http://www.nytimes.com/2008/09/26/business/26wamu.html

Those gov’t seizures are a scary thing. When the Fed is looking at bank failures that could sink the FDIC, the gloves come off pretty quickly, the investors, creditors, etc. be damned.

A big part of the problem here is that with the introduction of these new exotic financial instruments — default credit swaps and lots of others in addition to a menagerie of mortgage-backed securities — it became much more difficult for banks’ stakeholders (shareholders, creditors, even the boards themselves) to really understand their risk position. Hence a lot of what’s happening is irrational: based on the poor flow of information. The banks are afraid their creditors will terminate them with extreme prejudice if they find out their real risk profiles when they participate in the gov’t securities buyback. If the creditors and investors had had full information on the risk in the first place, then this wouldn’t have been a problem: they would never have gotten so deeply involved with the banks in the first place if they were afraid of the risks. This piece of the puzzle can definitely be blamed on deregulation which brought these new complex instruments into being and reduced the banks responsibility to provide good information.

My naive take …

The bank’s creditors don’t want bankruptcy, even if it involves write downs and restructuring. The Spice Must Flow. Unless, of course, the creditor is looking for an acquisition .. like, say, BofA or Citi.

Best case scenario for a bank’s debtors is debt relief, worst case is that their loans get sold to someone else and there’s some paperwork to keep track of it. Selling to the government would seem like a good deal to them, because it’s very low risk, and they gain a voice (as small as it might be) about how their debt is handled. Either way, the terms of the bailout don’t have much of an impact on a bank’s debtors.

Investors who are locked in don’t want to loose any more money. If a bank’s only options are to stay in business or go bankrupt, the investors are going to be looking for the best deal they can get that keeps the business afloat. Obviously, selling bad debt to the government for pennies on the dollar is a good deal, if it prevents bankruptcy.

On a slightly separate tangent … if the bailout bill’s teeth are too sharp, could this be an opportunity for private institutions to step in? There are still a lot of companies out there with a lot of money.

The scenario is this: you’re stuck with a lot of your assets in these mortgage-backed securities that you can’t sell because the market is dysfunctional. So you teeter on the edge destruction because you can’t get cash to pay your debts. The Fed comes in and offers to buy those securities at a dime on the dollar, which would provide you with enough cash to cover your debts. But you can’t take the deal because doing so would spook your debtors and other investors and might push you over the edge.

There’s going to be a game of chicken to see who goes first. Likely, the Fed will have to give some of these banks a hard shove to get the first deals done. Luckily they have an enormous amount of leverage right now in the form of chits and favors since they’ve been saving everybody’s skins for awhile now.

@jason: The point about mortgage relief for homeowners is a good one and should be done, but I don’t think it’s fair to consider it as an alternative solution to the current crisis. Shoring up homeowners with additional loans would slowly trickle up to staunch some of the loss of value in the mortgage-backed securities, but it’s a small piece compared with the real destruction of value from falling home prices. In the long run, aid to homeowners and, more importantly, potential new home buyers, would solidify the market by getting home prices moving in the right direction again, but that’s a very long term prospect, probably measured in years. There really is urgency here because if the credit crisis continues you’ll start to see commercial banks like WaMu and Wachovia fail in more spectacular ways. It only takes one real run with pictures on the news of people lined up outside on the street in front of a bank that airs national television commercials for an honest-to-god panic to get going. You think there’s a lot of fear sloshing around wall street right now (note the 700 point drop in the last two hours as the bailout package struggles in the house)? Wait until 100 million americans start to lose faith in the trustworthiness of their bank accounts which are backed by a flimsily inadequate FDIC. They’ll make what’s going on right now look like the peak of the tech bubble.

Do you have anything to look at about the market price breakdown on the mortgage backed securities? I’d read some comments in the WSJ yesterday that said that the lowest grade ones (ie last paid) were still trading, even if it was at 20 cents on the dollar.

I agree with you on the rhetoric and partisanship, but I also think it’s fair to point out that some of the people interested in seeing the current proposal negotiation fail do so because they want alternatives that aren’t on the table to gain more attention. I think the bulk of popular opinion comes more from distrust that this is a solution in general than us vs them politics.

From my armchair view the alternative that looked the most interesting was having the .gov loan capital to troubled home owners at a lower rate allowing them to pay down enough to afford their mortgage again improve confidence in these securities directly. I like that this acts directly on the target of all the leverage running around (like the CDS’s, which I only partly understand) preventing the triggering events rather than attempting to pump enough liquidity into the system to let everyone settle books on trillions of dollars.

And you gotta admit, the first version of this bailout was simple absurd: the .gov would buy up all this junk at above market price, and would gain nothing in compensation for that value. Sure Paulson et all make some arguments about how it’ll actually make money down the road, but I don’t buy that for a minute. If it were true, China, Dubai et all would already be doing it.

