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Bailout or Rescue?

21 September 2008

To the Public Editor of The New York Times:

The New York Times — and, to be fair, it appears every other news outlet — has been consistent in describing what the government is doing in the financial markets as a “bailout”. Consistent with this, opinion pieces rant about the “little guy” being left holding the bag while “Wall Street” gets off the hook.

But is a “bailout” really what is going on? Is that the best way to describe it? I have yet to see any kind of thorough and intelligent explanation of what, exactly, the terms of these deals are and of what the consequences are for the various parties. Isn’t that what “news sources” should be giving us?

Let me take some cases in point.

The first big “bailout” was Bear-Stearns. But what was it that actually happened? As near as I can tell from the sketchy reports (much of my take inferred rather than actually explained), the government convinced JP Morgan — who apparently had not been overly involved in the fiasco, insasmuch as they were not close to insolvent and had resources to bring to bear — to take over the ailing Bear by providing what amounted to an insurance policy for some of the worst of Bear’s questionable assets.  In the process, the investors of Bear-Stearns lost all (or at least most) of their investment and the executives of Bear-Stearns lost their jobs (and, we would hope, any “Golden Parachutes” they had lined up along with the value of whatever Bear stock they were holding).  JP Morgan presumedly paid a fair market value for Bear-Stearns’ assets, adjusted for the risk that the Fed took on. They probably did well on the deal, but not likely unfairly well given the residual risk they were taking and the arm-twisting the Fed had to apply to get them to take it.

So, who got bailed out, and what was the cost? The Bear-Stearns executives who made the bad investments lost jobs and investment value; perhaps their loss was not enough to undo the profit-taking they had indulged in earlier, before the bubble collapsed, but neither government action nor government inaction would or could have affected that. The Bear-Stearns investors, who trusted those executives, lost everything.  JP Morgan attained a potential for some additional profit in return for taking on some additional risk (not to mention by becoming a partner with the government in a public-good exercise).  Mid- and low-level Bear-Stearns employees — or at least some fraction of them — who were least responsible for the debacle got to retain their jobs.  The Fed took on some amount of future risk on questionable securities but, even in the worst-case scenario, those securities are highly unlikely to have zero value and, so, the risk is actually some fraction of the guarantee not the entire guarantee. In summary: for the most part, those most responsible for the trouble lost the most; those least responsible for the trouble lost the least; and the government took on some nominal amount of risk to smooth the deal. That doesn’t sound to me like a “bailout”.

Next, to AIG…

As near as I can tell, the government essentially bought an 80% share of AIG by covering their bad debts. That means, I presume, that AIG shareholders lost about 80% of their investment in the process, while the government obtained a valuable asset — 80% of a now viable company — at a relative bargain price.  Further, because it is now the majority shareholder, the government has effective control of the company’s future — at least until they opt to liquidate their majority share — so they have the control necessary to mitigate the risk they’ve taken on. The AIG executives who got the company into the mess are out on their ears, with whatever part of their own wealth that was tied to AIG stock eroded at the same rate as it was for any other AIG shareholder. The employees of AIG least responsible for the mess get to keep their jobs; the customers of AIG, with no responsibility for the mess at all, do not find their insurance contracts at risk. So, again: it seems like those most responsible for the trouble lose the most; those least responsible lose the least; and the government takes on some nominal amount of risk to smooth the deal. Was this best described as a “bailout”?

And on to the current plans moving through the Treasury and the Congress. It sounds like they plan to buy up the bulk of the questionable mortgage assets that are dragging the financial companies down. I have seen no details of those plans, but it would surprise me in the extreme if the deals involved buying those assets at face value. The whole problem is that the market value of those assets has plummeted relative to that face value and left the companies unable to sell them and unable to borrow against them to raise capital, so I would expect the government to buy them at a steep discount. True, that allows the financial companies to get them off their books and recapture some amount of liquidity to keep going — so they get to stay in business rather than going bankrupt — but I would be shocked if any of them were left with anything but some very large losses in the process. Unless the Fed and the Treasury and the Congress are stupid, those companies and their executives and shareholders will take some fairly large hits. And, again, the government will end up with some tangible, if risky, assets in return for their investment. Certainly the nature of the assets they are acquiring puts them at risk but the risk is almost certainly not for the entire amount invested; and, if they exert enough leverage in their discounting, they might actually make a profit on them. Again, if those responsible for the mess lose, those least responsible hold somewhat even, and the government takes on the potential both for loss and for profit, where is the “bailout”?

And finally as to the assets the government is acquiring: it is true that these were bid up and overvalued but they are not worthless. It was probably never the case that every one of the mortgages behind the mortgage-backed securities was going to end up in default; and, even with the decline in housing prices, those which do go into default will still retain some significant fraction of their face value because they are, in fact, securitized with real collateral. Certainly the government is taking on some risk but, to the extent that it acquires the assets at some discount, that risk is really only some reasonably small fraction of the purchase price.  It is entirely possible that the government could break even or even make some money. To the extent that the government acquiring mortgage-backed securities eases the financial pressures to “reset” variable interest rates and/or to foreclose quickly on problem mortgages, that acquisition could actually, in and of itself, reinforce the underlying value of the securities by reducing the number of foreclosures and bolstering the housing market by making non-sub-prime mortgages available again.

It is even possible that, in the long term, the net wealth transfer that will result from this debacle will be the opposite of what we are currently supposing. All those mortgage-backed assets represent real financial transactions using real money that was transferred from someone to someone else, and the initial transaction was to transfer money from financial institutions to home buyers to allow them to buy their houses. To the extent this government intervention reduces the pressure to reset interest rates and accelerate foreclosures, those people get to keep the houses and they end up better off. When they pay back the money on their mortgages, it now flows back to the taxpayers rather than to the financial institutions; and, to the extent the government can buy the now toxic securities at a discount, that means the financial institutions who bid up the securities lose and the taxpayers win. So, in the long-view, it may be that the winners in this whole mess end up being the original home sellers, the home buyers, and the taxpayers. That’s not guaranteed, but it’s not impossible.

To be sure, a lot of people on Wall Street probably deserve to lose more than they will lose; and the taxpayers are picking up some risk and might (or might not) end up worse off for it in the long term. It’s not the way markets are supposed to work.

But might it not be better described as a “rescue” of the innocent bystanders rather than as a “bailout” of the miscreants? If the primary effect is not to prevent Wall Street from suffering but to prevent their suffering from spreading — to ensure that their suffering doesn’t result in a general contraction in capital available for productive enterprises and for home purchases — that doesn’t sound nearly as horrible as all the news reports make it out to be.

Please, please, consider using your reporting resources to trace through what is being gained and lost by all the parties, rather than simply using loaded shorthand words to transmit a sense of outrage — and of dread.

Thank you for your time and consideration.

© Copyright 2008, Augustus P. Lowell

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