Don’t Feed the Alligators

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Bernanke, Bush, Greenspan

Creative Commons License photo figure credit: azrainman

Editor’s Note: Introducing guest poster Matt.  Matt and I have been close friends since our first days of college — we and our wives were in each others’ weddings.  Matt has been a bond market professional for the last ten years, and I strongly value his insight into the current economic/political crisis.  Despite the expected settlement by Congress, the American public still needs to understand and ultimately accept it.  I’ve gone back and forth on this all week, and Matt’s assessment below has certainly swayed me back the other way.

I would like to share some insights on the pending economic bailout package and perhaps clear up some confusion that seems to be circulating through political sound bites and media commentary.  To be clear upfront, as I’ve dedicated my career to them, I am a strong proponent of capital markets and believe in the model.  Also worth noting, I have never been in a role to participate directly in any mortgage lending or borrowing that is relevant to the issue at hand.

Despite my strong belief in free markets and my opposition to an RTC-like (Resolution Trust Corp as in the early 1990s Savings and Loan bailout) solution to this problem from the beginning, the recent bankruptcy of Lehman Brothers has pushed us to the breaking point and we now have no option but to pass this plan in one form or another.  This is not particularly evident by looking at the the widely tracked equity markets, but is painfully clear in the bond markets.  This is where all individuals, institutions and corporations secure loans and therefore, the economy cannot function without liquid and orderly money markets (short-term lending in the bond market).  The recent acceleration of this crisis of confidence occurred when Lehman Brothers filed for bankruptcy (as a result of a perceived weakening of financial strength leading to the loss of funding availability, the same effect that brought down Bear Stearns) and general creditors (people and institutions that loaned money to Lehman) will likely lose all of their principal.  This did not happen with Bear Stearns, Fannie Mae, Freddie Mac or AIG where only the common shareholder was wiped out.  Money markets were no longer safe and cash fled to safe haven FDIC insured bank accounts and US Treasury Bills, which briefly traded at slightly negative yields last week.  This means investors were willing to PAY the government a small amount of interest to LEND it money for one month and know their principal was safe!  The SEC ban on short-selling prevented traders from attacking the next weakest link via the equity market, but with many people unwilling to lend to banks, short-term interest rates surged and liquidity dried up.  Direct borrowing from the Fed, the lender of last resort, has exploded, and the Fed’s almost one trillion dollar balance sheet has been mostly used at this point for collateralized short-term lending to financial institutions around the world.  This is unsustainable and is a result of the inability of banks to fully fund themselves through the capital markets.  It is the combination of lack of funding, reduced equity and being saddled with illiquid assets that is preventing banks from extending credit, and the negative feedback loop that exists between these factors will ensure that the problem gets worse until something is done to turn the tide.

One important point is that this is a bailout of the economy as a whole and not just of the financial industry.  Most people do not realize how close we are to doing irreparable damage to the capital markets and how important that is to everyone in this country.  This crisis will now become worse at an accelerated pace and we haven’t seen anything yet if we continue down the current path.  This plan is the only way to restore confidence to the US banking system.

What are the reasons not to go ahead with the plan in some form?

1) Let’s not bail out a bunch of rich Wall Street people.

This is silly because they have already lost billions of dollars and over 120,000 jobs and are only one piece of the puzzle. It is an inaccurate simplification to only blame investment banks for this problem. Everyone from homeowners/spec buyers to mortgage brokers to foreign bondholders to the US government (a big part of it actually) share the blame and they have and will be punished in one way or another.

2) The taxpayer shouldn’t have to pay for this mess.

This needs to be clarified because the media is misrepresenting the facts in many ways.  The taxpayer may very well have to pay something in the end, but here are the important points:

a) The government is not “writing checks”, it is making loans and investments.  This goes for the AIG bailout as well.  Nobody “spent” $85 billion on that deal.  The government will receive LIBOR + 8.5% (London Interbank Offered Rate), which is currently more than 12% interest, on that loan and will own most of the equity upside of the future of the company.  Could it lose money?  Yes.  But it could also make a lot.

b) The government is not using taxpayer money to make these loans.  Think of the government as a giant hedge fund.  It borrows money and makes investments.  It will issue $700 billion of US treasury notes and bills and use the proceeds to buy the distressed assets.  The interest rates on the assets far exceeds the interest rates on the US govt debt so it will net receive income. As time passes, depending on default and recovery rates on the underlying mortgages, it will make or lose money on the assets, and losses, if any, may or may not be covered by the positive interest rate differential that the government will earn.  In the end, the taxpayer is on the hook for the losses, if any, and will receive the gains, if any.  Either way, the gains or losses are unlikely to be anywhere near $700 billion.  One other interesting point is that as soon as the government buys the assets, they will immediately become more valuable and private capital will most likely flow into the system again.  For example, Warren Buffet just put $5 billion into Goldman Sachs.  Would he have done that if he didn’t believe this plan would be passed?  Not a chance.
3) If we start with $700 billion, what if we need three times that much, and are we going down a dangerous road where we keep throwing good money after bad?

This is a concern and only time will tell.  It might need to expand at some point, and may or may not be approved in that event, but my feeling is the initial size will be sufficient.

This plan has more hair on it than the similar RTC-type plans in the past, but there is precedent for this.  Again, I don’t like that it has come to this, but unfortunately we have no choice.  The US economy, already effectively in recession in my opinion even though GDP growth has yet to go negative, will continue to weaken in the coming months.  However, with the passage of this bill, we have a chance to repair the banking system and enable the Fed to inject credit into the economy in levered form as it always does at this point in the cycle (i.e. the Fed cheapens lending and reduces incentive to save –> banks borrow –> banks lend ten times as much also at cheaper rates –> economic activity ultimately picks up).  Without the bill, we risk a serious disaster in the financial system and a dysfunctional banking sector will prevent the economy from operating properly.  Unemployment will rise significantly, many businesses will fail, asset prices will continue to deflate, possibly at a faster rate, capital will retrench and we risk a deflationary environment, a depression or a Japan-like scenario (also generated by collapsing asset prices and the unwillingness to write down and remove bad loans from bank balance sheets).  I think we can work out of this mess, but it’s time to take out the big bat and shock the system.  Too bad politics are involved.