Bailouts and the Fog of Finance

“Bailout” was a bad word in the US to begin with. The current financial crisis and the US government’s $700 B plan to revive the market for troubled mortgage based assets have made it toxic.

What does “bailout” mean to Joe Citizen? It means that a company made mistakes and as it suffers financially, is perhaps close to bankruptcy, the federal government rides to its rescue using taxpayer’s money (“my tax dollars”) to rescue the company. To any logical person that seems unfair.

But Joe Citizen is not all logical about this. There is a lot of emotion and mental imagery involved with the current set of bailouts.

First, these are big companies we are talking about. CEO compensation in the US was already being recognized as a problem – a political problem because it calls out the huge income disparity in the US, but also a real problem because it doesn’t work. To save companies from bankruptcy whose face to the world is their CEO and whose multi-million dollar pay package is publicly known, gets Joe all riled up.

Second, these companies are investment banks – the “Masters of the Universe” – as they are referred to. Their CEOs regularly take home $50 M + packages. Not just that – at a firm like Goldman Sachs, the average annual compensation per employee, which includes administrative staff, is well over $250,000. Joe Citizen, meanwhile, toils away for an average annual wage of $40,000.

Third, these are not good times for Joe Citizen. Unemployment is high. If he doesn’t have a job, he can’t meet the mortgage payments on his house. This means he loses his house, then soon after loses his job. He needs someone to blame. He doesn’t have to look far. It’s Wall Street. Their greed led them to corrupt the whole mortgage lending industry. They are the ones responsible for this mess. And now the feds want to bail them out! Over my dead body, says Joe.

But the point that Joe misses is the objective of what Secretary Paulson and Chairman Bernanke are proposing. It is not to bail out the banks, although that is essentially what will happen. The objective is to create a market for toxic mortgage backed assets. Currently, there is no market, so there is no way to price these assets. They sit on the banks balance sheet and eat into its capital. Lower capital means lower lending. Lower lending means bad things for the economy.

But that’s not all. If the illiquid mortgage based assets on a bank are large enough it can take the bank down with it. Once that starts, worse stuff can happen. Depositors coudl start withdrawing their money from all banks. As banks fail, the other financial institutions that they owe money to start writing down their assets. The dominoes start to fall. In the Depression, the government took a hands-off approach (no bailouts). A third of the banks failed.

So while Joe has every right to be angry about this $700B intervention where he is at the receiving end for mistakes that other people made, if he knows what’s good for him, he will support a “bailout” of the financial sector and will not weigh the bill down with other things that reduce its effectiveness. He will wait for the storm to pass. Then he will come back with a vengeance. He will push his elected representatives in Congress to set up a commission to apportion responsibility for the past sins of the industry. And to enact new laws that will address mortgage lending practices, the highly protected rating agencies who get paid by issuers of the debt they are rating, excessive risk taking and inadequate disclosure in publicly held financial companies and executive compensation at public companies.

And in the meanwhile, if this thing is indeed important to Joe, he might want to go a little deeper than what his local newspaper is saying which will not enhance his understanding of the issues at hand in any way.

For instance, the $700B is not going to be “spent” like say the Iraq war, which is what politicians and talking heads on TV most often compare this to. It is going to be “invested”. The price that will be paid for the asset is not the par value of the asset. It will be what a market-based price discovery mechanism produces (a reverse auction of some sort is what they are talking about). It is possible, that the Fed actually turns a profit on this, not a loss.

If the AIG deal was anything to go by, the Fed is not averse to striking a good bargain that might make some money for its shareholders (taxpayers). AIG had a market cap of about $200B in June of last year. The Feds terms are:

– The Fed opens a credit line for AIG of up to $85 B.
– AIG pays 8.5% interest over LIBOR. That is a huge risk premium.
– It pays an additional 2% “commitment” fee. I can’t tell what this is on, but it can’t be on balances – that would be too much.
– The Fed takes an 80% stake in the company that had a market cap of about $200B not long ago.

Any private equity investor would love to get these terms if they could raise the $85B. Essentially the shareholders are going to take a bath. The CEO lost his job. So yes, the company was “bailed out”, but the owners and the management both paid a price. Who was bailed out here? The employees, for one. But most importantly, all the companies and institutions who hold AIG paper. And by preventing the contagion from spreading, you and me. That’s who is being bailed out.

The tragedy here is that one of the biggest challenges facing the US today is so darned difficult to comprehend by the average citizen. A while back I wrote about the Fog of Economics in a similar context. The Fog of Finance is even harder to penetrate. And yet, the country’s financial future may be hanging in the balance on these issues.

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8 Responses to Bailouts and the Fog of Finance

  1. Brij Shah says:

    Basab, superb analysis of the crisis and the bailout. You missed one major cause for the current mess, Greenspan’s low interest rate regime that poured cheap money that everyone under the sun from hedge funds to your average Joe used to over-leverage themselves.

    I am also not sure if the follow-up action by lawmakers will come through. They might just go back to their pork-barrel days. Especially, if McCain (good man BTW) gets elected, he might have to return some favors to the big money.

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  2. I wonder what impetus will it take for the market to return and start pricing the credit derivatives that banks have hoarded up on. Will the Fed become the market-maker for these securities?

    Chris Cox of the SEC is one gentleman who is getting away big time in all this. Banks that are going belly-up have all built up ginormous amount of leverage all under his watch (Goldman’s Nov 2007 leverage was close to 25:1). Early containment of excessive leverage could have restricted the spread of the disease.

    An interesting question to ponder is whether having these derivatives traded on an exchange might have resulted in better (public) pricing and hence liquidity compared to what has happened because they were all OTC.

