Financial Bailout

October 8th, 2008

This is the hot topic of the year, if not the decade, so I might as well comment on it. First let me summarize some well known facts, than I’ll point out a few things I learned after some digging in Wha? below.

As you may know, last Friday October 3 the 451 page “Emergency Economic Stabilization Act of 2008” was passed – $700 billion bailout of the financial markets by US Government – $250 billion now, $100 billion later with president approval, $350 billion later with congressional approval.  Money comes with an oversight board, new office of financial stability, and a few other good moves.   It also contained an estimated $150 billion in earmarks or pork spending.  “Thats just the way things are done in Washington DC” – Senator McCain. Some of these are not bad, but they have nothing to do with the financial bailout. US Government must end this “bill rider” practice (earmarks, most importantly).

Here are top 10 sweeteners (all are basically federal tax breaks)

  1. Wooden Arrows .. worth $200,000 to Rose City Archery in Oregon
  2. Motorsports Racing Tracks .. worth $100 million
  3. Rum imported from Puerto Rico and the Virgin Islands .. $192 million
  4. Research in US .. $19 billion (Microsoft, Boeing, EDS, etc)
  5. Exxon Valdez plaintiffs ..$49 million
  6. Subsidize Rural Schools .. $3.3 billion (OR, ID)
  7. Deduct sales tax from federal income tax .. $3.3 billion (TX, NV, FL, W,A, WY)
  8. Keep Film/TV production in US.. $478 million (CA)
  9. Wool Fabrics .. $148 million
  10. American Samoa .. $33 million
  11. BONUS – Employers paying employees commuting on bikes .. $10 million (OR)


Getting back to the bailout – What caused this problem? That’s the hard question, and nobody knows the answer, but there are several contributing factors – Banks should not have given loans to people who could not pay them back.  Financial markets should not have blended and repackaged these riskier loans into things that were considered “safe”.  Government should not have left the CDS market unregulated.

What is CDS?  Credit Default Swaps.  This is a relatively new market that is entirely unregulated and limited to huge financial institutions.  When i say huge, i mean those that afford to pay billions.  For example, a hedge fund might want $1 billion insurance on Risky Corp. So they pay morgan stanley $20 million a year, and in return, Morgan Stanely would pay the hedge fund $1 billion if Risky Corp went bankrupt. Sounds like insurance, right? Well, if it was, insurance laws would require Morgan Stanley to keep cash reserves to cover the $1 billion, making it safer. So it is not called insurance .. keeping all that cash around to cover your promises limits how much you can promise, limiting the amount of profit you can make on these promises. In fact, in 2000, Everybody (president, senate, house, sec. treasurer, SEC, greenspan) agreed to keep the CDS unregulated.

How bad did it get in the CDS markets? First you have to understand hedging. In the example above, we have Morgan Stanley promising a hedge fund $1 billion if Risky Corp goes bankrupt, in return hedge fund pays 2%/year to Morgan Stanley. This is the CDS Contract. Now Morgan Stanley might turn around and buy $1 billion insurance on Risky from Lehman. Therefore if Risky goes bankrupt, Morgan can pay the hedge fund $1 billion using the $1 billion they get from Lehman. That is hedging – covering one position with an opposite position. Now understand speculation. If Risky looks like it is more likely to go bankrupt, more hedge funds buy $1 billion CDS contracts on it – they wanna get paid big if Risky goes under. Of course, they will be charged a higher fee per year, maybe 5% or 10%. But a smart hedge fund speculating on dozens of companies going bankrupt will bring in far more cash on bankrupt payouts than cash spent on those fees. That is speculation – betting on an asset going up or down. So lets say in the end, there are 10 CDS contracts on Risky Corp, $1 billion each, totalling $10 billion on the CDS market on a $1 billion company. Risky goes bankrupt, only able to pay off half its debt to its investors. Investors lose $500 million. However, $5 billion is lost on the CDS market. OUCH. One of the key things here is that you can buy/sell CDS contracts on any company at any time. This speculative nature in CDS markets is bad. In 2008, CDS maket was $60 trillion in contracts on $5 trillion in assets.

Let me repeat.  In 2008, there was $60 trillion in an unregulated CDS market – that’s more than all the money in all the stock markets in the world.  Thats insane. This is why Warren Buffet famously described derivatives bought speculatively as “financial weapons of mass destruction.”

Mortgage Backed Securities (MBS) are also problematic.  When you get a home loan from your bank, the bank packages up various loans and they turn into MBS.  These are regulated, unlike CDS, but the risk was not accurately rated.  No need to dissect this one – you’ve heard it all before – banks should not have been giving loans to people who couldn’t pay, markets should not have been buying these risky things and trading them like they were not risky, and these big banks should not have put all their eggs in one risky MBS basket.

A bit confusing, a bit interesting.  So what does that tell you?

I’ve learned that at least one area needs work – Assigning risk accurately.  Also, debt in the financial system is made extremely complicated by very smart people, so nobody really knows how big the problem is.

What’s the solution?  I’m not sure regulation helps, but transparency does.  Create rules that require transparency, and fine heavily (millions) when people do not abide.   For time-sensitive things, force transparency to a neutral agency that will hold information for a short time, fining heavily those whose actions don’t match what they said they did. Transparency helps math geniuses at the financial institutions assess risk more accurately, and leaves a trail for CEO accountability.

CEO’s who move debt around for years while they pay themselves millions should be forced to return cash when debt is revealed. If a bank robber steals $100 million, the bank and the feds go after the robber and the $100 million, even if the robber gives the $100 million to his mom as a bonus.  So if a corporation goes bankrupt, why do the CEO’s get to keep the millions they received?

Thats all for now .. if i missed any big points, please leave a comment.