The Back-Door Bailout

In a nearby thread, I argue that the quest for a pain-free correction to the current economic crisis, through government intervention, is likely to lead to more pain rather than less.  Unfortunately, this is of largely academic interest, because we have already granted the Federal Reserve such sweeping power over our economy that massive government intervention is a certainty.  Bloomberg reports that the Fed intervened to put another $630 billion into the system yesterday.

To put it another way, we do not have before us the choice between a “bailout” solution and a “free market” solution.  Our choice is between an explicit bailout, such as the one that failed yesterday in the House, or a back-door bailout.  As I understand it, the back-door bailout works like this: The Fed lends cash to struggling banks so they can meet customer demand.  In return for this cash infusion, the Fed takes collateral from the banks — it is, after all, supposed to be a loan.  But as the demand for cash increases, the banks find they need to give the Fed poorer and poorer collateral.  When a bank fails, that bad collateral ends up on the federal balance sheet anyway, despite the Congress’s failure to pass an explicit bailout.

The difference between the explicit bailout and the back-door bailout is not that one of them puts taxpayers on the hook while the other does not; it is that one of them accomplishes the transaction in one step, via direct purchase by the Treasury, and the other accomplishes the transaction in two steps, via a Fed loan and then a bank failure. Thus, in creepy imitation of the “lesser of two evils” philosophy at work in most national elections, some readers have argued to me that I should support the explicit bailout because it is preferable to the back-door bailout in at least two respects:  (1) it engenders greater confidence in the system because it avoids widespread bank failures; (2) it arouses greater anger among the electorate (most of whom will never realize the back-door bailout took place), and this makes them (us) more likely to demand systemic change after the election.

This is a plausible argument, and I would feel better if I heard supporters of the explicit bailout articulating their position this way — and making anticipatory declarations of support for the long-term reform we need.  As long as the dominant theme is the avoidance of short-term pain, I’m not persuaded — I think the pain is both inevitable and necessary as a wake-up call.  But I thought I’d put the theory out there and see what reasonable minds think about it.

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6 Responses to “The Back-Door Bailout”

  1. Timothy Peach Says:

    Sorry about that spam magnet, but what kind of fortress is this? This place is like Swiss Cheese! Can’t you despam it anyhow? You gotta have better tools if you want to keep volatile top talent like me in the house.

    Printing, printing, printing, lending, lending, lending… this is what happens when Congress won’t give Ben and Hank more powerful, direct tools:

    http://www.nytimes.com/2008/09/30/business/30plan.html?hp

    Oh hang on, I need to get under my desk. They’re trying to take me to the Fed window again…..

  2. David Fitzgerald Says:

    Mark, I wonder if the Depression analogy is inapproriate? As I understand it, the Great Depression started as recessionary pressure in the real economy, resulting in a severe contraction in equity prices, followed by margin calls which investors (including banks) could not meet resulting in bank failures and a run on the banks because deposits were not insured. Here, the situation is somewhat reversed in that this started as a crisis in the banking system which is leaching out into the real economy. If bank balance sheets can be “rationalized” the “pain” in the real economy need not be ridiculously severe.

    While it is no doubt true that the fiscal insanity we have colluded in for the past 8 years has contributed to inflated asset prices and a dangerous reliance on foreign sources of credit, that problem is not directly related to the current banking sector issues.

    Your post does however, make an important point. The Federal Reserve, for the last six months, has been pulling every lever it can (and some of dubious legality) to curtail systemic liquidity risk. Those actions have been unavailing. It is important to remember that what prompted the Paulson plan was what resulted from the decision to let Lehman fail, the provision of the $85 bn to AIG and the takeover of Merrill Lynch by BofA.

    On that fateful weekend, Paulson tried to draw a line in the sand and decided not to provide a liquidity lifeline to Lehman. I think he got comfortable doing that largely because he found a buyer for ML, i.e. he recognized that a firm who had taken appropriate steps to clean up toxic assets on its balance sheet could still attract private sources of new capital. But within hours of that decision he got slammed with two tsunamis (1) the inability of AIG to find any credit because of its CDO obligations and (2) the breaking of the buck in the Primary Reserve money market because it held AAA rated Lehman paper which now needed to be marked to market, the subsequent unprecedented outflows from the money market funds and the inevitable seizing up of the commercial paper market, making it impossible for even the GE’s of the world to borrow.

