The Bailout

I haven't been able to devote much thought to the bailout yet, so let me turn the microphone over to others. Tyler Cowen explains why the bailout is needed:

What if we didn't bail out the creditors?, by Tyler Cowen: ...[L]et's say that the Treasury did not support the debt of the mortgage agencies.  The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless.  The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly.  The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value.  Most of the U.S. banking system would be insolvent.  Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot.  The rate of unemployment would climb into double digits and stay there.  Many Americans would not have access to their savings.  The future supply of foreign investment would be noticeably lower.  The Federal government would lose its AAA rating and we would pay much more in borrowing costs.  The deficit would skyrocket.

And I haven't even mentioned the credit default swaps market.  Well, I have now.

But for another point of view, try Jeff Rogers Hummel.

Can't have that, hence the bailout. Tyler also plays traffic cop:

World's biggest bail-out: update, by Tyler Cowen: Arnold Kling wonders: what is the exit plan?  Brad DeLong and John Hempton think the Bush Administration showed some courage.  Brad thinks the preferred stock can do OK.  Here's what forced Paulson's hand.  All lobbying from the agencies has been eliminated.  WSJ reports: "House Financial Services Committee Chairman Barney Frank (D., Mass.) said in an interview that the near-term effects of the conservatorship will be to "strengthen the public mission of what they do" to prop up the housing market."  Preferred shareholders lose dividends.  CalculatedRisk has the clearest bottom line so far.

Let me add two from Robert Reich, Fannie and Freddie, as Predicted, and Fannie and Freddie, and Why the Accounting Gimmicks. In addition, Felix Salmon has Frannie's Future. I'll add more as I find them. [John Jansen at Across the Curve has a stream of entries on the bailout, the latest is here. Here's Andrew Samwick.]

Is it a good bailout, or a bad bailout (relatively, not absolutely)? My own view is that the bailout was unavoidable, but I'm waiting to learn more details before judging the quality of the intervention (both with respect to the current situation, with respect to moral hazard concerns going forward). Nouriel Roubini, though, has heard all the details he needs and writes about Fannie and Freddie’s Bust and Deeply Flawed Government Bailout.

Comments

[Matt]

If they are as insolvent as Tyler claims then why does he think the taxpayers can help?

Are we supposed to inflate? Is this the scenario? Deflate the currency over time so all of us share equally in the financial failure.

My advice is to get some inflation hedges, because I see no where that the taxpayers have any more money.

[Circular Flow]

Basically, more money is now being borrowed from foreign savers to pay the same foreign savers back what the the foreign savers previously loaned to citizens via GSEs.

[Invisible Hand]

This bailout is basically a 12-month program to buy time for the next administration to come up with a responsible and sustainable plan. In theory it would be wonderful if this became a major election issue, but it's too complicated and the best solutions are too PAINFUL for vote-seeking politicians. Besides, neither candidate has impressed me with much in-depth economic knowledge.

Do I think that the next administration and Congress can develop a successful long-term program by next summer? Probably not, but the opportunity is there.

[paine]

"The flow of capital from them and from other central banks, sovereign wealth funds,.. would shut down very quickly"

crapola...

the strategic national self interest behind
for example
the rmb peg
hardly goes away because they find their holding some
dollarized duds

okay so maybe their estimate
of the long run cost to the nation
of their industrial development plan
---based on eating trade surplus dollars
to maintain their aggresive north market penetration---
needs an up tweak now and again

ps hey have u noticed
the dollar moves
both ways

over the longer term trade imbalance
adjustment cycles
errr ...at least against most north currency blocs

if not the gang of resolute south pegsters

[el rei]

This has been a very entertaining year. Is the United States financial market/monetary policy/fiscal policy always like this? I'm just now turning 21 and have only started paying attention since I started college...

[paine]

the imperial dollar makes its own rules

[Aaron]

The taxpayer will bear the brunt of it again, but I'm afraid this bailout was necessary.

[Ryan]

Our money system is a mess, and this bailout is little more than a short respite from the inevitable Japan scenario.

[SanFranciscoJim]

el rei there is always something interesting going on. Things only blow up like this every decade or so, though.

