What was the ulitmate plan for the financial bailout?

During the debate about the financial bailout, there was some talk about the Gov’t acting as a buyer of last resort for securitized debt that had become illiquid due to difficulty in assessing the risk associated with it. Is that in fact what ultimately happened?

No. You’re absolutely right that that was the early plan that was sold to Congress, but it was quickly abandoned. There were several problems with it, and so Treasury asked Congress for broader leeway with what to do with the bailout funds.

One such problem was choosing a “fair” price for these assets. Pay too little for them and the government gets a good deal on its investment, but the big financials would have still been insolvent. With the financials still in danger of failing, credit markets would still have been frozen. No recovery in this scenario. In contrast, if you pay too much for the assets, the banking system is saved, but the government taxpayers get shafted by paying far more than these assets actually end up being worth. The taxpayers end up holding the bill, while the investment banks get directly awarded for their bad decisions. And that’s not even the end of it. On top of that, it’s not a great way to pump money into the system by just replacing one form of asset with another. You don’t get much bang for the buck that way. So thankfully, that plan was dropped.

The bailout was actually accomplished by purchasing equity shares (technically, a piece of ownership) of the big banks. Unfortunately, this also resulted in the banks being rewarded for their bad decisions. But on the other hand, it’s much easier to price equity and know that it’ll be stable, and so ensure that we get our money back–and we will, indeed, be getting the vast majority of our money back. The equity purchases also led to bank stability with a (relatively) smaller necessary investment. However, these shares were non-voting, and so the government couldn’t dictate terms to the banks without going back to Congress and asking for another piece of legislation to be passed.

So, all in all, a miserably messed up system on almost every level, but still not as bad as it could’ve been. And hey, no depression. Now we just gotta figure out a way to buffer up our regulations to keep it from happening again–and then somehow convince Congress to listen to the regulators instead of the banks.

Don’t the debt instruments in question have a face value? I am not in a position to judge this, but it seems to me that the government would be in a better position to go long on these instruments. Of course, the default rate is still unknown.

Incidentally, what types of new regulation did you have in mind? What is proposed? I hear a lot about penalizing CEOs, but that of course has nothing to do with fixing the current mess nor plugging this particular hole in the dyke. (I personally think penalizing CEOs is just populist revenge fantasy, but that is for GD).

Thanks,
Rob

That the default rate is unknown is the whole problem.

These things are separated into “tranches”, where some people get paid before others. And so the value of the investment is entirely dependent on how many people pay their mortgages and how many people default. The face value could be interpreted as the best case scenario, which is, what you’d get paid if everything worked out alright. But that’s not the situation we’re in, and so the actual price of these things has been up in the air, just like a junk bond will reward you a nice hefty sum if you buy it cheap (far below its face value) and the company doesn’t happen to go bankrupt before it matures.

And one other thing that’s been misleading in the news reports: This market was not actually frozen. People were, in fact, buying and selling these things. It’s just that the market price was incredibly low, and my rather imperfect understanding of this is that if the banks had had to mark their assets to that market price, they’d have been in some serious shit. The bad numbers could’ve caused their creditors to call up their debts all at once, leading to the big investment bank equivalent of a run, where they would’ve been obligated to sell what they had at firesale prices, which is another way of saying they’d have all gone bankrupt at once and left us in the middle of a depression without a functioning financial sector.

I agree entirely that revenge is not at all the answer.

The problem largely wasn’t criminal malfeasance. I mean, yeah, people like Madoff exist, but this trading was by and large done by regular legal traders. Some of the ratings agencies were engaged in fraud, but that’s still one illegal piece in a large, and largely legal, shitpile. It was simple, ridiculous, and entirely lawful short-sightedness that primarily drove the process. I mean, geez, they’re bankers. Bankers are, and long have been, the most short-sighted wealthy people on the planet. The entire business is centered on the notion of taking gigantic risks with other peoples money, and people are suddenly surprised that they often make bad decisions? It is to laugh.

The key to regulating is not some misguided sense of vengeance, but to be able to punish the ridiculous short-sightedness properly while keeping the system functioning. When a small depository institution fails, the FDIC is there to wipe-out the owners, repackage the assets, and sell the pieces that are left. We need a similar process for the big investment institutions, so that the stockholders get properly smashed in the face and lose everything, while the bondholders take a hit, too, but a predictable hit so everyone knows where they stand.

This is already getting outside my realm of expertise, but we also need to clean up our regulatory structure as well. Basically, Congress has created a ridiculous hodge-podge of agencies in order to solicit bribes–er, excuse me, “campaign contributions”–from the entities they regulate. That needs to be cleaned up, and the budgets of these agencies should be tripled. And I’m sure there are all sorts of piddly details involved in this that need to be worked out. The problem, for me, is that high finance is as much about contract and bankruptcy law as it is about economics. I read some sophisticated commentary on this stuff, but I can’t claim to understand half of it.

It’s also worth pointing out, without me adding any political opinion or commentary, that the GOP voted unanimously against the House financial reform bill, which was drafted after the worst financial crisis since the Depression.

I am neither a Republican nor a Democrat, but rather, a pragmatist. I feel we need effective regulation that favors long-term over short-term thinking that doesn’t hamstring the broader economy. The key, of course, is what does that entail? It is a question I would like answered, but I fear that the answers may beyond the understanding of my tiny little mind.

Thanks for your help,
Rob

It is not true to say that the bailout went to the big banks. It was forced upon nine original big banks. Following that, banks of all sizes received funds. Also, a huge amount of the funds of the financial bailout went to the auto companies, to AIG, and to a mortgage modification program. The majority of the dollars that went to the banks were in the form of preferred stock, which in certain ways has some similarities to debt.

The FDIC failure process is not simply for small depository institutions. For example, Washington Mutual went through that process. Wachovia very nearly went through that process until Wells Fargo stepped in and bought them.