The Big Bad Bank Bailout

For my first ever blog, I thought I'd tackle a nice, easy subject - the proposed bailout of the banks by the Feds. I'm no expert on this, but I thought I'd publish my non-technical understanding of the situation in the hope it may help others. Most of this stuff has been gleaned from reading Calculated Risk.

First, a recap of the problems facing the economy. As we all know, the bottom has fallen out of the U.S. real estate market, which has left the banks with a lot of bad debt on their balance sheets, which in turn means they don't have a lot of cash to lend out. So the economy is grinding to a halt as businesses are unable to acquire new finance, or even to roll over existing loans.

So, the banks need to raise cash. They could do this by selling the bad debt they're weighed down with. After all, the debt isn't worthless - all those foreclosed houses are worth something - so there's a market price for the debt. However, the banks don't want to sell at that price. They hope (and they've got their fingers and toes crossed very tightly) that the real estate market is suddenly going to spring into life, raising the value of the debt. If they sold now, they might make too big a loss (shame!), or even go bankrupt.

Another way of raising money is to issue new shares, in a rights issue. Unfortunately, the price of bank shares isn't very high right now, so they'd have to issue a lot of shares to make up the shortfall. This would leave existing shareholders with only a small portion of the bank, and a correspondingly small share of any future profits. So that option isn't attractive to the banks, either.

So, what the banks have done is asked Hank Paulson, the Treasury Secretary, to come up with a plan. Which, luckily, he has. It's not a very good plan (unless you're a banker), so Hank's had to wait until things got really bad, and then tell Congress that THE MARKET SYSTEM IS GOING TO FAIL IF YOU DON'T PASS THIS PLAN IMMEDIATELY!!! You'll remember they did something similar with the Patriot Act.

Anyway, the plan gives Hank (the same guy who presided over the mess in the first place, remember) far reaching powers to tidy everything up. It also gives him $700 billion (just put it on the tab.)

Here's how it works. Hank buys $700 billion of debt from the banks, at the lowest price they'll accept. This is, of course, higher than the price they'd get from the market, otherwise they'd just sell it to the market instead. Then Hank sells it to the market at market price. Let's say that's $500 billion.

Who buys the debt? Well, the banks have suddenly found they've got $700 billion to play with! Who'da thunk? So they keep $200 billion (ca-CHING!), and buy the $500 billion of debt that somebody's placed on the market.

Hank's now got $500 billion of taxpayer's money to play with. So he buys $500 billion of bad debt from the banks at the lowest price they'll accept. Then he sells the debt (market price $400 billion) back to the banks, who pocket the $100 billion difference. Ca-CHING!

When he runs out of money, the banks let out a long, satisfied belch, and ask Hank if he's got any more where that came from. Not unless he can frighten Congress again. What do you reckon?

The plan is being sold on the basis that taxpayers might make a profit. Technically, they might. If Hank buys $700 billion of debt just at the moment when Americans decide to start buying houses again at ridiculous prices, the taxpayer will hit paydirt. Anyone think that's going to happen? Thought not.

But we have to do something, don't we? Well, maybe, but there are ways of spending $700 billion of taxpayers money that don't involve just giving it away. For an example, we could require all banks in trouble (which seems to be all of them) to issue new shares, with the sale backed by the Treasury. If private investors buy the new shares, then the banks get their much-needed money at no cost to the taxpayer. If they don't, taxpayers at least end up with a share of the banks - and a share of any profits the banks make.

But that would mean Hank's friends in the banking industry losing out, wouldn't it?

UPDATE: The U.S. will be bailing out foreign banks! As a foreigner myself, I'd like to say thank you very much for your generosity! I suspect, though, that this will be used to crowbar our governments into joining the party, which would not be good news.

One suggested action to take if this thing goes through is to withdraw as much cash from your bank account as possible, letting them know why you did it. Remember, due to the wonders of fractional reserve banking, every dollar you withdraw is worth much more than that to the bank. If you do withdraw cash, consider putting it in a mutual or building society which, as it's owned by it's customers, means you get the benefits of any bailout.