[Cyrille]

SanFranciscoJim: more like once every 50 to 70 years.
This is truly major. That in the face of the catastrophe of Republican rule McCain may be leading in the polls only makes it even more worrying.

[esb]

Pop, then crash.

There is now a single entity of record, United States of America.

Paulson has shot his last wad.

Enjoy this week, and possibly Monday, 15September2008 and the first trading hour of Tuesday, 16September2008.

And then it is game over.

Full stop.

[Blissex]

But it is not a bailout -- it was always well understood and very explicit since a few months ago that the full faith and credit of the USA supported GSE debt. The conspicuous warnings to the contrary on GSE paper were just dissembling required to keep their debt off the USA balance, thus the mostly fake privatisation (profits were privatised, but not risks).

This is not a a bailout -- it is just the USA honoring their debt.

Interesting detail: since the fake privatisation was to create an off-balance-sheet vehicle, now that the USA have officially acknowledged that GSE debt is USA debt, shouldn't those 5 trillions be added to the 10 trillion already acknowledged? What about the 11 trillion debt ceiling limit? Hasn't it been vastly exceeded? Or is the accounting of the USA considerably less honest than that of Enron?

Bear Stearns was a bailout of both its shareholders and its creditors; it was a wholly private investment banks, wholly unregulated, wholly outside the insured deposit taking institution system, and so was JPMorgan and its other counterparties.

[Blissex]

And what about the AAA rating of USA debt? The rating agencies a few months ago were thinking of cutting it.

That AAA rating was when the USA acknowledged only owing 8-9 trillions. Now that it owes 15 trillion, after admitting to Enron-style accounting, with exactly the same sources of revenue, shouldn't the rating be cut to at least A?

But then I have a modest proposal: finance this whole mess with a large TAX CUT! Cap all taxes on incomes above $250,000 to 10% total and watch as a torrent of money floods into the USA tax system and trickles down to everybody else. Probably cutting taxes on incomes above $250,000 to 5% would be even better.

A country that has financed a few expensive wars with TAX CUTS can use the same technique to finance the repayment of its debt too!

[Linda]

heh (Blissex, that's all I can manage, but I did try)

That must be why McCain is now ahead in the polling with 50%! (It couldn't possibly be his new celebrity running mate.)

[BJ Feng]

Let's not forget Fannie and Freddie were government created entities that Congress for some reason, never fully privatized, yet another reason why I'm against most government programs and always skeptical that they will work as intended.

How much did homeowners gain from having Fannie and Freddie around all these years? Was it worth it? We've yet to see the full results so a judgment will have to be postponed. There is some reason for optimism as Calculated Risk states,

"The cost to taxpayers is also very unclear. It is possible that taxpayers will not be negatively impacted in the long run. This depends heavily on the losses in the retained portfolios of Fannie and Freddie, and the cash flow from the good portion of the portfolio, and also on future defaults and house prices. Even if the Treasury has to purchase $50 billion or $100 billion in senior preferred shares to maintain the positive net worth of Fannie and Freddie, the Treasury will own the first equity in line to be paid off from future profits (assuming future profits). This makes the losses very unclear."

[kharris]

Blissex,

Let us not forget that the ratings agencies' business models rely on their legislated place in the financial world. If there were no government requirement to pay ratings agencies in order to raise money through credit markets, it would be a very different world for the ratings agencies. Under such circumstances, and given that a good many collateralized debt obligations with junk as collateral had AAA tranches, I see little risk to US credit ratings.

[Mother of All Bailouts]

From

Roubini: Restructure Fannie, Freddie Debt, Skip "Mother of All Bailouts" http://www.nakedcapitalism.com/2008/07/roubini-restructure-fannie-freddie-debt.html

"Nouriel Roubini has consistently been accurate in predicting the course of our snowballing credit crisis, and has also made some important intellectual contributions to the discussion. such as how the breakdown of the Bretton Woods system has lessons for the future of our Bretton Woods 2 currency program.

But in my view, Roubini's post today is his most important contribution to date. Sadly, I anticipate, just like his early warnings of coming financial trouble, that it will be ignored.

