclosed homes. While that might bring home prices down to their proximate market values, it won't solve the underlying problems of why they were over-valued in the first place. Consequently, the whole inflationary process would merely begin anew once the market became flooded with vulture capital. Who would benefit from this? Again, only the rich, those with enough in their pockets to take advantage of such scavenging opportunities. The average homeowner will merely see their home value fall, while their mortgage remains the same. In short, the rich get a nice opportunity, while the rest get turned into mortgage serfs, bound to houses they can neither afford to sell, nor afford to keep.
Wednesday, October 1, 2008 at 1:07 am
Justin - Thank you for your response re CDSs etc and thanks for this forum. And for those of you awake or with DVRs, Charlie Rose is interviewing Warren Buffett on tomorrow's program. If you have missed his recent shows, which have been tremendous on the financial meltdown, they are all on his website and well worth a look.
Wednesday, October 1, 2008 at 9:36 am
The Dems response to the Bush "plan" was pathetically weak. Can these guys fight for the American people. What about insisting on protections and buyins and regulation which will help prevent a repeat? Congress roled by a lame duck!!
Wednesday, October 1, 2008 at 10:15 am
Great questions and thoughts Mr Fox!
What a huge whole greed has made in American economics. I do disagree that those who were the consumers of these mortgages were just as guilty or more guilty than those who offered. As with any buying and selling, the consumer has the decision to make, not the lender. If you can't afford it ..don't buy it. As a nation we are over our heads in credit debt. Unfortunately the generations being raised in this mess are the ones that have to suffer the consequences of those before them.
Casino or Wall Street. I don't see a difference.
Wednesday, October 1, 2008 at 11:28 am
As the price of living goes up so does inflation. As the price of living goes down so does stagflation. The consumer pays the price. If we were to add taxes to busineses the taxes for consumers would go up. The consumer will have to pay. Buying out the market creates unusual subsidies. If mortgages were to sell it would skew the budget causing forcloses. Buying out the banks creates security in the market. Can we aford this though.
Wednesday, October 15, 2008 at 9:23 am
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