The Bailout

The bailout measure failed the House 228-205 and the Fed has continued to provide short-term loans to banks. Most people don't understand what is meant by a bailout and what exactly is being bailed.


The Numbers - Hank Paulson, Secretary of the Treasury, is asking for $700 billion. It would start with $250 billion with the rest subject to Congressional veto. $700 billion is about 5% of the gross domestic product.

What would they spend the money on - Mortgage-backed securities and Collateralized Debt Obligations

• Mortgage Backed Securities - Cash flows paid out of principal and interest from mortgages. The buyers of these securities need to look at interest rate risk, prepayment risk, and default risk. They also need to look at the value of the underlying collateral in the event of a default in order to value these securities.
• Collateralized Debt Obligations - A special purpose entity created to buy fixed income assets(other structured securities, mortgages, bonds, loans). They are sliced up and sold to investors in tranches. The senior tranche receives payments first, followed by mezzanine, subordinate, and equity tranches. So, if the underlying asset does not pay off, investors in the equity tranche lose first.
  

Why? - Bank balance sheets are filled with mortgage backed securities and CDOs that there is not much of a market for right now. The credit markets have tightened and banks are not willing to lend money.

What does it all mean? - Estimates of the actual cost of a bailout have varied. The securities that the government buys are probably worth more than zero. Some even say that the Treasury will make a profit on this deal like in the Mexican bailout. Some have asked where the government will get the money for this scheme. It will get money from where it always does: taxing, borrowing, or printing. At least right now, it is in a good position to borrow with treasury bond rates at very low levels. The Treasury can borrow at these low rates and buy these more illiquid securities, behaving like a very large hedge fund. Albeit, a hedge fund with other motives than return on investment.


If you have any questions about this situation or if you think I should cover more in this entry, post a comment or send me an email.

Paulson

1. 

Gramm-Leach-Bliley

I have been saying it throughout this crisis that the repeal of Glass-Steagall, the Gramm-Leach-Bliley Act, passed in 1998 was not responsible for the troubles in housing or the banks. In fact, we see that the strongest financial institutions are those that follow a universal banking model.

Two links to Marginal Revolution

Glass Steagall: The Real History
Did the Gramm-Leach-Bliley Act cause the housing bubble?

The Great Depression brought about much financial regulation. Let us not make the mistake of hastily enacting new regulations just to be doing something. Remember the windfall profits taxes on oil companies in 1980, Nixon's wage and price controls, industry-wide cartels of the 1930s... You could fill volumes with examples of bad or ineffectual regulations that followed because people wanted to do something.

Credit Default Swap in a few lines

Not everybody knows about credit default swaps. Basically, let's say A issues a bond. That bond is traded in the open market. B can write a contract to C that says "I will pay if A does not pay(defaults)." If A defaults, B would have to pay C. Typically, the amount is the value of the CDS contract minus the recovery rate(how much is received from selling the company's assets).

So why should you care? There is an outstanding notional value of $65 trillion dollars of CDS contracts.

Quote of the day

"Let me issue and control a nation's money and I care not who writes the laws."
-- Mayer Amschel Rothschild

More true today than ever.

Who, What, Where, Why, How?!?!?!?!?

Still watching the bond market here.

Take a look at this treasury yield curve The 3 month rate is basically 0. The real rate is negative.
I'm not quite sure why you should buy treasury bonds right now. Basically, you are paying the government for the privilege of lending them money. Flight to safety seems overdone now, but where oh where to go? More at 11.

The LIBOR / 3 month treasury spread is up up up

Yes, it really is that bad -- Worst Crisis Since 30s

Are we there yet?

Another bailout on the way

The case for a bailout of the auto industry is weak.

What to say

Lehman had its long slow, descent into bankruptcy. It makes you wonder why Bear and not Lehman. Part of it is that Bear failed first. The other is that Lehman's troubles were relatively well known for months and the market had time to absorb the news. If anybody else some better ideas, please comment.

