More Thoughts on the Bailout

The proposed bailout does a simple thing: it authorizes the Secretary of the Treasury to buy $700 billion worth of mortgage-backed securities at a price he sets. The bill is being peddled as the only solution for a crisis that may bring down our financial system.

I agree that the crisis may bring down our financial system. I think we all need to be skeptical about the idea that this is the only fix.

The reason this crisis may bring down the financial system is that most of the major banks have billions of dollars of mortgage-backed securities on their balance sheet. Those securities are probably valued at a price much higher than their actual value. Right now, those securities can't be traded because nobody wants to sell them -- there's no market in them.

Once someone starts selling mortgage-backed securities on the market, and once it's apparent that the real value of those securities is pennies on the dollar, banks holding those securities will have to "mark them to market". In doing so, those banks will acknowledge that their assets have shrunk. Some banks' assets will have shrunk so much that their debt-to-asset ratios will fall below the regulatory minimums. In other words, some banks will become insolvent and fail.

To avoid this, Hank Paulson proposes to buy those securities at a price he sets. Presumably his price will be high enough that banks will stay solvent.

Think of it this way: you bought a house with a $100K mortgage. The house is now worth $40K and you must sell because you can't afford the mortgage. But you only have $20K in the bank. You're bankrupt, since you owe the bank $40K if you sell the house. But wait! Rich Uncle Hank agrees to buy the house for $80K. You lose some money on the deal, but you're not broke.

Rich Uncle Hank isn't concerned about the real value of the house -- he only cares that you will walk away intact. Hank might sell your house for $80K someday, but that's unlikely. It's more likely that he'll take a loss, and he's certainly assuming a big risk. Shouldn't Rich Uncle Hank expect something in return for doing you this favor? Wouldn't he at least expect you to change your ways so you don't make a bad investment like that again?

In the bill currently being proposed, Hank gets nothing in return for assuming $700 billion in debt. This bill is an extremely generous solution to a real problem. Here are some questions Congress should be asking before they expect taxpayers to shoulder this burden:

Why isn't this bailout coupled with legislation to regulate or eliminate mortgage-backed securities? Isn't it clear by now that they were a bad deal for everyone?

What about the rating agencies that rated those securities as "AAA", which allowed banks to buy this junk? Shouldn't the hammer be falling on them?

How about the executives who took home huge bonuses for selling mortgage-backed securities?

And, in my mind the most important question: Why not let the market work, and create a backstop instead of a savior? In other words, let the banks fail, but announce that the Treasury will insure that no bank customer loses any money. This is what happened with the S&L bailout in the late 80's and early 90's. The S&L's failed, and were operated in receivership. If we're going to do it again, do we need to be more generous this time?


Your idea sounds like a good one, but I don't have the expertise to comment any more than that.

Did you see this?

I hadn't seen that. Thanks.

Sounds like it's a party for everyone but those of us who are paying for it.

And I don't doubt that it will sail through Congress. We're right before an election, and anyone opposing the bill can be called out as someone who's enabling the failure of our financial system.

I think that we'll find out next week, when the markets are open, whether it will be possible politically for conservative Republicans and progressive Democrats in Congress to slow the approval process down. It may be that the perception that something massive will be done to deal with the problem will continue to prevent a panic. In that case, if both sides play it right, the process could be drawn out to November or later.

Bipartisanship at this point, reasonable and responsible or not, will not have a payoff for either party at the polls. Certainly the candidates, who are too close in the opinion polls to exercise any real power will have to keep a low profile.

It's ironic that this crisis is probably worthy of the hype that followed 9/11. For us to screw up again by giving the Bush cronies a blank check and no oversight or liability would be a real tragedy and things would truly "never be the same."

I hope that we can have a bit of a stall on this, but it looks like the rails are pretty heavily greased right now.

We are definitely being pushed into an $700b-or-catastrophe position. There have to be other measures that don't cost $700 billion that might stabilize the market.

Another question: Should hedge fund managers pay income taxes rather than capital gains?

The tax code should be restructured so that the intent of capital gains vs ordinary income apply to hedge funds. I don't know the details of how that would look.

Capital gains tax treatment exists to get people to risk money in longer-term ventures. Hedge funds are a dodge that take advantage of some artifacts of capital gains tax law.

My understanding is that managers of hedge funds have their income for services rendered taxed as capital gains. Of course it's their clients who are reaping the capital gain or loss and the managers are collecting fees and commissions. Hedge fund managers have also been instrumental in selling huge amounts of Mortgage Backed Securities to their clients, contributing greatly to our current problems. These managers have been cleaning up and many of their clients have taken the fall.