Wednesday, September 24, 2008

Understanding the $700B "Bailout"

Thanks to Les for bringing this subject up...

I have been thinking about this for a few days, but since I'm surrounded by finance people, there has been very little debate, since we all pretty much agree on its necessity. However, after reading what's out there in the mass media and debating with non-finance people, I have realized there is a significant gap in understanding.

First out, the $700B is not:

1) A blank check
2) An one-time authorization
3) A bailout

The $700B being proposed has a specific purpose: it is designed to add "liquidity". It will add money into markets that are currently skittish. Primarily, it will focus on the distressed mortgage-backed securities. The principle reason for many write-downs and the failure of multiple financial institutions is because there is little to no money currently wishing to buy them. When a market has all sellers and no buyers, its no market at all. When there is no market, there is no price, and assets without price immediately have no paper value.

The amount of the "bailout" is a subject of debate, but a rather moot one, since the plans call for up to $700B in securities to be sitting on the government's balance sheet at any time. These securities can be bought and sold constantly, as long as the total is never over $700B.

Finally, the notion of bailout provides the idea that the government is lending help to "Wall Street fat cats" who couldn't properly manage risk. It is not a bailout. The government is merely providing liquidity at a time when assets are severely distressed. The term distressed means the asset is very cheaply priced, perhaps below intrinsic value. Since the government has the ability to borrow large amounts of money and is very patient, allowing the government to buy cheap assets and hold over the long term not only provides liquidity, but it will make money in the long run as the market for these securities come back.

This situation has happened once before. I link to the Wiki entry here.

Currently, most of the sane Senators have also realized the need for this "bailout". The real discussion is over minor, what I refer to as punitive, details, such as CEO compensation, mortgage foreclosure help, and the use of equity warrants whenever the government helps with a distressed asset.

Hopefully, these issues will get hashed out soon, since the financial stability of the US depends heavily on a stabilized market for these assets.


Les@SpillingBuckets said...

I've heard it suggested that another (cheaper and less government involved) solution could be changing the "mark to market" laws for these securities - since the mortgage backed securites are priced artificially low (due to too many sellers not enough buyers, as you said) but in reality they still have homes behind them that have not decreased in value as much.

Do you think that more accurately reflecting the value of the securities in this way would work to increase buyer demand, or increase their paper value for the companies that currently own them?

Les@SpillingBuckets said...

Also - the government doesn't have $700B to spend, we already have a huge deficit ($58B) and this would come from taxpayers.

FoodMerchant said...

Come one, Not a bail out??? Of course it's a bailout. How many times did the goverment step in to provide liquidity to the individual investors as the value of their assets(omes) tanked the last couple of years. The point that the goverment can borrow money cheaply so it should do it is BS.This is capitalism. The goverment is not in the business of buying "no value" securities and holding them in their books. Whe ends up paying for these distressed securities? Me! I agree it is necessary step to stabilize the markets but let's call a spade a spade, shall we? How long do you think the goverment will end up holding these securities and when is the goverment going to sell them back?