What if They Gave a Bailout and Nobody Noticed?

11/05/2008 05:12 am ET | Updated May 25, 2011

The government (Treasury Dept.) has been given very broad authority to purchase distressed assets. Over on, Chadwick Matlin observes that the language, "interpreted loosely . . . could mean tax dollars could be spent purchasing a depressed, yet invaluable, bank employee." Certainly the range of things the government *may* undertake is almost unlimited.

Undoubtedly, however, the government will begin by doing two things:

1) Buy individual mortgages, probably through Freddie and Fannie, with full information and all the usual bells and whistles.

2) Buy securitized debt as whole bonds, which requires arriving at a valuation for the mortgage pools that are the underlying assets, which is a problem about which numerous people (including me) have said a great deal already.

If all of this works, the banks holding the mortgages and the banks or investment houses holding the bonds will find their balance sheets looking better, which makes them and others more willing to lend and borrow money, which will open the taps on the flow of credit and commercial paper. As the government buys mortgages and pays them off, a lot of the derivatives -- e.g. the infamous credit default swaps -- will dry up in a reverse ripple effect (take the rock out of the pond and all the water reconverges to the center.) That last part is important: there are something like $1.7 trillion in sub-prime mortgages, and something like $67 trillion in derivatives of which more than $40 trillion are CDS's. And in the medium-to-long run the underlying assets' value may yet recover, and the taxpayers may be made whole.

This is the Rosy Scenario, and it is not outside the realm of possibility. There's an interesting numbers comparison here. Out of $85 billion made available to AIG, AIG has drawn $61 billion. Out of $200 billion available to Fannie Mae and Freddie Mac, those institutions have drawn . . . zero. At the moment of their failure, those two institutions were actually solvent as far as cash flow and immediate needs; it was the long term prospect revealed by the list of non- or under-performing assets on the books that constituted the "failure." AIG, by contrast, was in the tank, dragged down by the weight of credit debt swaps. This gives some support to arguments that techniques for valuing assets ("mark to market") were part of the problem all along. It also provides some encouragement that rescuing the mortgages and their assets can work, while the solution to the derivatives is to make them go away.

BUT. Even assuming all of this works as advertised -- what's the timeline? It will take weeks for this program to get capitalized, likely months before the first mortgages or securities are identified and purchased, and it may take 5 or more years to complete the process. Meanwhile, the consequences of drying up credit are being felt right now, in everything from lenders canceling or cutting back on student loan programs, states cancelling public works projects, car dealerships unable to purchase inventory.

The stock market is down 880 points last week, with no positive reaction to the enactment of the bailout, but the stock market is not the thing to be watching. At the risk of tiresome repetition, the thing to be watching is the London Interbank Operating Rate and the spread between that rate and 3-month Treasury bills, called the "TED Spread" (stands for "The Euro Dollar spread") and three-month US Treasury bills. That spread is the cost that one bank charges another to take on the risk of loaning money rather than parking that money in a guaranteed safe place. (Theoretically the U.S. could eventually default on its bonds, but at that point we are talking apocalyptic science fiction scenarios.) Conversely, the more eager people are to park their money in bonds, the lower the rates those bonds have to offer. So two connected signs of a credit crunch are a rise in the Libor rate and a decline in Treasury yields; when these two things happen together, the TED spread gets wider.

At one point last week 1-month T-bills were selling at negative 1%. People were willing to take a 1% outright loss on their money to find a safe place to store it for 90 days. 3-month bills went down to 0.143%). And the spread? On October 2 the Ted Spread was 254 basis points. For comparison, in the 12 months ending in July 2007 the average was 8 basis points.

"Main Street," as the candidates are fond of saying, is not going to feel relief from this program until that spread starts to come down. But unless I'm missing something pretty basic it's hard to see how that will happen in less than a matter of months. Here's just one likely consequence: colleges will close. There are a lot of small schools -- some of them academic bottom-feeders -- that cannot survive without a constant and readily available flow of student loan money. State schools and community colleges are in the same bind. Expect state systems to close outlying branches, public university tuition to rise, you name it. Investment in primary and secondary education is usually funded by bonds: oh, well, what the hell.

This is the kind of change that can have sociological consequences, the reverse of the GI Bill in its effect on America's culture and future. The job loss numbers will only get worse, the tide of foreclosures will not stop any time soon, the tide of bank failures around the world is far from over, and I have a suspicion that the major credit card companies are sitting on some Very Bad News.

There is one class of workers who should feel immediately reassured by the bailout, however. I am talking, of course, about the nice folks on Wall Street who did so much to create this scenario, the lawyers and accountants and hedge fund managers. The unofficial sub-title of the bailout legislation is "The Financial Advisors Full Employment Act." It only cost $150 billion in pork spending to get it passed: that's $500 per U.S. citizen just to pay the transaction costs of the political process. (There is an area of computational theory that studies Very Large Numbers. Sounds like an area with which we should all start becoming familiar.)

The next president is going to have to be capable of taking the Paulson bill as only the beginning. The basic relationship between government and the economy in the United States is open for reconsideration for the first time in 50 years, and it doesn't stop there. Our current understanding of 'the New Federalism" -- the relations between federal and state governments that has been constructed over the past two decades -- is likely to come under considerable strain. And judicial appointments take on a whole new significance that goes way beyond Roe v. Wade or the Pledge of Allegiance.

The one thing that would be absolutely, unquestionably, criminally irresponsibly wrongheaded would be to do exactly what the McCain campaign is suggesting: treat the economy as a closed issue and "turn the page." Maybe he can put up a big banner that reads "Mission Accomplished" to emphasize his point. (Actually, I can imagine a really good Obama ad drawing that connection.)

Crisis over? This crisis has barely begun.