Big Bail Out

How is the big bail out supposed to work? The basic idea seems to be that the U.S. government will pay bad financial assets. Once these have been purchased, financial companies will know how much money they have. Right now, nobody will lend money, because they don’t know how much they should keep in reserve. Once they’ve unloaded all their bad assets, they will know how much to keep, and they will be willing to lend money. At least, that is the theory.

This means that for the bail out to work, the companies will have to have enough cash on hand to support themselves after selling their bad assets to the government. As far as I can tell, that means that the government will have to pay something close to book value for these assets. If they pay much less than book value, then financial companies will be in the bad situation which they have been trying to avoid: they won’t have enough cash to cover their remaining loans, and they won’t be willing to make new loans.

However, if the government pays book value, then the government is (probably) vastly overpaying. Some people are saying that this approach is like the Reliance Trust Corporation which was created to clean up after the S&L debacle. It is not. The Reliance Trust Corporation took over entire S&L’s, good assets and bad. It cost a lot of money upfront, but in the end the RTC was able to sell the good assets and recover a lot of the money. That bailout cost the taxpayer a decent amount, but it wasn’t outrageous. And, of course, the S&Ls were federally insured, so it was already an obligation of the government, unlike this case.

If the government buys the current crop of bad assets at book value it will be stuck with many of them. The worst stuff out there is worth zero; it’s mortgages that were taken out by speculators to build houses. The speculators are gone and the houses don’t exist. Then there is a set of mortgages out there which people do want to pay, but the value of the mortgage far exceeds their ability to actually pay. The government will have to negotiate with the homeowners in those cases, but they will in the end get something back, though probably much less than they paid for. And then there is a large set of complicated assets out there which nobody can price at all. There is no market for these assets, and nobody has the least idea what they are worth.

So this could wind up being very expensive. The money is going to come from taxpayers. The money is going to go large financial firms. They will use the money to lend it out, and also to pay large salaries. We’ll be propping out Wall Street to save Main Street. Doesn’t that seem backward? Why not just prop up Main Street—e.g., start a new financial services company with the $700 billion.

We need some basic guidelines on the money. Any company which sells assets to the government must cap the pay and incentives of all executives to some reasonable value. If they won’t take the money on those terms, let them go under. Any mortgage acquired on a primary residence must be renegotiated to let the homeowner stay. We can only hope that Congress can stand up to the stampede to put on some basic guidelines, rather than just handing out cash to the wealthiest people in the country.

How did we get into this mess? A lot of people cite excessive deregulation, but I think that slightly misses the point.

  • The financial system has become too complicated for anybody to understand. Companies made bets without understanding just what they were betting on. Many companies effectively bet on the fact that housing prices would never go down. That was nuts, considering how many people were pointing out the housing bubble. We could see this complexity happening ten years ago with Long Term Capital.
  • A big success today means a big payout today. A big failure tomorrow means zero. The people in the financial companies had a huge upside, and their only downside was they might lose their job. The incentives were strongly in favor of taking a big risk, because if it paid off you got a ton of cash which you never had to give back. If the risk didn’t pay off, you could always try something else.
  • People increasingly believed in market fundamentalism: the market is always right, so it follows that the prices set by the market are always right. They can’t be far too high because the market wouldn’t permit that to happen. There is of course a limited sense in which that belief is correct: the market has not permitted those high prices, and is now correcting them down. Unfortunately the correction only kicks in after several years of high prices–plenty of time for people to take a lot of money home with them. That is, even if you believe in market fundamentalism, you can only believe in it if you allow a long time lag.
  • There was indeed a significant lack of regulation, showing that it’s been too long since the last economic debacle, and that people have forgotten its lessons. However, people will always try to work around the rules, because there is so much money to be made. A responsible government would not necessarily have increased regulation, but it would have ensured that the collapse of financial companies would not affect the ordinary use of business credit. This government—both Democrats and Republicans in this case—was completely irresponsible. The root cause was most likely that the government is for sale, and the people who were making money had more input into the law than the rest of us.

Most of the bad effects of the crisis are still on Wall Street, not on Main Street. The Main Street economy is weak but still moving. The effect of paying $700 billion to Wall Street is going to hit Main Street down the road, when the government raises taxes and inflation to cover the losses. I’m not at all sure that this is a good idea.


  1. davem said,

    September 23, 2008 @ 12:00 am

    I don’t think it’s so easy to say that the government can just demand all kinds
    of terms on these buyouts, such as capping executive pay and whatnot.

    To a certain extent these financial firms do have an upper hand in these
    negotiations. Consider why the government is offering to do these buyouts
    in the first place. The idea is that if enough of these firms go under, the
    whole economy is going to reverberate negatively with the side effects.

    That seems to be an interesting aspect to all of this.

  2. Ian Lance Taylor said,

    September 23, 2008 @ 4:47 pm

    You’re right, it’s not unlike the old saying “If I owe you a thousand dollars, it’s my problem; if I owe you a billion dollars, it’s your problem.” That said, I really think it would be inappropriate for the government to bail out these firms with no terms at all. A possible tradeoff would be to grant the executives who take the pay cuts immunity against shareholder lawsuits–we know that any executive of a company which goes out of business is going to spend a few years defending against those lawsuits in court.

  3. etbe said,

    September 29, 2008 @ 4:09 am

    The entire world economy is going to reverberate regardless of what happens.

    I think that a large part of the problem is anticipation. If the banks were all declared bankrupt and managed by the government tonight then tomorrow people could go about their business in a normal manner. But waiting and not knowing what will happen next is hurting the economy everywhere.

  4. Ian Lance Taylor said,

    September 29, 2008 @ 8:24 pm

    etbe: I agree that that is a big part of the problem, in that the anticipation you mention is freezing the actions of the banks themselves.

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