I’m right with you on the points that the government’s role in this process is to create stability, and what you say seems to fit with my (basic) understanding of economic principals and practices.

Thanks for the clarification on the updated proposals. I agree that the first point is mostly a psychological issue — limiting executive paychecks doesn’t provide any real incentives for rational change. The threat of the government owning a significant piece of your company does.

You’ve brought us closer to “why” … but I’m still vague on “who.”

$700B is a lot of money, but it’s no where near the total sum of the problem debt, which means the bailout money has to be spent carefully. Figuring out who gets the money is a very significant part of the issue, and I’m keen to learn more about how that process works.

My guess is that once the terms of the bailout are set, there’s going to be some battling to get the money — demand (bad debt load) is high, supply (bailout cash) is low. The wild card is how the incentives are structured … how much of the company is a bank willing to sell to the government, in exchange for debt and risk reduction?

Thanks for the insightful post. I appreciate it!

This is important because the panic has not simply caused prices in these securities to fall, but it has also drastically reduced the volume of trading in them which has meant that banks and other financial instruments who depend on the flow of capital caused by that volume are failing due to temporary liquidity crunches.

While these banks are, in fact, suffering heavy real losses, that is not the true reason for their failure. What’s happening to them is a little bit like having your auto-repaying bill come due right before your paycheck gets deposited. You fail to pay the bill (due to insufficient funds) and bad things happen (you car insurance gets canceled, for example) even though if the timing had worked out slightly differently, you would have had plenty of money in your monthly budget to pay the bill. Obviously, you don’t get into this problem if your financial situation is completely healthy, but it’s not quite the same thing as having to declare bankruptcy because you have no prospect of having your income cover all of your debts.

And these problems have been rapidly worsening: as each large formerly trust worth institution fails or accepts bailout, the fear of lending to the remaining players increases pushing them closer to their own liquidity crunches.

The US government is pretty much the only entity in the system that can help in a situation like this. It has near infinite access to capital (it prints the money itself, so the only limit is the threat of inflation which is moderated by the enormous existing supply of dollars) and it’s raison d’etre is creating stability.

While these particular actions and mechanism are being rapidly improvised by Paulson in reaction to the current situation, the spirit is very much in keeping with the core of the Fed’s mission.

Now, when we begin to talk about the details, however, there’s room for criticism. Paulson wants the $700B as a blank check, with no legislative restrictions on his ability to use it. He also wants all the money right now so that the new administration that takes power in January can’t change its mind and add strings or take away the money.

The Democratic leaders in Congress have pushed for and won a compromise that reduces some of the flaws in this plan. While the plan appropriates all $700B, it has provisions for disbursing it in a series of smaller ($250B) chunks, which is simply a way for congress to reserve the right to change the rules later on in reaction to events. Further, the plan has two important strings attached: one largely psychological and one that’s solidly economic. Firstly, the plan includes limits to executive pay for any companies that participate in the bailout. This is mostly to make the majority of tax payers feel like they aren’t getting screwed by having their money given directly to multi-millionaires. The second provision is in place to actually prevent the majority of tax payers from getting screwed. It requires that the Fed receive an equity stake in the companies that participate in the bailout so that, over the long term, as they recover, the federal government will be able to roll a percentage of the profits into the federal budget, relieving us of some part of our tax burden. This was a tactic that was extremely successful as part of the bailout after the Savings and Loan crash of the 80s and eventually resulted in hundreds of millions of dollars coming to the treasuring (that was a much smaller event).

( Paul Krugman has a very good column on these issues in the Times right now: http://www.nytimes.com/2008/09/26/opinion/26krugman.html?hp )

Obviously these are incredibly huge, complex, and technical issues that are poorly covered when they suddenly emerge into the mainstream press. I’ve been following this stuff for awhile and I still feel that I have an extremely poor grasp on things.

And also while I can identify with your anger and desire to blame someone, I think it’s important to distinguish between that justifiable sense of outrage and what actually makes the basis for good policy. Some on the left (especially at Daily Kos) and on the right (House Republican leadership) are hoping to see the bailout come tumbling down because they are so offended by it. To my mind though, the more I learn about what’s at stake and what forces are in play, the more those kinds of responses seem selfish and petty to me. Trying to push a small piece of your personal or partisan agenda when things are looking a Great Depression ( checkout this: http://idfdz.tumblr.com/post/51830173/its-not-a-good-sign-when-you-search-for-great and this: http://en.wikipedia.org/wiki/Wall_Street_Crash_of_1929#Timeline ) is just not cool.

I don’t know enough to say whether Sweden’s specific approach is correct for the US, but it certainly should be taken into consideration .. especially when the current proposal amounts to a blank check with no teeth.