We are seeing the 3 month treasury bond yield at near zero.
When the government can borrow for nearly free and a nominal basis and a negative real interest rate, it's not a good sign. You cannot help but think of Japan when you see the rates this low. There are some parallels, but the actions taken recently have been different than Japan in the 1990s. In Japan, bad banks were propped up by the government. At least the bailouts here seem to be designed so that the common stock holders do not receive much. I believe the goal of the recent bailouts is different than the bailouts in Japan. I hope the goal here is to assist an orderly liquidation of assets rather than to protect the older and established companies and to keep up appearances.

AIG received an $85 billion loan from the Fed in return for 80% of the equity. The Fed now has control over AIG. The effects of this are being felt by the financial markets today.
"Banks abruptly stopped lending to each other or charged exorbitantly high rates Tuesday, threatening to spread the troubles of American International Group Inc. and Lehman Brothers Holdings Inc. to a broad range of financial institutions and the global economy."

"The depth of the money-market problems became clear at lunchtime in London, when the British Bankers' Association published Tuesday's Libor borrowing costs. Every day, 16 banks report what it would cost them to borrow at certain maturities and currencies. Overnight dollar Libor soared to 6.4375% from 3.10625%, the largest jump on record. Three-month dollar Libor rose to 2.876% from 2.816%."

If you are relatively informed on the recent events, I'd enjoy having a conversation about it to see what you think.

Links

A few links

I thought this post was quite interesting on valuing oil reserves. It talks about the real options and how NPV would undervalue oil reserves substantially.
http://www.marginalrevolution.com/marginalrevolution/2008/09/hail-giacomo-po.html

Hedge funds to the rescue
http://dealbook.blogs.nytimes.com/2008/08/27/hedge-funds-sprout-in-gaps-in-real-estate-lending/

Nanosolar raises $300 million
http://www.mercurynews.com/breakingnews/ci_10316469

A Few Observations on Financial Markets

These observations are nothing new.

Liquidity is not there when you most need it - In good times, there is liquidity for most people. Unless you are a giant player in the market, most of the time you can buy and sell without affecting the price much. You more or less know what something you own is worth. In times of poor liquidity, you have no idea what something is worth. When you are subject to regulatory requirements like banks or use high levels of leverage, you sell what you can sell as quickly as you can sell it.

Models are always wrong when they most need to be right - Models do not hold up under times of market stress. Maybe it is getting better, but knowledgeable people like Alan Greenspan basically say economic models are not any better than they were years ago. These models do not have much predictive power for the correlations between returns in situations of market stress. Remember that LTCM should have never lost so much money as it did in the history of the universe.

Similar things happen, but different enough where we don't know how to correct it in the future - All regulation tries to fix the last crisis in the markets. We never really know if a regulator was correct, but we know when they were wrong. We can never know the cost of lost opportunities due to excessive regulation and it is impossible for government to keep up with the dynamic free market. About every ten years, there is some new disruption in the market. Commodities in the late 1970s and early 1980s, leveraged buyouts in the late 1980s and early 1990s, Dot-com stocks in the late 1990s, and credit right now(also commodities and housing). Ultimately, we need creative destruction and it must be allowed to take its course rather than protecting everyone who lost money or might lose money.

Valuations come back to reality, but sometimes it takes longer than you can stand - Whether it is Dutch Tulips, Beanie Babies, or Internet stocks valuations will reflect fundamentals eventually. It is a question of when. Keynes said, "the market can stay irrational longer than you can stay solvent." Ask anyone who shorted Internet stocks in 1999. Within a bubble, many people know the prices do not make sense. They hope to make a profit according to the "greater fool theory" and get out before the prices fall back to reality. Not all bubbles could mean higher prices. The extremely low oil prices of the late 1990s did not seem to reflect the rising cost of exploration and production and the lack of new discoveries amid growing demand for oil.

I may develop these points in further blog entries with better examples and analysis, but this is a start.