    This caused Paulson to realize that unless he could find a way to clean the toxic assets out of the system in a comprehensive way the Treasury, in the guise of the Fed, would never be able to provide enough liquidity and confidence to attract private capital into the banking system. Financial institutions with very profitable businesses, like AIG, but questionable balance sheets, would continue to fail. That would wreak havoc in the real economy and, here’s the key point, unnecessarily.

    The trouble with the securitized assets is that they simply can’t be appropriately valued. They are worth something and, if they are held to maturity, most of them will fully perform, PROVIDED THAT A SEVERE DOWNTURN IN THE REAL ECONOMY CAN BE AVOIDED. Private buyers for the assets can’t absorb the risk of the proviso and therefore, they aren’t buying the distressed assets thereby almost guaranteeing a severe downturn in the economy, which is driving the value of the assets down further, which is further constricting the ability of banks to lend, etc… I believe that in physics, they call this an autoclatic (right?) system.

    The Paulson plan is nothing more than a holding pattern. The government will warehouse the assets in the hope that by doing so the financial system will start to operate and the “fundamental soundness” of the American economy will continue. There is, no doubt, some risk that some of the warehoused assets will not perform to a hundred cents on the dollar. But the real cost of doing nothing is almost ceratin recession and a painful contraction in individual net worth. What’s the solution for that? The standard Keynesian playbook of economic stimulus, thus exloding the fiscal problems further.

    On balance, I think the Paulson plan is far more likely to get us back on the road of fiscal restraint than any of the alternatives.

  3. Steve Grannis Says:

    The preference for the explicit over the back-door bailout makes sense to me but isn’t the problem now that no one, or not enough legislators, like the current version of the deal?

    The current version gives taxpayers ownership of asset-backed mortgages, many of which will pay off. Some will not, however, and we’ll be left holding some of the underlying properties, all of which will be worth less at the time of default than the debt (otherwise, why would the borrowers walk away?). So there’s no way taxpayers can make money on this deal unless interest rates go far lower some day and “our” asset-backed securities are paying a better than market rate i.e they’re a marketable security again. Fat chance.

    If we’re going to be Wall Street’s saviour why shouldn’t we be its partner as well? Why not offer the good people of Wall Street a cash-for-preferred stock deal like Buffet negotiated with Goldman? Does one have to be a billionaire to cut a deal like that? Hey, come to think of it, we ARE billionaires in this deal!

    It seems taxpayers should get some upside potential here in addition to avoiding a credit crisis, although I realize the latter is the big prize.

  4. Timothy Peach Says:

    The Paulson plan is a proposal to establish a levered sovereign wealth fund, which would have had the same advantage Buffett has when he buys — the self-fulfilling prophecy. That’s the way it should have been sold — we’re buying up assets and more likely than not to make money for the taxpayers while stabilizing the econony.

    The second the sound bite “$700bn bailout for Wall Street” got into the idiotsphere, this thing was in big trouble.

    I have to tell you, I think this thing is not going to get through the House. I think the naysayers have been emboldened both by the failure of markets to totally crash, by news that fair value accounting may be softened by impending guidance, and by a sizeable body of “experts” praising the naysayers for blocking something they believed (narrowsightedly) to be misguided.

    Luckily, the back-door bailout already got WaMu and Wachovia into reasonably stable hands. The US supply of crud may be manageable now without the original Paulson plan. It’s the rest of the world I’m really worried about. Nationalization seems to be the general attack plan. Can that be good in the long run?

  5. Timothy Peach Says:

    The linked article by Nouriel Roubini adds some color for those trying to understand the systemic risk here.

    http://www.forbes.com/opinions/2008/10/01/goldman-morgan-run-oped-cx_nr_1002roubini.html

    Roubini is a well-known “perma-bear” who was predicting the housing collapse very early on (at least as early as 2005, maybe earlier). One thing he harps on in the article is how vulnerable both Goldman and Morgan Stanley are because they are still almost exclusively funded by overnight lending. He implores them to find a buddy with a big deposit base.

  6. Patriotic Songs for Our Newest National Protectors « Reasonable Minds Says:

    […] Bernanke could do anything about it.  They were kind enough to ask Congress for permission, but as we’ve noted, they went ahead with a back-door bailout anyway, even before Congress […]


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