Roubini argues that restructuring Fannie's and Freddie's debts is not an awful prospect. They have large books of, by housing standards, pretty decent assets. He estimates that the haircut required would be only 5%, which could either be handled via principal restructurings or payment reductions."

Read the entire article.

End of the world? Not likely. Losses after the Russian default and Argentine default were much larger.

Would the Chinese be annoyed? Yes. So what. They knew the risk they were taking. Moreover, what are they going to do? Stop buying U.S. assets? Let the RMB rise?

Only in STRB's dreams.

The truth is that Paulson wanted to bail out Wall Street and everyone (both parties) want to reflate the housing bubble by maintaining artificially high housing prices and low mortgage rates.

Dismal (and doomed) public policy.

[BJ Feng]

Given that the US has a GDP/debt ratio of ~67%, we're no where near the trouble Japan and Italy are in. US government debt is backed by the assets of the US people. As long as the US people remain wealthy the US will continue to receive AAA ratings. After all, politicians like Obama can always raise taxes. Besides, the US T-bill rate is THE defacto risk free interest rate all other rates are compared to. As many have said in the past, an AAA rating understates the credit of the United States, some have called for a new AAA+ rating to be given only to US Govt. debt to reflect their special status as the risk free benchmark rate.

[Lafayette]

Gross negligence

kharris: Let us not forget that the ratings agencies' business models rely on their legislated place in the financial world.

OH, So now we are going to blame the rating agencies' "business models". Ok, let's do that.

They got the business models wrong. They should have been more diligent about the fraudulent manner in which the SIVs contained credits that were based upon faulty risk management. They were negligent and that negligence resulted in large capital losses.

What's the punishment for gross negligence that has provoked enormous loss of not only capital but economic misery?

Let's say that you are driving your car that, in an accident, kills someone because the brakes failed. It is found that the brakes failed because you did not inspect them and change the brake pads. Which is tantamount to gross negligence.

In a court of law, what should you expect? A reprimand and slap on the wrist? That's all?

[Blissex]

«now that the USA have officially acknowledged that GSE debt is USA debt, shouldn't those 5 trillions be added to the 10 trillion already acknowledged?»

Well, at least just recently the GAO said that the income/lost of the GSEs will be consolidated with that of the USA:

http://www.ft.com/cms/s/0/e30472a6-7e79-11dd-b1af-000077b07658.html

«The operations of mortgage finance companies Fannie Mae and Freddie Mac, which were placed into a federal conservatorship, should now be treated as part of the federal budget, the head of the Congressional Budget Office said on Tuesday.
”That means that revenue earned would be reflected as a receipt, and spending would be reflected as an outlay,” CBO Director Peter Orszag said at a briefing.»

If income/loss, then asset/liability should be there too.

«Roubini argues that restructuring Fannie's and Freddie's debts is not an awful prospect. They have large books of, by housing standards, pretty decent assets. He estimates that the haircut required would be only 5%,»

Well, 5% of $5,000 billion is not so trivial. About $250 billion. Admittedly spread of several years as Hank Paulson hopes.

People, in this crisis we have been numbed with figures in the "a few" hundred billion range as if they were trivial. A few hundred billion here, a few there.

Even in the UK: the Northern Rock nationalization may be costing $50-100 billion, plus the UK central bank has lent in its various "facilities" close to $400 billion to UK banks.

The Fed have been doing their best to lead of course.

Let's update the old saying: a few hundred billion here and there and eventually you are talking real money :-).

Perhaps it was the Iraq war budget that got everybody inured to talking of hundreds of billions as the new level of triflingness for expenses...

[Blissex]

«Let us not forget that the ratings agencies' business models rely on their legislated place in the financial world.»

The most remarkable thing about the rating agencies is that at some point their management woke up, realized that they were sitting on a gold mine, and their stock ZOOMED UP 400% as they started getting a lot of very profitable business giving AAA ratings to a lot of derivatives:

http://finance.yahoo.com/q/bc?s=MCO&t=my&l=off&z=l&q=l&c=%5EGSPC,%5EIXIC

I think that graph very clearly shows how incentivized the rating agencies have been to give the right ratings.

