The bailout Part 2

I read this week’s The Economist that had several articles on the bailout and related topics and here’s my updated understanding and explanation for the bailout problem and cure. In the end, The Economist thinks this plan is as good as any plan and is simple, so they believe it should be passed. Read “The Economist’s article”:http://www.economist.com/finance/displaystory.cfm?story_id=12305746 or read my summarized version…

My understanding of CDSs was not accurate. They aren’t simply fake securities, they’re insurance against the risk of bad loans (defaults on credit, or “credit-defaults”). It still seems a dubious idea to me to create a risk assesment (CDS) on top of a risk assessment (a loan). But those are the types of things that financial people create. Ultimately, they’re fine as long as the risks are correctly gauged. In this case, they clearly weren’t. The rest of my explanation seems to be accurate. Amazing.

As for my alternative options, _The Economist_ only addressed one: have the government buy all or part of the banks. The Economist explains why that wasn’t chosen:

bq. But banks might not volunteer to sell equity to the government before they reach death’s door; and the prospect of share dilution could discourage private investors.

I’m not convinced. Banks that don’t sell equity to the government would go bankrupt and the ones that don’t would stay afloat. That’s good enough to save the credit problem. We only need two banks to take up the government’s offer. If they all refuse, the government could force some to do it. But the article goes on to say:

bq. In any event, the Treasury plan could be flexible enough to permit such capital injections.

So if banks want to sell equity and the Treasury decides they want to buy, they can. Basically, the plan says the Treasury gets the $700 billion and can do whatever it wants with the money.

Apparently, no one seriously considered my first option: to buy the bad mortgages and restructure them. That’s probably too much work and wouldn’t solve the problem the government is really concerned with: the inability for banks to make new loans.

Will it work? No one knows. But it seems to be clear that this should stop the near-term catastrophe in the banking industry. There’s no reason to believe that it will solve all the problems in our economy. The core problem is that the housing bubble has burst and it’ll take years for that to reach the level it was.

People who oppose the entire notion of a bail-out have been asking “Shouldn’t we just let Wall Street fail?”. The answer is no because we are the ones that would be suffering from the consequences. Like it or not, Wall Street is important to our economy. It’s true that the “fat cats” on Wall Street make a lot of money, but they perform an important job that makes our economy work. To those who think it’s such an easy job for such high pay, then they should go do the job themselves and earn the money. The truth is that it’s not an easy job and there are few people who can do it (which is why they’re paid so well). They screwed up this time, but on the whole, Wall Street works pretty well and they are a big reason our economy has been such a juggernaut for 100+ years.

If the only reason not to do something to is a question of morality, i.e., not rewarding the “fat cats” for their failure, then we’re very likely dooming ourselves to several years of a very bad economy. Morality is important, of course, but as the song says, “no one needs morality when there isn’t enough to eat”:http://www.musicsonglyrics.com/N/newmodelarmylyrics/newmodelarmythechargelyrics.htm. And given that the “FBI is now investigating”:http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302673.html this mess for fraud, some people may get their punishment.

Besides, we’re not rewarding the people who caused the problem, we’re rewarding those people who can _fix_ the problem. If you can go to Wall Street and fix it, you’d be paid well to do it too.

Why $700 billion? Currently, 4.5% of all mortgages are in default by three months. That amounts to $500 billion in mortgages. Over the next few months, as our economy remains weak, the number of mortgages that default will surely increase. The extra $200 billion is a cushion. _The Economist_ is optimistic that they’ll spend less:

bq. The true cost to taxpayers is unlikely to be anywhere near $700 billion, because many of the acquired mortgages will be repaid.

We’ll see.

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