Wade Armstrong

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Good News: Bailout Voted Down

Posted Monday September 29, 2008 in Business

So they voted down the bailout. Thank goodness! The last-offered plan was a bad one that would be expensive and not solve any problems over the long term. Let’s hope that there’s room for fast response to the crisis with a good, equitable, and market-based idea this time.

What’s Everybody So Worried About?

For the benefit of those readers who do not have Masters in Finance - fewer than you’d expect - I offer the following summary, which is almost completely not accurate but also not entirely wrong:

Banks are required to have a certain level of reserves - cash on hand - to loan money. In the US, banks need to have about 5% of the money they loan, by law. Investment banks and other non-bank lenders¹, and even mutual funds and money market funds, don’t have the same requirement but they do have to keep enough cash on hand to cover what they expect investors will sell.

But cash isn’t a good investment to hold - if you have inflation, then cash loses value every day, if only just a little. So most banks, etc., hold things that are supposed to be as good as cash - easily-valued stuff, like treasury bills or bonds that can be sold very quickly. Unfortunately a lot of these bonds and other securities are actually based on mortgages - and so now nobody knows what they’re worth. So they’re not like cash, so lenders can’t lend. At the same time lot of organizations need a lot of cash to cover their immense losses in mortgage-backed securities. The result is what some have described as clogged financial plumbing. The question is: how serious is the clog, and how to unclog it?

Paying Too Much for Too Little

The $700B was earmarked to enable the Treasury, directed by Secretary Paulson, to buy these mortgage-backed securities from the banks that hold them. Paulson made it clear that he planned to start spending his money straight away, immediately buying up the securities.

But why aren’t the securities being sold? Just because they can’t be precisely valued doesn’t mean they’re inherently unsellable - hard-to-value things are sold all the time. There is some price at which these securities will sell, just the holders aren’t currently ready to go that low. But why should the government, in a free-market state, pay more than market price for these securities?

Meet the New Bubble, Same as the Old Bubble

In the ordinary course of events, the lenders would just go bankrupt. This is painful for everyone. Managers are punished by humiliation; shareholders, who have supported management in their investments,² and who would have been the ones to reap the rewards of those investments, are punished by losing their investments; debtholders, who have loaned money even knowing their risks, are punished by losing a lot of the money they invested. People who make bad business choices are punished under the current system - which is as it should be. In fact, a lot of bad decisions are actual crimes - see, for instance, Enron. This reduces the incentive for making morally-dubious choices, such as refusing to repay a debt owed, stealing money, diverting money for one’s own use, etc.

But, under the bailout plan, the punishments of bankruptcy would be removed. Our bailed-out lenders would not go bankrupt; executives would not be humiliated; investors will not lose their investments; debtholders will be repaid. Just they will all get the taxpayers money instead of the lender’s.

So what does a reasonable executive of a lender do in the future? They take the risky investment, knowing it will either pay off well or their company will be bailed out if the investment fails. Do we really want to go through this bailout in the future, as well? Certainly not - so lender bankruptcy needs to be included in any solution to our liquidity problem.

Economic vs. Financial Distress

The plaintive wail from the financial sector seems to be: if we don’t fix this problem, it’s the Great Depression all over again. But is it? The Great Depression had a major finance component - the famous stockbrokers diving from high windows after the crash - but it also had its roots in a global economic slowdown, with massive job losses and decline in demand from countries around the world.

Surprisingly enough, consumer demand has been consistent in the US, even to the point of driving a substantial portion of our domestic growth over the past decade. Exports are growing. While current job losses ought to be worrying anyone, the economy’s fundamentals, to borrow a term from the McCain campaign, are fine.³ Even better, economies around the world are growing. We aren’t set up for another Great Depression here, no matter what happens to the financial sector, so long as the effect on the rest of the economy isn’t that bad.

Balance Sheet vs. Statement of Cash Flows

And that’s the problem. Pundits go on about how many bad debts finance companies have on their balance sheets, but the problem isn’t on the balance sheets of American companies - that is, the accounting measure of what the company owns and owes - but on these companies Statements of Cash Flows - the accounting report of where a company’s cash goes.

And a lot of companies need cash. For instance, if GM makes a car, they have to pay for the parts and the labor involved in making that car pretty quickly, but that car may well sit on the dealer’s lot for months before it’s sold and cash comes into the company. They rely on finance companies to provide them with cash to pay for the parts and labor before they take your cash. If that source of cash dries up, then companies like GM can end up bankrupt, just because they can’t afford to pay for their inputs during the time before they get cash from selling their products. So the finance companies’ balance sheets may look bad, but it’s really the statements of cash flow of ordinary companies that we need to worry about.

So, Where’s the Cash?

The Fannie Mae/Freddie Mac bailout was designed to save the cash flow by putting a stop to the drop in value of the mortgage-backed securities. That failed. The new rescue was designed to do the same thing. Again, this is just throwing good money after bad. To prevent an economic problem from replacing the current finance problem, we need to focus on the economic consequences. Many corporations, cities, and other organizations need to access short-term capital markets to survive; let’s not work on saving sick finance companies that need to go, let’s concentrate on saving healthy entities that wouldn’t be in trouble if the finance companies weren’t in trouble.

So, instead of spending $700B on bad loans, let’s spend the money to guarantee - for a short time only, say, 30-60 days - good loans to good companies, so long as they’re made to companies conforming to simple criteria and are made meeting other simple criteria of rate, payment options, and the like. Have Fannie and Freddie — they’re bailed out now, remember — back for the same time any mortgage re-worked into a type that’s affordable for the homeowner, with the caveat that there may be a lot of 50-year mortgages now. That would prevent an immediate collapse and provide time in which the finance industry could work itself out. And there’s an incentive for strong finance companies to step in - with the new loans guaranteed, there’s plenty of opportunity for profit there.

¹ Investment Banks aren’t regulated the same way banks are in the US. In fact, investment banks are not particularly regulated - it’s mostly the securities (stocks, bonds, futures) they trade that are regulated. But derivatives - of which we’ve heard so much - are pretty much unregulated.

² In theory, since shareholders can vote out management; in reality, many have valid concerns that shareholders are unable to influence management unless they’re very rich and very patient or outrageously numerous.

³ Or something not entirely unlike fine.