In order to better think about the problem at hand, the $700 billion dollar bailout Wall Street wants from you and me, it’s helpful to understand the financial connections between them (ultra fat cat bankers) and the rest of us.
First, some definitions:
Commercial Banks – these are banks that accept deposits from and loan money to everyday people (via personal loans, credit cards, etc.) where they charge anywhere from reasonable to Mafia rates depending on what they can get away with and how good a credit risk / how savvy, you are.
Investment Banks – these are (or were) a combination of investment brokerages (places to buy and sell stocks, bonds, mutual funds, etc.) and banks that invested in businesses and business related activities. Investment banks were who you went to in order to issue your stock if you owned a company, or if you needed to raise money for expanding you business or investment activity.
Not to put to fine a point on it, but there is, or was, a lot of investment activity that went on around these Investment Banks that was centered mostly on making money on money. The lay public likes to think about things like this in terms of stocks and bonds, or in percentages of savings account interest, but those are usually tied to real investments, that is, the bank’s money (from deposits by you and me) goes toward something tangible, a commercial building, a share of stock in a company, that is, something that has some relative real value. But lately, much of the activity of Wall Street Investment banks has been centered around creating investments that are linked to other investments – the “Collateralized Debt Obligatioins” (CDO’s) of the mortgage crisis, and things like “Credit Default Swaps” (CDS’s) that act as insurance policies for those and other risky investments. These are generally referred to as “Derivatives” because they are derived from other existing investments, usually, but not always, leading back to some tangible investment assets.
A little history: back in about 1994, two professors at MIT thought up a system of investing call “hedging” where you could mathematically predict the risk of various investments and then buy new investments (diversify) to offset that risk. In fact, those two guys won a Noble prize in economics for that idea. Must have been a pretty good idea for a Nobel prize, right? Not really. Their idea led to the creation of “hedge funds by the billions, and in fact they, the two MIT professors cofounded one of the first ones, it was called “Long Term Capitol Management”. Trouble is that LTCM went broke in 1998. Ok, maybe they weren’t as good at investing as they were at thinking up investment theories, OR, maybe there’s something fundamentally wrong with the whole idea. By the way, the Swedish Academy praised this “financial innovation” based on the notion that now, finally, financial markets could take the risk and instability out of investment. That is, they assumed, as many since have, that by hedging, you would never lose over the long run. Today, there is $2.6 trillion invested in hedge funds worldwide, even though some have blamed the Asian financial collapse of 1998 partly on hedge fund trading and LTCM.
What all of this has played into is the naive and childish hope that eventually, everyone, everywhere, could sit home and make money on their investments instead of actually doing something for a living. Of course sitting behind a computer screen and trading hedge fund shares does look and feel like you’re doing something, even if what you are doing is of no value to anyone but you.
What has made possible this illusionary world of mindless mega-investing, a world that was greatly expanded and reinvented by Wall Street Investment Banks (with the help of a long series of deregulation and even anti-transparency laws enacted in Washington), was the central idea embedded in hedging, that you can always defer your risk by expanding your investments. It was a dream come true for an industry built not so much on sound investing as copious investment. And, around the start of the new millenium, Wall Street took this idea one step further – they started thinking up ways to get others to assume risk for them.
This came in two parts. The first part was things such as CDS’s where someone else would agree to backstop your risk for a fee. As long as the overall economy was sound, the risk in that was limited to the risk in any one investment, something derivative investors could assess and manage. By the way, Billionaire inverter Warren Buffet has called Credit Default Swaps “financial weapons of mass destruction”. The second way that Wall Street has chosen to forget about risk is through inventing cleaver new securities that pass that risk on to other investors and hide it in the ratings that those securities are measured by. That’s what happened with the CDO’s (collateral debt obligations, a type of investment) that were built on all the sub-prime mortgages issued by shady mortgage lenders.
The reason that shady, and even not so shady, mortgage lenders could write outrageously shaky mortgage loans to marginally and sometimes flatly unqualified applicants was that they, the mortgage writers, didn’t have to be on the hook for those loans if they went south. The reason for that is that all of those loans were then bundled into CDO’s and shipped off to Wall Street to be sold. This had the effect of removing the risk from mortgage lending and passing it off to someone else, somewhere else.
This is the “financial weapons of mass destruction” part of the whole scheme. If anyone is allowed to create an investment instrument, a piece of paper, that they can sell without having to fully describe the risk – and all CDO’s are built of large blocks of mortgages bundled together, some sound and others not – then what incentive do they (people like mortgage lenders) have to adequately and soundly make prudent initial investments? The answer is not much.
The irony is that most of these “opaque risk” financial instruments were sold to other banks, both investment and commercial. Therein lies the problem we face today, that is, that investment banks have been dropping like flies in a snowstorm because no one really knows which CDO’s are sound and which aren’t. The financial culture is (or was) that they borrowed money at low rates, in traditional ways (inter-bank loans), to buy these investments at a ratio of up to thirty to one; so they borrowed thirty dollars for every dollar of their own money they invested in these things.