[Blissex]

«What's the punishment for gross negligence that has provoked enormous loss of not only capital but economic misery?»

What do you mean punishment? These guys are winners who MADE A LOT OF MONEY for themselves and their customers and friends. Quite a few other winners are very grateful to rating agency executives for enabling their business model.

Everything else is secondary, why would any true American care about losers? Losers will be losers. Focus on the winners and their campaign donations.

These winners got very large bonuses and options, and tax cuts, even if they were not generous enough.

And you know my Modest Proposal to give tax credits to those who are so productive in taking money from losers.

:-)

[Blissex]

As to incentives and the just rewards for WINNERS, perhaps some people have missed this graph with the stock price of the two GSEs since 1975 or so. Note what happens in 1995 with the Great Republican Credit Explosion:

http://finance.yahoo.com/q/bc?t=my&s=FNM&l=off&z=l&q=l&c=FRE

Isn't it wonderful what a DELUGE OF FREE MONEY from the Fed*mart and a few hundred billion dollars of implicit free USA provided risk capital can do to the compensation (think bonuses and options) of the WINNERS?

[Lafayette]

Bliss: Everything else is secondary, why would any true American care about losers?

Cynicism becomes you so well. But, I would have to agree.

In our super-competitive society all that counts is winning. Losers are the dregs of society.

Yes, that's a cynical appraisal. Anyone care to prove it's wrong ... ?

Then, there is also my Modest Tax Proposal: Tax the piss outathem.

[Blissex]

«In our super-competitive society all that counts is winning. Losers are the dregs of society.»

What's fascinating is that 80% of Usians seem to define themselves as "dregs of society".

Or perhaps the key to understanding most of USA politics is that poll finding that 60% of voters believe that they are or will be soon in the richest 1%; this might explain why would not care about the losers. This also might explain why they are outraged by the inheritance tax.

Except that then they find themselves middle aged or old, with no savings and no health insurance, and by then it is too late to admit that they have been played, or even worse, played themselves.

The "aspirational" middle class is the most wonderful and fertile ground for the true winners to continue winning.

[Lafayette]

Life as a lottery

Bliss: The "aspirational" middle class is the most wonderful and fertile ground for the true winners to continue winning.

Winning or whining? I'm not quite sure ... ;^)

From one to the other, and back, is just a roll-of-the-dice away.

If life becomes principally a matter of chance and those who are luckier than others merit the rewards of their good fortune -- then are the less lucky living on the wrong planet? Maybe we should get off?

I thought the purpose of society, that of banding together, was for self-protection but also the well-being a market economy could provide. But, I am being told, in fact, that though we are all born equal in opportunity ...

... Some are more equal than others. But, that's OK!

Orwell would turn over in his grave -- if he knew that Brave New World became a reality not in 1984 but 2008, nearly a quarter of a century later.

[Bill]

Bailout is not the answer... We need to stimulate spending. All the bailout does is give more money to the fat cats to go on their lavish corporate retreats, buy out their competition and the like. Since it is taxpayer money it should go to the taxpayers...

In the case of mortgages... I have seen plans that would would stimulate lending. The one I seem to like the best is the 1% mortgage... Use the billions of dollars in bailout money to guarantee one time up to 500K mortgages at 1%. Those in higher rate mortgages could refinance if they wanted to, and those that are on the verge of default could refinance as well... This would stimulate the economy because mortgage payments would greatly be reduced, lenders would still make a little bit of money but wouldn't have all of the defaults, and we wouldn't be in the situation where we have a locked up credit crisis. Give the people the opportunity to get back on their feet.

Same could hold true for the auto industry. Rather than give them billions of dollars lets get the American people buying American automobiles. Give the billions back to the people. Let the people decide. Perhaps something along the lines of a 25% incentive... You buy a US auto and the government would subsidize 25% of the purchase which the auto industry would be responsible for paying back. If I buy a 10,000 car, I as the consumer could decide which American car company I want to buy from and I would in effect be writing them a 2500 loan when I purchased my car from them.

The money belongs to the people... Let us decide how to spend it.