Thoughts on the “Bailout”

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 bailout 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 (typo, corrected and replaced “nominal” with “notional” -CB) 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.

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12 Thoughts on “Thoughts on the “Bailout”

  1. Anonymous on September 25, 2008 at 8:55 AM said:

    If the assets are being sold (to the government) for a price where they will be profitable for the government then how is that helping the banks? From my readings it seems it is Bernanke/Paulson’s intention to not sell anything near true market value bur rather to recapitalize the banks.

    Also, if this is really about avoiding financial apocalypse then why not wipe out the shareholders? Why shouldn’t the government take equity stake in these companies in some form?

    Warren Buffet has shown that he is willing to invest in financials (OK well maybe I should have said A financial) but only if he shares the equity upside. Why shouldn’t this be the case for the US government.

    Finally, how can you agree with this plan when you don’t even know the details of how it will be administered?

  2. Chad Brand on September 25, 2008 at 9:27 AM said:

    From what has been explained thus far, the plan is to use a reverse auction process to buy assets from the banks. This simply means that assets will be divided up into groups based on type, and the banks will submit bids for the lowest price they are willing to accept for their assets. The Fed will also hire advisors to do valuation work, and that is how prices will be set. It is a market-based system, rather than an arbitrary figure the Fed just comes up with out of thin air. There is no assurance the taxpayer will make money, but it certainly could given how cheap the assets will be based on where delinquency rates currently are (6-8% prime, 20-25% subprime).

    The idea is to provide a working market for these assets because one does not exist right now. The goal is not to recapitalize the banks, hence diluting current shareholders of banks that are not in danger of failing imminently really doesn’t serve any purpose. The goal is to liquify the bank balance sheets so that private investors (like Buffett) and other banks have enough confidence in the balance sheets to make acquisitions and invest new capital, which is what would recapitalize these firms.

    I agree with this plan in general, which is what we know so far. I can only comment on that, not what we don’t know. However, if they stick to the general outline they have already explained, there should not be too many unexpected surprises about the plan.

  3. Anonymous on September 25, 2008 at 11:23 AM said:

    I restate my point. If the purpose of this plan is to ensure the survival of the financial industry then why not wipe out the shareholders of companies using the financing? I mean that seems pretty simple to me. They say this is to prevent a meltdown, fine. Let’s prevent a meltdown. Why does that mean that the shareholders benefit by not going bankrupt? Those are 2 mutually exclusive arguments.

    On the flipside if the plan is not required to prevent a financial meltdown then it should not be in place at all.

    As far as your contention that there will be a reverse auction, that is but a rumor. We have no even know how they will administer it. It looks like there will be an oversight board but the specifics are unknown.

  4. Chad Brand on September 25, 2008 at 11:44 AM said:

    The point of the plan is to get the credit markets working properly again. A dysfunctional credit market for any prolonged period of time would cripple the economy because lending would cease. I don’t think the point is to ensure the survival of insolvent financial services companies (contrary to the media hype). If that was the case, Lehman would have been saved.

    If you wipe out the shareholders of banks using this program, nobody would use the program. What CEO would voluntarily wipe out their shareholders when their firms are not insolvent?

    By trying to help open up the credit markets, it helps illiquid firms survive but does not prevent insolvent firms from going under. This plan will not prevent an insolvent bank from filing bankruptcy and being taken over by the FDIC.

    Re: the auction system, I am taking Bernanke and Paulson at their word, since they are the ones who discussed the auction process during the congressional hearings. I’d be surprised if they renegged on that and just set prices themselves out of thin air. They would lose all credibiltiiy in that case. As for administration, there should be an oversight board, but don’t forget, the Federal Reserve conducts auctions for money all the time, so this is not some new concept to them.

  5. Danielle on September 25, 2008 at 11:51 AM said:

    Chad – what do you think of today’s Opinion article in the WSJ (http://online.wsj.com/article/SB122230704116773989.html) where Andy Kessler asserts that the government “could net a trillion dollars and maybe as much as $2.2 trillion”? I’d really love to hear your thoughts.

    By my calculations, he’s predicting the Treasury will buy loans for an average of 35 cents on the dollar. Obviously there is a wide range of possible prices based on the risk level of each security, but that average seems mighty low…

  6. Chad Brand on September 25, 2008 at 12:26 PM said:

    Danielle,

    Thanks for the link. Andy Kessler was a sell side technology analyst, so crowning him an expert on recovery rates of financial asset-backed securities seems to be a stretch to me. That said, let’s look at his vague assumptions.