    Sincerely
    Subrata

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  3. Basab says:

    Subrata, there seems to be a strong case for exchange traded derivatives vs OTC derivatives. The key question is how to push more volume onto the exchanges without shutting down OTC derivatives which is not really practical.

    http://www.informationarbitrage.com/2008/09/transparency-on.html

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  4. Omkar says:

    Basab,

    It is really a great piece of suggestion for “Joe Concerned Citizens” = American Citizens.

    I really wonder what will be there for “Common Man Pathetic Citizen” = Indian Citizens: with the policies, economic “sanction/taxes” of our Harvard educated ministers coupled with the mentalities of our great leaders.

    Reason: I am stunned with the fall of Lehman: a company which survived the great depression in early 20th century, two world wars, recent bubble in Y2K, but could not handle this one. And it is no secret that when America sneezes, normally the world catches cold and India can not be immune.

    I have read the earlier one – Fog of Economics, but they just do not work now. Labor reform is still a pipe dream even without the Communists at the center! Simplifying things is not in the mind of our leaders – created a Saral (Simple) form to file taxes earlier which is actually complex,moving into fancy ITR types now! People are not actually involved in any decision making at all, rather they are bombarded with hoopla and emotionally charged dramas (=Singur).

    I really wonder what will be the current impact of this crisis and above all, what “practical” changes can be done to educate the masses – considering dismantling License Raj was a miracle, education is not of prime importance in many regions of India, politicians have started dividing the nation based on language, caste, ethnicity and of course people with some money (= middle class) have closed their soul long back based on “moral” grounds.

    Of course we will still come out of it, like we have done earlier = DO NOTING! But depression is cyclic, and it will be much much harsher in the coming years when India opens up further to the world.

    Or leaving for the “still greener pastures” (= the US and other developed countries, short term or long term) is the only solution – like many had done before, doing now or will do in future ???

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  5. Krishna says:

    The average Joe is angry because these banks didn’t yield him a penny when the going was good. So now when they go belly up, why should he care? Why is he not allowed a choice not to care? Why is his tax dollars being pinched to bailout a few self-serving sinners?

    How noble can be the objective of (re)creating market for paper that’s issued on fallacies (like housing market will always go one way, that’s up)? The paper got soggy because it was built on wobbly foundations of marshlands. It met with its destiny. That’s about it.

    How will Hank Paulson justify the selective application of bailout? While Lehman Brothers is allowed to founder, Bear Stearns, Merrill Lynch and the FM twins get rescued. Why? Is it because Lehman Brothers did not demonstrate a genius for screwing up? No. Perhaps, the lucky others that qualified for the bailout were too”Chinese” to slip through the cracks?

    Financial intermediaries like Bear Stearns and the FM twins function like the heart of the global financial system. If they go into cardiac arrest, the whole body is in danger. Since Bear Stearns was a counterparty to (and guarantor of) trades and financial arrangements with the world’s major financial players, its failure would have triggered a cascade of losses. In the same vein, huge quantities of the $5.4 trillion in debt issued and insured by FM twins sit on the balance sheets of central banks and financial institutions around the globe. For the U.S. government simply to let this debt — which it had been implicitly backing for decades — go bad would have meant inflicting severe damage on America’s most significant diplomatic and trading partners. Fannie Mae wasn’t too big to fail, it was too Chinese to fail.

    Paulson can go down a hundred times before Ms.Palosy with folded hands. But average Joe won’t fall for Catholic gimmicks – for he trusts no one now. He’d like to get a life!

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  6. The reason it’s a bailout is because the idea is to provide capital to the banks. Otherwise there could have been a Maggie Mae – a company setup to buy teh distressed assets, which would be funded with $700b as debt from the Treasury, and then listed.

    The problem with that is that Maggie Mae will be incentivized to pay lowest dollar, which does not help current banks. Banks need the cost to be higher than current bids. And there are current bids from the likes of John (not Hank) Paulson who have raised distressed asset funds.

    SInce the price paid will be on a rigged reverse auction basis, there is no chance that the bottom dollar will be paid. Thus, a bailout, but of the banks involved.

    What the current bill does is adds serious guarantees and capital/comp limits, which does not help the banks or the bankers. The “bailout” may only help the institutions into a situation not worse than today, but not much better off. Even with the $700 b, nothing much is likely to change – prices of homes, for instance, are not going up. That in itself is a guarantee that what is currently distressed will stay distressed, or go completely down. Even with a mortgage modification – principal or interest – it is unlikely that someone who is 20% underwater will jump at the opportunity.

    And this time, the person takign the hit is the government, a non profit organisation who doesn’t really want to foreclose…so why bother paying your mortgage if the government will do whatever it can to defy foreclosure? I think we all underestimate the level of moral hazard this bill has created.

    Recession is a given, in my opinion. Perhaps a very deep one . The average Joe will not like it, either ways – and that includes even the average Deepaks in India.

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  7. Basab says:

    Deepak,

    The Maggie Mae option is basically saying that the market will find a price for these securities. That is not happening. There is no market for MB securities. Which is why the bailout fund needs to be set up.

    A reverse auction that finds a price at which the securities can be sold is not “rigged”.

    We’ll have to see what the final bill contains, but yes, there is a good chance that in helping people deal with the difficult situation of losing their homes, we will end up rewarding some people who were living beyond their means. A different kind of a bailout, if you will.

    There is no question that the economy is going to take it on the chin. And be down for a good part of the count.

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  8. I would disagree with there being “no” market for these securities Basab – I think there are buyers and bids but banks are unwilling to sell at those prices. That’s what I hear from a number of people in the space – that the deal is to get better prices than those currently being bid.

    One bill out. Another one coming up soon. Interesting times.

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