Sunday 21 September 2008

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.

14 comments:

stocksystm said...

Thanks for the synopsis. That made the whole scheme a little clearer. The last option that doesn't enrich the scoundrels sounds interesting.

Scott from Oregon said...

You did not go back far enough. The real estate "boom" was to cover for a recession that came after the tech bubble popped.

This was all the federal reserve's doing as it dropped and held interest rates to almost "free money" status.

Couple that with a golf course economy and little production of actual wealth, and you can see what the scam actually was.

Proclaim wealth by inflating housing to obscene levels and then use that proclaimed wealth to produce credit to run the golf courses...

You fail to mention th emillions of Americans who bought into this scheme, pulling out mass amounts of phony "wealth" out of their homes and buying mass amounts of stuff.

Ponzi schemes end, and somebody always gets left holding the bag.

This time, it be the taxpayers.

This is only round one of this. There is another larger wave of housing failures coming this winter and next spring.

Which will lead to credit card debt going unpaid and more mass failings.

Stand back. You might get some on ya...

DL said...

The update informing that the bailout would be extended to foreign banks speak volumes about the national allegiance of the US government.

ema said...

You forgot to mention the minor point of, you know, ignoring the constitution:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Kevin Anthoney said...

You forgot to mention the minor point of, you know, ignoring the constitution:

Is that old bit of paper still in force? I had no idea!

Hank Roberts said...

Krugman drew a picture of the plan:

http://krugman.blogs.nytimes.com/2008/09/20/follow-the-money/

Jeff Wunder said...

And what's all this gonna do to the dollar? Will I ever be able to get out of here, or are we doomed to become a devalued third world country, due to games being played by fat cats at a higher level? Gold is looking mighty good. Wish I knew that 6 years ago.

Dark Matter said...

Good synopsis! I knew there was something bail-out-y going on, but this is the first really clear explanation I've had of just precisely how they're pulling it off.

Jeff Wunder said...

And what's all of this gonna do to the dollar? Will I ever be able to get out of here, or are we doomed to become a devalued third world country, due to games being played by fat cats at a higher level? Gold is looking mighty good. Wish I knew that 6 years ago.

Jeff Wunder said...

And what's all of this gonna do to the dollar? Will I ever be able to get out of here, or are we doomed to become a devalued third world country, due to games being played by fat cats at a higher level? Gold is looking mighty good. Wish I knew that 6 years ago.

Free Lunch said...

In the USA, the most common mutually owned financial institution is the credit union. Most of the savings and loans either went out of business or demutualized during the S&L deregulation disaster that John McCain is so proud of.

Duncan said...

I suspect, though, that this will be used to crowbar our governments into joining the party, which would not be good news.

Fat chance. I honestly doubt that either the British or Swiss governments (which seem to be principally implicated here) are going to find cash of the suggested magnitude to throw at the problem.

Since I'm a Brit (but a US taxpayer, and I happen to own stock in Barclays...) I suppose the feds paying off Barclays might be good for me personally. Somehow, though, I still can't believe that what is being proposed is a good answer.

Anonymous said...

If enough people withdrew their money, couldn't that really strain the system and cause an even greater problem? I don't see how that would help.

Ralph Musgrave said...

For an insight into the farce taking place in European banking circles, see this:

http://blogs.reuters.com/great-debate/2009/07/28/europe-borrows-from-peter-to-lend-to-peter/