    He thinks the Fed can buy $2 trillion in notional value assets for $700 billion (35 cents on the dollar as you point out). He then assumes a 50% loss rate and comes up with proceeds of between $1 trillion and $2.2 trillion.

    I see where he gets the $1 trillion (.5*2T), which would be a $300 billion gain (+43%). To me that sounds overly optimistic because I don’t think the worst of these assets (which is what the banks would sell) would net 50 cents on the dollar over time. An average purchase price of 25-35 cents on the dollar is not out of the question, but in that scenario, a profit of even 10% would be a success.

    As for the upper end of his range ($2.2 trillion proceeds from $2 trillion in notional value), I don’t understand what that means and he did not explain it.

  7. Anonymous on September 25, 2008 at 1:49 PM said:

    It seems a contradiction to say that the banks are not going bankrupt but if we don’t lend to them there will be an economic catastrophe. Clearly the leveraged holders of credit, even the higher quality banks are going to get hit hard and probably go bankrupt if the type of doomsday Paulson is warning of comes to be.

    I would suggest that any bank that wants to use this facility trade for preferred shares similar to what Buffet got. This is still more than they deserve.

    For the taxpayer to take on this burden and risk with 10% upside is ludicrous. There is no reason why the taxpayer could not be getting some reasonable upside out of this. Perhaps saying that the shareholders should be wiped out was an overstatement but certainly there has to be dilution as this facility is used.

  8. Chad Brand on September 25, 2008 at 2:09 PM said:

    I see where you are coming from. It seems people mostly differ on what issue should be the one targeted in any Fed plan.

    I don’t think it is a contradiction, though. If lending in the U.S. is halted, that would not bankrupt banks in and of itself, but it would cripple the economy because businesses could not function normally.

    Preventing that from happening, which would affect taxpayers’ jobs, pocket books, benefits, and investment portfolios, is where the upside from a plan would mostly come from. I don’t think we should do this to make a certain level of trading profit because we don’t know what the gain/loss will be. I think they want to win by not losing control of the economy, rather than making a killing on these assets. The taxpayer can win by limiting economic damage, not just by capital gains on bank stocks.

    It appears the Fed will get warrants to buy shares in return. That will likely cause some banks to not participate, but not those who really want the money. Preferred shares would just drain the banks from the cash they receive for the assets becasue they would have to pay out huge dividends to the Fed. Banks can sell preferreds now if they want (i.e. GS), but that doesn’t solve the problem of asset illiquidity.

    At any rate, I sure hope it works to some degree after all this time and effort exhausted.

  9. Early on, Paulson mentioned a reverse auction but since then Bernanke said they’ll pay “hold to maturity prices” which are above current market prices. So the purpose seems to be to both get the market moving again and jack up the value of all these assets on other banks balance sheets. The plan has been not explained at all well. I think that’s because they don’t really know what they’re doing and want the flexibility to change things as conditions evolve.

  10. Anonymous on September 25, 2008 at 9:18 PM said:

    Moom, what you are saying amounts to price fixing. If they buy for above market prices they are trying to artificially raise prices. That is not a long-term solution. What happens if this isn't just about some short-term fear in the credit market, I mean for God's sake it's been going on for a year now. What if this is coupled with an actual recession. As the other debt classes sour is the government going to buy them up too?

    This is ridiculous. You people approach this thing from the short-term perspective of whether or not it will solve the immediate problem. You don't even know that it will, you just take solace in the fact that someone is 'doing something about it'. However, in reality this is not guaranteed to fix the problem. You are trusting the same boobs who were in power while this credit bubble reared up in the first place.

    What about moral hazard, what about the federal debt which with this bailout will be approaching $11 trillion. What about future medicare & social security costs? America is already deeply in debt and your solution is to pile more debt on the federal government? What if this is more than a 'sub-prime' issue which I believe to be the case, what if this is just a plain-old credit issue. Too much debt. This is a recipe for disaster.

  11. Anonymous on September 25, 2008 at 9:20 PM said:

    "The plan by Treasury Secretary Henry Paulson to buy troubled assets from financial institutions “is an incremental addition to the federal government ledger,'' Fisher said today in a speech in New York. Existing federal obligations in Medicare and Social Security mean “we are deeply submerged in a vast fiscal chasm,'' he said."

    http://www.bloomberg.com/apps/news?pid=20601110&sid=abK2j4XZsBuU

  12. Hey Anon 12:18 I’m just reporting what Bernanke said.

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