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)


WHA?

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.

  1. Jess Stockton
    October 8th, 2008 at 11:29 | #1

    Chad, I appreciate the effort, but I’ve tried to wrap my head around this thing from every direction, and I still don’t get it. Seems like fuzzy math to me.

    Can’t we just blame this on the republicans and move on?

  2. October 8th, 2008 at 16:11 | #2

    Chad – Very well done. Too much of the commentary has been focused on assigning blame to the Republicans or Democrats or Bush administration or Clinton administration or Carter administration or Nixon or FDR and so on…. Don’t get me wrong, there are definitely people that deserve blame, and I suppose there’s a place for that. But it doesn’t really help people understand what’s going on. I’m not sure your summary covers everything, but you do a good job of making this whole complex mess a bit more comprehensible. I also have to say that I whole-heartedly agree with your point about transparency. Transparency could also help clean up our political culture a bit. Not sure how you get it, though. Politicians and bureaucrats thrive in the dark.

    I haven’t posted on this topic on my blog yet (yes, I have a blog, with all of 4 posts to date), but I’m thinking I probably will soon. Anyway, good job.

  3. October 9th, 2008 at 10:02 | #3

    Great synopsis, Chad, but I disagree a bit about the transparency vs regulation. To the people that traded in derivatives and Credit-default swaps, I think they knew exactly what they were getting into and they already had transparency. If you or I wanted to know more into them, we could probably read up on them and figure the things out. The thing is, we probably wouldn’t want to, because we don’t have a direct interest in them, and in an absence of this, we assume that government will play a role in governing an industry that is worth $60 trillion. But since it wasn’t regulated, it didn’t govern, and now the house of cards has fallen. My point is, regulation of this industry is absolutely essential. And keep in mind, regulation does not have to equal a decline in profits- this industry is nothing less than insurance, which is highly regulated and is also generally a highly, highly profitable industry.

    One thing to keep in mind here, to put all of this in perspective, is the whole nationalization aspect. I mean, we’re talking about decades, if not centuries, of American capitalist thought that is being thrown out the window seemingly by the hour. This is a country that portrayed any country that wasn’t privatizing itself to the core as an international pariah, that a short time ago sought to privatize it’s pension system, and is currently privatizing it’s prison complex and military campaigns. In economic circles, nationalization is nothing less than Satanic. And now the very core of our capitalist system is being taken over by the government. It’s amazing, really.

  4. chad
    October 9th, 2008 at 13:58 | #4

    Jess –

    Yes we can blame the republicans. Everything is their fault, like, when i got a parking ticket last week 2 minutes after the meter expired.

    Stanzy –

    You’re right, its not about blaming republicans vs. democrats. First of all, who to blame comes after we know what is to blame. There are many contributing factors and yet to be consensus, and prolly won’t be till this mess bottoms out. Second, the republicans and democrats are both party to the big problems – lobbyist control over policy, earmarks, and lack of leadership. Oh, and did you like my ‘party’ pun? I knew you would. heh.

    Adam –

    My transparency comment was half baked. However, here’s what i know – markets will always be smarter and one step faster than any legislation. And individuals need to be made accountable when they milk millions and leave a company to die. Not sure how to do the first, but transparency increases accountability.

    I definitely think regulation is needed in CDS. However, I’m not sure “regulation” is always best. I do not think the actions in the CDS market were completely transparent .. financial kids still don’t know who’s gonna make out on this melt down, one of the reasons a CDS Exchange was proposed.

    I’m not sure I understand the point in your 2nd paragraph. What is being thrown out by the hour? Nationalization would be the government taking over a private company, which i think is different than the government acting not much different than a really super wealthy private entitiy (like warren buffet) by helping companies core to our economy.

  5. October 10th, 2008 at 07:09 | #5

    Thanks! Got some things clarified… I still love my sisters comment when I asked for her new address in Manhattan (she is a financial analyst for BofA) “new address is….but I might be living at home soon if investment banks keep exploding over here…” Exploding- not imploding. She says it not the low rungs on totem like herself but parts of the upper echelons. Buffet is right- this is like a hydrogen bomb.

  6. Sharif Khaleel
    October 10th, 2008 at 12:55 | #6

    Chad, very good synopsis. I agree that the blame neither lies solely with the Republicans nor the Democrats. Some argue that the Republicans are responsible because they are in favor of deregulation coupled with free markets. I think we learned our lesson that free markets devoid of any regulation is very dangerous. People also lay blame on the Democrats for passing a bill that encouraged Fannie and Freddie to loosen their standards when it came to providing loans to the poor or those with bad credit. I think the Republicans and Democrats, alike, let us down. When companies are profitable and housing is booming, the last thing a politician wants to do is disrupt the momentum. These gov’t officials are more concerned with their “track record” then what is best for the people. You’ve heard “track record” a million times by John Mccain and how he has a tremendous amount of experience. Do these track records truly demonstrate their stance on issues? Absolutely not, sometimes they vote along party lines, sometimes to keep a consistent track record, sometimes for special interest groups and sometimes out of spite. Sure you can also lay the blame on wall street and lenders but like everything else, you have to go to the top. There were many warnings of this looming disaster by Alan Greenspan, Warren Buffett and countless others. The point is, our government officials are too caught up in politics, track record, reputation and getting reelected.

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