Understanding the bailout in the US financial markets

By Basab Pradhan

“Bailout” was a bad word in the US to begin with. The current financial crisis and the US government’s $700 B plan to revive the market for troubled mortgage based assets have made it toxic.

What does “bailout” mean to Joe Citizen? It means that a company made mistakes and as it suffers financially, is perhaps close to bankruptcy, the federal government rides to its rescue using taxpayer’s money (“my tax dollars”) to rescue the company. To any logical person that seems unfair.

But Joe Citizen is not all logical about this. There is a lot of emotion and mental imagery involved with the current set of bailouts.

First, these are big companies we are talking about. CEO compensation in the US was already being recognized as a problem – a political problem because it calls out the huge income disparity in the US, but also a real problem because it doesn’t work. To save companies from bankruptcy whose face to the world is their CEO and whose multi-million dollar pay package is publicly known, gets Joe all riled up.

Second, these companies are investment banks – the “Masters of the Universe” – as they are referred to. Their CEOs regularly take home $50 M + packages. Not just that – at a firm like Goldman Sachs, the average annual compensation per employee, which includes administrative staff, is well over $250,000. Joe Citizen, meanwhile, toils away for an average annual wage of $40,000.

Third, these are not good times for Joe Citizen. Unemployment is high. If he doesn’t have a job, he can’t meet the mortgage payments on his house. This means he loses his house, then soon after loses his job. He needs someone to blame. He doesn’t have to look far. It’s Wall Street. Their greed led them to corrupt the whole mortgage lending industry. They are the ones responsible for this mess. And now the feds want to bail them out! Over my dead body, says Joe.

But the point that Joe misses is the objective of what Secretary Paulson and Chairman Bernanke are proposing. It is not to bail out the banks, although that is essentially what will happen. The objective is to create a market for toxic mortgage backed assets. Currently, there is no market, so there is no way to price these assets. They sit on the banks balance sheet and eat into its capital. Lower capital means lower lending. Lower lending means bad things for the economy.

But that’s not all. If the illiquid mortgage based assets on a bank are large enough it can take the bank down with it. Once that starts, worse stuff can happen. Depositors coudl start withdrawing their money from all banks. As banks fail, the other financial institutions that they owe money to start writing down their assets. The dominoes start to fall. In the Depression, the government took a hands-off approach (no bailouts). A third of the banks failed.

So while Joe has every right to be angry about this $700B intervention where he is at the receiving end for mistakes that other people made, if he knows what’s good for him, he will support a “bailout” of the financial sector and will not weigh the bill down with other things that reduce its effectiveness. He will wait for the storm to pass. Then he will come back with a vengeance. He will push his elected representatives in Congress to set up a commission to apportion responsibility for the past sins of the industry. And to enact new laws that will address mortgage lending practices, the highly protected rating agencies who get paid by issuers of the debt they are rating, excessive risk taking and inadequate disclosure in publicly held financial companies and executive compensation at public companies.

And in the meanwhile, if this thing is indeed important to Joe, he might want to go a little deeper than what his local newspaper is saying which will not enhance his understanding of the issues at hand in any way.

For instance, the $700B is not going to be “spent” like say the Iraq war, which is what politicians and talking heads on TV most often compare this to. It is going to be “invested”. The price that will be paid for the asset is not the par value of the asset. It will be what a market-based price discovery mechanism produces (a reverse auction of some sort is what they are talking about). It is possible, that the Fed actually turns a profit on this, not a loss.

If the AIG deal was anything to go by, the Fed is not averse to striking a good bargain that might make some money for its shareholders (taxpayers). AIG had a market cap of about $200B in June of last year. The Feds terms are:

– The Fed opens a credit line for AIG of up to $85 B.
– AIG pays 8.5% interest over LIBOR. That is a huge risk premium.
– It pays an additional 2% “commitment” fee. I can’t tell what this is on, but it can’t be on balances – that would be too much.
– The Fed takes an 80% stake in the company that had a market cap of about $200B not long ago.

Any private equity investor would love to get these terms if they could raise the $85B. Essentially the shareholders are going to take a bath. The CEO lost his job. So yes, the company was “bailed out”, but the owners and the management both paid a price. Who was bailed out here? The employees, for one. But most importantly, all the companies and institutions who hold AIG paper. And by preventing the contagion from spreading, you and me. That’s who is being bailed out.

The tragedy here is that one of the biggest challenges facing the US today is so darned difficult to comprehend by the average citizen. A while back I wrote about the Fog of Economics in a similar context. The Fog of Finance is even harder to penetrate. And yet, the country’s financial future may be hanging in the balance on these issues.

Crossposted from Basab's blog, 6ampacific.com

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