So now the fear, and it has been glimpsed at in part as financial markets have swung wildly and banks have been afraid to lend between themselves, is that if the government doesn’t step in and take these bad securities off of the hands of banks who don’t want them anymore, that large parts of the entire US banking system, including the commercial banks that have deposits from people like you and me, will go belly up.
Isn’t it a wonderful world we’ve constructed through “financial innovation” and the “I’ll hold your risk and you hold mine, and we’ll both make money” approach that has come from Wall Street and the investment banks?
Now comes the $700 billion. Treasury secretary Henry Paulson has floated a proposal from the Bush Administration that gives HIM, and himself alone, sweeping powers to buy any bad debt that anyone anywhere wants to get rid of, without oversight or accountability. Presumably, this will free up the banks to go back to lending money and everything will be fine, but if the government becomes such a larger player in the home loans gone bad market, two things could scuttle this rosy little cruise.
Firstly, in order to finance the buying of massing quantities of bad housing debt, and the foreclosed houses that stands behind it, our government will have to borrow money from somewhere else in the same fashion that it has been borrowing for the sake of the $9 trillion in national debt that the US has run up, that is from US treasury bills issued to domestic and foreign investors. Since the US already has a massive national debt, another trillion dollars or so would further deflate the US dollar around the world and make the cost of everything we import even more expensive, as well as prolonging our inability to pay off our national debt.
This could have additional long-term implications for the overall economy. And it is the strength or weakness of our economy that makes it possible for the government to recover its investments in the bad debt of foreclosed houses. If the economy rebounds as a result of this bailout (doubtful, considering all of the other factors that are ailing it), then the government can resell those houses at only a small loss, perhaps a few hundred billion, and not get the US taxpayer in much deeper. The opposite is more likely. Most of the home loans that went belly up, and that will continue to go bad (it’s estimated that there could be up to $2 tillion worth) were valued in the inflated housing market of the housing bubble. In the post bubble economy that we are now (mostly) living in, real people don’t make enough real wages to be able to afford those homes at those prices and so there will have to be a considerable correction in the cost of housing, before the part of the economy related to housing can recover. Under the Paulson plan, Uncle Sam (and so you and me) will become the unlucky middleman. What this also implies is that we are in for some real deflation, at least in the housing market, if not elsewhere.
A different approach is to take the $700 billion and shore up the homeowners who are still left holding these mortgages. That would stabilize the value of these securities so banks wouldn’t have to take the lasting hits, with their risks of collapses. The worst case estimate is that there are up to 4 million potentially bad loans embedded in all of this, so if you take $700 billion and divide it by 4 million you get $175,000 per loan. What this does for the overall economy isn’t clear. All of those loans would have to be restructured so that home owners could make the payments and still continue to live and work as they are now (and the longer this goes on the less likely it is that that will be possible, as the economy is now clearly contracting, and people are losing those houses, along with jobs and wages). The up side is that if this could be done quickly, our economy might be better off then the depression era scenario of massive numbers of displaced homeless or homeowner less people who further bring down the economy. The downside is that the government losses would not be recoverable, but in the Paulson plan they may not be anyway as the housing market determines that in both cases, and that, is determined by the economy.
Option three is to backstop the commercial, consumer only, banks (and not the remnants of the investment banks, who have lately transformed themselves into purely commercial banks) for their losses so as to keep the economy from freezing up. It will amount to the same price as the Paulson plan’s losses and would have to come with a cut of the profits of sale of the bad debt. What would be different is that would be less chance for abuse then in the Paulson. If a bank is in trouble, it could be subject to additional oversight and regulation as part of a bailout. Another problem is that a chain reaction multi-bank failure is still possible with this, but if a workable plan with forced forbearance is instituted, it could be managed.
Option four – reconstruct the origins of All of the questionable CDO’s so as to know what is sound and what is not. The Investment banks have claimed that this is impossible because of the ways that they were constructed, but I don’t buy it. Mortgage lenders like Countrywide are in the business of collecting payments on the loans that are still good and those payments go into a pool for payments made to the holders of these securities. If a home defaults (and or is written in a risky way) and doesn’t contribute to that pool, it is a known item, and so is subtracted from that revenue, where the costs for foreclosure and administration are put upon someone, mostly likely firms like Countrywide, who know all about it. How complicated would it be (what with computer technology and all) to deconstruct the bad, shady loans from the sound ones and reconstitute those securities with distributed losses that the government could then backstop? It would be time consuming and so might not give the financial world the reassurance it wants right now, but it minimizes both the real losses and the impact of those on the overall economy. If our government is to be in the business of bailing someone out, it has to be able to separate the value from the junk in a way that is efficient and not prone to abuse. The Paulson plan is not that mechanism, and, with its lack of transparency and accountability, is ripe for abuse by the remnants of same people who created this mess in the first place that is, it’s more Bush administration inside deal policy making at its finest.
P.S. The real men of genius on Wall Street have also collateralized just about every other kind of loan there is from credit card debt to auto loans, so whatever plan we arrive at, it had better provide a mechanism for dealing with those, or at least the potential economic impacts of those, as well – my bet is still option four.
