Albert Einstein is noted for stating, “you should make things as simple as possible but not any simpler.”
Perhaps that could help us in understanding the current debate over the possible bailout of our credit markets. I know the $700 billion bailout package worked out over the weekend was voted down today but the 777 point drop in the Dow Jones Industrial Average should bring some folks back to the bargaining table. I get the feeling that a lot of people, including people in the U.S. Congress still don’t understand what this is about and faced with that lack of understanding many of our representatives put their collective fingers up in the air and voted accordingly. The winds may be shifting after today’s carnage in the markets.
While we are talking about quite complex stuff, the bailout itself should be quite simple to all of our readers. We, through our proxies in the Treasury, Federal Reserve and Congress will be speculating on a huge pile of illiquid and distressed securities. Those holding the risk, various banks and brokerages (commercials in this context) will be transferring their risk to us. The problem is that nobody else wanted their risk and we through surrogates decided to pay a price much higher than the going rate. It would be as if we decided to pay $50 per barrel for crude oil back in 1998 when it was trading at $10. We are told that perhaps it will be worth what we are paying for it some day as would have been the case with our crude oil example. In essence we are buying way out of the money options but paying as if they were deeply in the money.
So the main question should be what additional premium are we receiving for taking on this risk. As we noted here earlier, the fact that there was no restrictions on executive compensation for firms unloading these toxic instruments in the original bailout proposal is telling. When the Fed agreed to loan AIG $85 billion, it (we) basically got 80% of the firm as collateral, what are we getting in this bailout?
One additional point needs to be made. While we talk of the huge bailout being debated, it would be good to remember—even better if the Department of the Treasury and Federal Reserve Board noted—that a bailout has been ongoing ever since the crisis began in July of 2007. It has included many components such as a dramatic drop in the Fed funds rate, the opening up of the discount window to investment banks and brokerages (something that hadn’t occurred since the depression era), the Fed’s Term Auction Facility (TAF) and other special auctions that involves the Federal Reserve loaning solid Treasury assets and accepting the toxic debt that is behind this whole mess as collateral. Yes, we have been buying this junk, bailing out these institutions for quite some time but it has not been enough to turn the tide.
That is why we are at this critical juncture. I am afraid to think that the 350 point lower opening in the Dow affected some votes. It seems to me that the market hasn’t begun to price in the damage from the subprime mortgage mess. There seems to be a pollyannaish notion that something will get passed and everything will be all right. We have a serious problem and the bailout will create more problems in term of the value of the dollar and inflation but it may be necessary to salvage a working credit market — either way there are hard times ahead.