Economic Bailout Q's

[Echoes]

Hey guys,

Got a question. Can some of you financial guru's out there (or at least someone who knows more then a 22 year old non-business grad student) throw some information out about all these financial institutions failing and the pros and cons of bailing them out, or what would happen if they didn't?

I'm not completely dumb when it comes to business and the economy, but really there is no place to get information like this that I see. I try to read on cnn and insert_news_outlet_here site for info, but you know how that goes.

I'm pretty sure BRR and a few others are knowledgeable on the economics end of things, and sadly, I can get better information from this message board then I can from reading most other sites.

So, thoughts/opinions on government bailouts and how they work, etc?

[tommieharris91]

http://www.cnbc.com
http://www.bloomberg.com

A couple good business news sites there. Anyway, pros to these bailouts are that, basically, the economy and financial systems don't collapse completely and begin a prolonged worldwide depression. Cons are that taxpayer money is used for these bailouts, which deepen the debt, can weaken the dollar (not in all cases) and can also cause inflation.

[Vaevictis]

This is not not directly on point, but it's worth a read because it gives you a window into why the government/Fed is behaving this way:

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

The short story is that the government and the Fed are scared ****less that instability in certain institutions will cause credit markets to lock up; current economic thought is that such a thing was one of the biggest contributors to the depth and duration of the Great Depression.

By bailing these companies out, they hope to prevent those markets from locking up, and to reduce the depths to which the economy will sink and the duration of the downturn.

If you want to know about what's going on, read: A Monetary History of the United States, 1867-1960 by Milton and Schwartz. This book is pretty much the start and underpinnings of the school of thought that is behind these actions.

[Echoes]

Thank you much, Vae

[Frozen Sooner]

http://www.cnbc.com
http://www.bloomberg.com

A couple good business news sites there. Anyway, pros to these bailouts are that, basically, the economy and financial systems don't collapse completely and begin a prolonged worldwide depression. Cons are that taxpayer money is used for these bailouts, which deepen the debt, can weaken the dollar (not in all cases) and can also cause inflation.


This is not not directly on point, but it's worth a read because it gives you a window into why the government/Fed is behaving this way:

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

The short story is that the government and the Fed are scared ****less that instability in certain institutions will cause credit markets to lock up; current economic thought is that such a thing was one of the biggest contributors to the depth and duration of the Great Depression.

By bailing these companies out, they hope to prevent those markets from locking up, and to reduce the depths to which the economy will sink and the duration of the downturn.

If you want to know about what's going on, read: A Monetary History of the United States, 1867-1960 by Milton and Schwartz. This book is pretty much the start and underpinnings of the school of thought that is behind these actions.

I'm Mike Rich, and I approve these messages.

The Fannie Mae and Freddie Mac issues run a bit deeper-the main point to remember is that neither of them actually pursued an aggressive credit policy. The reason they got in trouble was the malfeasance of others causing the market for CMOs to contract rapidly.

[Vaevictis]

Also, a big part of what is jacking up the investment banks is illiquid assets, leverage and short sale rule changes.

I'll go over these for the folks who don't quite know exactly what's implied by these -- and so other knowledgeable folks can pick it apart and help me improve my own understanding.

Illiquid assets:

Simple to explain and understand. If an asset is illiquid, it means there are fewer, infrequent buyers. If you need to sell the asset in a hurry, you have to induce demand by lowering the price.

Leverage:

Financial theory says that the optimal capital structure in an environment with income taxes is as close to 100% debt as you can get; basically, if you have a small pool of equity holders with a huge amount of debt generating returns, your small pool of equity holders gets a larger return.

Simple exercise to see why this is so; imagine you invest $1 in a company, and it borrows $100 at 5% for one year. Company invests it in operations that yield $110. Company repays bank $105, dissolves and pays you $5. You just got a 400% return. What if you invested $101 as equity instead? You get $110 back, for a $9 profit -- approximately 9% return.

Anyway, my guess as to why this really jacked them up: Investment bankers are finance guys. They know this. So they really ramp up the leverage to jack up returns.

How does leverage work in this case (according to my guess)? They borrow against collateral. Often times, they can borrow much more than the asset is worth, essentially working it like a margin account.

Margin account works like this: Borrow a certain amount of money, put it in an account. Then put a fraction of your own money in. The portion you put in is your "equity" in the account. Now, using the account, buy an asset. As the asset changes in value, your equity changes by a like amount. Gains and losses are posted directly to your equity.

If your equity goes below a certain percentage of the original amount deposited, you get a margin call -- which means you have to put in more equity, or your lender will close your position. Closing your position means, essentially, selling the assets in the account to cover the shortfall. They may close only a portion of your position -- just enough to cover the shortfall.

Short Sale Rule Changes

Short selling (in this context) is the act of borrowing a share of stock for a certain period and then selling it on the market. If the share price drops, you can buy it back at the lower price, return the share at the end of the term, and pocket the difference.

There was a post-Depression Era rule on short selling -- you could only short sell after an increase in stock prices. This rule was recently removed from the books, allowing folks to sell short as prices declined.

