What if They Gave a Bailout and Nobody Noticed?

The government (Treasury Dept.) has been given very broad authority to purchase distressed assets. Over on Slate.com, 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.

Comments

[Uncommon-Sense]

Thomas Jefferson said it (er, wrote it) best:

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."

Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin (1802) 3rd president of US (1743 - 1826)

[JonRaymond]

Bush has proven to be, in this last week, a much greater terrorist to our country than Bin Laden and all his operatives before and since 9-11.

[Rule Of Law]

once more--

You go to the heart of the matter, about which I've commented many times, to no avail.

The banks are the enemy, have always been the enemy, and will always be the enemy. Even in Lincoln's time (he who died because he dared to print "Greenbacks" against the will of the international banks) His sec of State said that the boot prints of the Rothschild family was all over the beginnings of the Civil War. Google it. There has not been a modern war (1600--present) that has not been created by and fought for the banking industry. They arm both sides--Prescott Bush assisted in this for the Nazis all through WW2--and they get wealthy on death. Imagine the worst monster in mythology or horror--Dracula, Alien, Satan--and they do not compare to the Banks for sheer malevolence and soulless, murderous greed.

[avraamjack]

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There could have been an immediate boot to the credit markets if the .7 trillion were used to create 20 new banks.
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With a 10 percent reserve requirement, that would translate into a 7 trillion lending capacity.
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In 5 years, the stock could have been sold to the public and the government would have rexouped the money.
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The new banks could have employed the many unemployed financial people and bought out the failing institutions on advantageous terms.
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A much better deal for the economy and the taxpayer.
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[KillTheMessenger]

"In 5 years, the stock could have been sold to the public and the government would have rexouped the money."

You assume that these banks are going to be profitable. They won't be because well established businesses with positive cash flow will retain their old banks (and vice versa). Your new banks would have to charge enormous interest rates to just cover for the kind of high risk loans there are required to serve.

Risk, like energy, can not be destroyed, it can only change form.

[Rule Of Law]

Watched a Georgetown Professor of Law--multiple award winning author and world renowned expert on law and finance--on Bill Moyers. She said, unequivocally, that the actions of many banks, mortgage brokers, and investment banks were, without a doubt, illegal. Not just grey and kinda sorta maybe...but Illegal! This puts all those new home owners in a different light, or at least it should. Like sheep to the slaughter springs to my mind.

Now, today, in reference to your remark about risk and change, we have the following blog:

"Facing a lawsuit over deceptive mortgage practices, Bank of America Corp. is agreeing to pay more than $8 billion to modify hundreds of thousands of loans to keep people from losing their homes.

http://www.huffingtonpost.com/2008/10/06/countrywide-mortgages-to_n_132132.html

I have no illusions that the People will win this class war, unless we become mush more serious about it, but just this little adjustment, shows the weakness in the argument of those who still want to lay the fault for this crisis at the feet of the people most hurt by it!

[avraamjack]

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That may well be but my understanding of the issue is that even the well qualified cannot get funding.
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Even California and Massaxhusets are begging !
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[Sam1]

This was a bad deal. The government should have used the Warren Buffet model. Inject capital into the banks for preffered stock and common stock warrents. The banks could then write down and take the loss on the bad assets and the govenment would have been in a position to recover the taxpayers money. Purchasing the bad assets the govenment takes the loss and the huge bonuses and rewards to the people that created this mess just continue.
This was a bust out, not a bail out; after you have slaughtered the sheep you can no longer shier them!

[KillTheMessenger]

Loss is loss. Banks and investors writing down losses pay less taxes. So you taketh away with one hand and giveth with the other. And since the assets would keep lingering for years, they would tax the systems for years. If you buy them out, they are gone in an instance.

It's a judgment call. I think the judgment of the Fed is to cut the cancer out rather then to let it linger and metastasize.

[tompoe]

September 19, 2008, Bush sends Paulson out to gather $1 trillion dollars for his going away present to cronies. That is the date the Republican Party became the Party of Corporate Welfare. America does not tolerate corporate welfare. Howard Schweber will keep us updated on progress, not of the crisis, but of the mounting evidence that the Party of Corporate Welfare must abandon its charter, and move to the margins of society now occupied by domestic terrorists. Their eight year reign of raping and pillaging of America will linger for decades to come.

[twofish]

The best description of this handout/bailout I heard was the description of a cartoon (sorry, don't know the author): George Bush headed out the door with two big bags of money in his hands. The caption: So long, suckers!

[Henry]

There is something very strange going on here. The Fed Funds rate (our not guaranteed interbank rate) has been running less than 1.0% (target 2.0% at FED) and the U.S. Dollar has gained 10% to 15% in value to the Eurocurrencies. See linked graph:
http://finance.yahoo.com/q/bc?s=USDGBP=X&t=1y&l=on&z=m&q=l&c=

If it is the U.S. that has lower central bank rates than the referenced economies and all the bad news of the credit crunch, it would follow that the U.S. dollar would be weakening. And it is not. Something is strange. Libor dollar denominated rate is 6.0% and our effective Fed Funds (interbank) is 0.6% and Treasury yield negative. And... we are in a credit crunch? And over this period of time, the dollar is strengthening? Can anyone explain these variables in such dissarray? (I have a guess but it's only a guess)

[Henry]

My guess is that we are observing the unwinding of the carry trade in foreign exchange rate difference between the US and Europe. Like this: Initially the dollar was borrowed at 2.0%, converted to pounds (dollar down pound up) to avail a rate of 5.0% in Gr Br and with "hedgie" leverage return of 15% or so. The carry trade is being unwound. The Euro banks with carry deposits are being withdrawn and converted to U.S. dollars to be repatriated. Demand for U.S. dollar high there for a 6.0% borrow rate for LIBOR dollar denominated. And also this unwinding explains the gains in the dollar vis-a-vis the eur, gbp, nok, etc etc. It is also true for the Brazilian Real etc. (I mean the dollar is gaining against the real) Afterall ... supply and demand really have to play some role in this game. It is not all the subjective measure of risk to explain the difference.

[DixieMelody]

Cities across the nation are imposing harsh penalties on the homeless.

According to AARP Bulletin:

"In Santa Cruz, CA, a BLANKET BAN punishable by fines makes it unlawful for people living outside to cover themselves with a blanket from 11 p.m. to 8 a.m. Sleeping in cars is illegal during those hours. So is lingering in covered parking lots, where many people seek shelter in bad weather."

"Almost every city in the United States has tried to make it illegal to be homeless. Mayors and legislators think you can legislate homelessness out of existence."

So if we become homeless we need to be very afraid, not just of muggers but of bureaucrats who will be only too willing to kick us while we're down, now that they have robbed us blind and ensured their "trickle down" sewage has thoroughly covered us.

[KillTheMessenger]

Do you want homeless in your neighborhood? If you do, I can send a few of mine over.

Of course homelessness should be outlawed. We need a law that every county has to supply everyone at all times with shelter and a minimal amount of food.