The Bailout: Why I Like the Idea But Not the Sales Pitch

A reader asks:

"Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?"

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bail out Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers' expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional value. By doing so, we are converting unrealized losses on the banks' balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn't functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn't want to do that anyway, since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don't understand why anything needs to be done or are misguided in their belief that all we are doing is "bailing out Wall Street." The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

Comments

[cjct:]

I couldn't agree more with your assessment of the TARP. While there is certainly some ambiguity regarding the plan, even at ridiculous levels of mortgage defaults these assets should produce enough cash to ensure that at worst the government loses 100-200bn and at best turns a healthy profit. The plan should have been marketed as creating the US's first soveriegn wealth fund which would primarily focus on distressed debt.

2008 Sep 26 02:46 AM

[Steven Hansen:]

chad, the message is getting through because the truth is not being told. this is what happens when you sugar coat economic conditions, and joe public sees something different than what the government is saying.

anyone watching the congressional hearings sees in the body language of bernake and paulson a lie is being told - like a parent would do to a child. i can guess what the lie is, but i would rather they just tell the truth.

2008 Sep 26 03:00 AM

[poet1:]

The mechanics of Wall Street went too long without fixing. Christopher Cox should be fired.

Credit swaps for $62 trillion need to be unwound--paired off. Treasury is going to buy the CDOs. The CDOs have been "marked" or valued at 20 to 50% of face value. No one knows if the underlying
mortgages will be paid or not. If the whole economy goes to hell, more
won't be paid than otherwise will be the case. If Treasury buys them now at 50 cents on the dollar & the situation stabilizes, Treasure will be able to sell them in 2-3 years at 70 to 90 cents on the dollar & make a killing, ie. the taxpayers will win.

Most of the other credit Treasury is extending now is replacement money borrowed by banks & companies for 30 to 90 days
that they have used to buy other securities with higher yields (interest
income) just from greed & because they could. Lack of oversight by the SEC.
Treasury's money will be paid back, 100% on the dollar with fees & again Treasury will get it back. Same with money market funds---some held Lehman paper. People with millions
in money market funds are panicked, the managers can't sell their holdings fast enough to make redemptions---$3 trillion. Treasury can facilitate these refunds, without effective risk but prudent to keep the system going.


Having he & Bernicke testify in front of idiots from both sides of the aisle is like taking fireman away from the hoses that are pouring, spraying, water on a burning house to explain how the fight is going.

Time is of the essensce to put Paulson's bailout plan in place. If congress does not act to put this stabilizing plan in place then there is a very good chance the fiancial markets will just freeze up and come to a screaching halt.
Commercial paper allows all the major corporations to handle payroll and deal with employees. if this plan isn't put into place , then
we're looking at layoffs and possibly even the inability to access cash from your ATM. The way i understand it, the govt will own
alot of illiquid assets that major corporations had on their balance sheets BUT at HUGE discounts. so the american taxpayer will not be hurt by this.
JUST SAW PAULSON PUTTING THE BLAME OF FUTURE ADMINISTRATIONS. HAH. DOES ANYONE OUT THERE REALLY THINK THAT THESE BIG WS GUYS DON'T DO 50 YR PROJECTIONS? THEY KNEW IT WOULD FALL, THEY DO PERCENTAGE STUDIES ON HOW MANY /WHO WILL DEFAULT ETC.

2008 Sep 26 03:39 AM

[mathdummy:]

Why can't our politicians behave more like the smart money?

When this crisis started, plenty of financial institutios needed cash. So, they went to the smart money. Of course they would have loved to sell the snart money their distressed assets at a reasonable price. But, the smart money being smart money said no and instead traded their cash for a slice of equity.

You see, the smart money knows nothing about esoteric mortgage backed derivatives and other assets. Even a great price, they figured, it's going to cost a fortune to manage these things. Whatever upside in price there is, will be evaporated by the management cost of these equities from now until it's a good yime to sell. "Thanks, but no thanks" they told the financial institutions. We;ll buy a piece of your equity and let you manage these assets. You have the know-how, people and structure to do it cheaper than us.

Why can't our government behave more like the smart money? Yes, the financial institutions need a $700B financial infusion lest the entire system collapse. Yes, it is in the best interest of the taxpayers to give them this infusion. So, let's do it. But, wait a minute, why do we have to take these assets that not even the financial institutions understand in return for our money? Let's change the accounting rules so they don't have to price them in their books at distressed prices and let's take instead some interest or equity for our $700B.

X years from now, these mortgage backed assets will be worth more than today. Who will be able to cutody them in the meantime at a lower cost? The financial institutions, or the federal government? Who eill be able to sell them at a better time and at a higher price? The financial institutions, or the federal government?

Dear fed: Please give the banks the money, just don't trade it for a complex financial instrument you don't understand and will spend a fortune managing. Buy stock or a CD, sit down and wait. After all, that is what politicians do best and at a lesser expense. No?

2008 Sep 26 09:27 AM

[finmah@yaho...:]

You article is right on. However the govern is not in the habit of managing assets well and if they have a profit they cry poor and buy votes. This then becomes a structural increase in govern spending. There is behind the scenes politicizing because the more it seems like a bailout the more the money is supposed to stay with the govern and not dispensed to the public.

Where is the real scrutiny into how the US govern had to take in 4 trillion in bad mortgages due to a runaway govern agency that mainly was supported and defended and contributed to key Democrat politicians including Obama. That is why the press needs to point blame at Wall street - to pull Republicans in. A quick sweep under the rug of these 4 trillion in mort blurred by silly lawsuits after the fact of mort companies will gain political traction for the Dem - that is why the plan was stopped for awhile. No question the middle class will get hurt is something is not done but over the greater term absorbing 4 trillion in homes will impair any recovery. Have you any growth policies such as eliminating cap gains or reducing gov payroll or reducing taxes for significant payors from the dominant party?

2008 Sep 26 09:34 AM