(next post will discuss the interaction that jacked up the investment banks)

[Vaevictis]

Okay, so, the investment banks want to maximize return for their shareholders. Being educated financiers, they know that a good way to do this is to lever up. They do so.

As collateral, they post their own stocks and the assets that they purchase.

Many of the assets they purchase are collateralized mortgage obligations (CMOs), which are essentially shares in a pool of mortgages. These were widely regarded as safe investment vehicles. That perception changed, which reduced demand for these securities -- and in fact, pushed them into illiquidity. If you want to unload them, you have to discount them considerably.

Okay, so, here's how it goes. Investment banks have margin accounts which are backed by their own stock and these CMO's.

(1) The market figures out that the CMO's aren't really all that great, because the agencies rating them did a bad job. They realize that a bunch of banks are exposed to this stuff, and they short sell en mass. Remember that short selling involves selling the stock, and so doing so en mass can actually push the stock price down. The stock price moves down, so the short sellers are rewarded -- and they do it more, continuing to push the price down.
(2) The banks backed some of their debt with stock. Stock price goes down, so their lender executes a margin call. Bank decides to sell assets to cover.
(3) The assets the bank is trying to sell are CMO's. But, the market realize these things are junk, and doesn't want them. To induce buyers, bank sells at a discount.
(4) ... but the CMOs were also collateral. Now their value declines, and ANOTHER margin call happens. What the hell does the bank do now? Sells even more at a loss.
(5) ... the market gets wind that the bank is in distress and selling assets and the stock price drops.
(6) ... and the whole thing starts over again.

------------------------------

Note that I don't actually know if the short sellers were the initial cause of the problem. It doesn't really matter what was. The cycle started somehow, and at the leverage levels the banks were maintaining mean that the only out is bankruptcy.

Anyway, that's my belief as to what's going on. :)

It should be noted that the banks got screwed on the CMO's which if constructed properly are perfectly safe -- the ratings agencies did a bad job on their due diligence, which encouraged loan originators to loan to ever less credit-worthy debtors. The banks did not receive what they thought they were paying for.

[Vaevictis]

And now that I've illustrated how these loops can happen, let me pose the following rhetorical question:

If this sort of thing can blow up the bank, what do you do about the companies of these banks that were relying on these banks making good on certain contracts?

Those companies also have all kinds of assets tied up with the bank and leverage of their own. If the bank blows up, they lose these assets or have them devalue considerably... and with their own leverage, they may enter into their own nasty little loop.

And these companies also have their own customer companies, which may have assets tied up with the bank's customers, and leverage of their own...

You get the point, I hope.

[Vaevictis]

The cycle started somehow, and at the leverage levels the banks were maintaining mean that the only out is bankruptcy.

I should point out that there is another way out: massive infusions of cash.

If you get a margin call, you can always post cash to cover.

The problem is, the bank doesn't have enough cash of it's own. Who in their right mind is going to give cash to a distressed bank?

... yeah, that's right. Us.

But, like I said in another thread, this may not turn out too badly for the tax payer. I think a large amount of these asset write-downs are due to having to sell at a discount due to illiquidity, and folks with enough cash and courage to buy in at the current discounted price (like say, the Federal Government) and enough fortitude to hold them to maturity (like say, the Federal Government) will make out like bandits.

Something similar to this has happened before (cf Long Term Capital Management), and the folks who bought their positions at a discount were handsomely rewarded at the end, if I recall correctly.

[OUHOMER]

OK, let me ask you a question. How does a little guy make money in a market like this. I guess Okla, has been some what insulated to the housing market, so does a guy try to find and buy rental property NOW? Does he invest in the stock market, Does he put his cash in a fruit jar and bury it in the back yard.

Does he up his 401k, Just what does the little guy do???????????

[Vaevictis]

Does he up his 401k, Just what does the little guy do???????????

Right now? Hell if I know.

People are freaked right the hell out. Yesterday, people were paying more for T-Bills than they'll get from them.

Personally, I've been in government bonds since March (as much as I can be anyway, I have some restrictions preventing me from going 100%). It may be a little late for that at this point for those of you that aren't. I don't know.

I'd say follow the standard investing advise. Consider your horizon. If it's short, you want to be in safer assets. If it's long, you want to be in riskier assets. In all cases, diversification can lower your exposure to non-systemic losses -- but in this market, systemic risk is very high.

I don't think real estate is all that safe. Yeah, so far Oklahoma has been fine, but the pessimist in me says that just means we're still overvalued and haven't been hit yet. It may not be true, but it could be. But consider that Oklahoma's fortunes have always been tied up in energy... and that energy has been tanking over the last few weeks. If it doesn't bounce back up, we could see folks in Oklahoma start having a hard time too. I'm not saying that's what *will* happen, just that it could.

So, seriously -- hell if I know. This market is ****ed right the hell up right now.

I can say I'll be back in stocks not too far into the future, I think. My horizon is something like 25+ years, and I'll be kicking myself if I'm in bonds when the market recovers.

But if it was <15 years, there's no way I'd make a play like that.

[OklahomaTuba]

On the other hand, there are a TON of great buying opportunities right now.

[Vaevictis]

On the other hand, there are a TON of great buying opportunities right now.

Yeah, I'm sure there are. Good luck reliably identifying them though :)