It's economics time again.
I hate economics. I find it hopelessly dull. But apparently my style of explaining
it is really helpful to people, so they keep sending me questions; and as usual, I do my best to try to answer them. Even if I don't particularly enjoy it.
So people have been asking me to explain what the proposed bank bailout plan is,
how it's supposed to work, and why so many people are upset about it.
The basic problem underlying the current financial mess is, quite simply, that banks made
a lot of bad loans. They took those bad loans, and bundled them up into packages, and
then sold those bundles, which they called investment vehicles or collateralized
debt obligations. Somehow in the process of tying bad loans up into bundles, they
transformed them into something that they claimed (on the basis of very silly
arguments) was an extremely safe investment. (I wrote about this before here.)
Then they took those CDOs, and used them as collateral for borrowing money to make other
investments - often in the very same kind of bad-loan based bundle. Of course, they knew that
this was all a pile of bullshit, so in order to supposedly cover the mess, they created what
they claimed was a kind of insurance called a credit default swap. But credit default swaps
aren't insurance: they're bets, plain and simple. And once they had a gambling system in
place, they went wild: they used things like credit default swaps and the CDOs to create a
gigantic, international gambling ring that makes the folks who own casinos in Las Vegas look
like a bunch of pathetic pikers.
Naturally, a scam like that can't go on forever. At some point, someone needs to collect
the money that's at the bottom of the pile. But the bottom of the pile is a heap of bad loans!
So, naturally, a huge portion of the base loans aren't every going to get paid back. And that
means that many of those CDO investments aren't actually worth anything. And since they're not
worth anything, the things built on top of them really aren't worth anything either. So the whole thing comes tumbling down. All of these piles of worthless loans stacked on top of worthless loans, collateralized by worthless loans - that's what people are calling toxic assets.
So now we've got banks and other big financial firms that are, effectively, bankrupt: they've god huge debts which they can't pay back, because both the collateral for the loan,
and the stuff that the loan was used to buy are both now close to worthless.
That's the basic background.
The Proposed Bailout
What's the current proposed bailout? The idea is to prevent the banks from
going bankrupt by helping them sell those so-called toxic assets. If they can get enough
money by selling those, then they'll be able to pay off their debts.
Of course, if they could just make enough money by selling them to pay off their debts,
they would have done that already. No one wants to buy that crap for full price. People will
buy it for a fraction of its face value, but buying full price? That's ridiculous: we
know that they're based on bad loans, most of which will never be repaid.
So what the bailout tries to do is make the toxic assets into slightly more attractive
investments. And the way that they're proposing to do that is by providing low-interest loans
to help people buy them, and by saying that if the things they bought using the loans lose
value, the loans will be forgiven.
With that incentive, it becomes a much better risk. After all, for the guys buying it
using the loans, most of the money that's going to be risked buying the garbage isn't theirs.
And the stuff is bad - but it's not all worthless. Some portion of those
loans will get paid back. Some of those CDOs will eventually make some money. Most probably
won't. But some will. And they're not going to be selling for full price - they'll
sell for a lot more than they'd get without government help, but still less than
face value. So at the discounted price, a lot of them will make some money.
What the government is proposing to do is to hand out loans to investors, which
they can then use to buy up some of those bad assets. If the asset makes a profit, the
investor pays off the loan. If it doesn't, the loan is forgiven. Something like
85% of the purchase price of the toxic assets can be covered by one of these
no-recourse loans. So the investor is only on the hook for 15% if it doesn't work out.
That leads us to part one of why people are upset: what this loan program basically does
is what Paul Krugman calls "privatizing the gains, socializing the losses." Just think about
what happens to the money backing those loans. If the assets purchased using the loans make
money, then the private folks pay back the loan, and keep all of the profits. If the assets
purchased by those loans don't make money, the loan is forgiven - and the loss falls onto the
taxpayers. So the taxpayers whose money is backing this plan will get stuck covering the
failures, but they get no share of the successes. In other words, one way of looking at it is
that it's a huge transfer of money from the federal treasury to wealthy investors. That's all
too typical of how things have been working in our economy over the last couple of
But to make matters worse, there's another reason to be upset: because there's cause
to believe that the whole thing won't work. Even though it will effectively transfer something like a trillion dollars from the government to private investors, it still won't fix the basic problems with the banks or the economy!
That argument is based on the fact that there are really two different ways that a
bank can fail. A bank can fail because of something called a run, and it can fail because
it's really bankrupt. The proposed bailout will work if the basic problem is a run; but
it won't work if it's a bankruptcy.
Banks operate by borrowing money from depositors. When you put money into your bank
account, you're actually loaning it to the bank. As a payment for the loan, they pay you interest, or they provide you with some set of services. Then they take your money, and
they invest it - either by giving loans, or by buying various kinds of assets. The difference
between what they make on their investments of the money that they borrowed from you, and
what they owe you in interest and services is their profit.
The catch to this is that the money that's invested is not available for immediate return
to all of the depositors. Banks invest in a lot of long-term things that they can't pull money
out of on a moments notice. So if everyone who deposited money in the bank suddenly wants
to pull their money out at the same time, despite the fact that the bank hasn't lost anyone's
money, they can't pay back all of the depositors. That's what a bank run is: when everyone
wants to pull money out at once, and the bank can't do it because the money is tied up. The
thing about a run is that the bank does basically have the money - it's just that they can't
get it immediately. In a run, the government can help a bank in two ways: it can either loan
them money to cover them until they can sell their investments, or it can buy the investments from them. In either case, what the government is doing is providing a short-term bridge. It works because the bank does have the necessary assets; it just needs time to cash
The other way that a bank can fail is bankruptcy. That is, it's got a bunch of
people that it borrowed money from to invest in some collection of assets. But the assets
lost value, and they're worth less that what the bank owes. It's not a short term
problem, where they just need help covering things until they can sell assets - they're
genuinely short of assets: they owe more money than they have in assets. In this case,
the stopgaps don't help - because all that they do is give the bank time to sell its
assets. If they're really not worth as much as the bank owes, then time doesn't help.
The current proposed bailout is designed assuming that the problem right now is just a
bank run. That is, the banks and financial firms really do have enough assets to cover
everything; it's just that due to people's paranoia, they can't sell them right now. But given
time, people will realize how much they're actually worth - and when that happens, the banks
will have plenty of money to pay off their debts. So all that the government needs to do to
solve the problem is to provide a way for the banks to cash in those toxic assets for their
real value, and everything will be OK.
But what many critics believe is that the assets in question are genuinely worthless,
which means that the banks and financial firms are really bankrupt. The assets that they're
trying to get rid of aren't worth anything. The problem is that they really don't have
enough assets - they've got piles of paper, but that paper isn't worth anything close
to what they owe, and it's never going to be. They're never going to be able to
pay off those debts. Never.
So helping the banks to sell worthless paper as if it was worth something isn't really
doing anything about the fundamental problem. All it's really doing is handing the banks
money to cover part of their bad debts - but pretending to be doing something
Worse, that way of handling the bad debt isn't going to work. Because the total
size of the bad debt dwarfs the amount of money that's going to be used for buying those
toxic assets. The total amount of money that these big firms have tied up in garbage isn't
know for certain, but I've seen estimates ranging from 3 trillion to 45 trillion
dollars! So at best, this plan covers 1/3 of the bank debts. That's not enough to save them from bankruptcy. So this supposed rescue amounts to handing the banks a trillion
dollars, without actually solving the problem.