Worst...Bailout...Ever!

The bailouts are coming at such a regular basis that they ought to make them into a “reality” TV series. What distinguishes “reality” TV from other forms of entertainment is that one, they are “unscripted” but highly manipulated formats, and two, they have nothing to do with reality. Certainly the weekly bailout plans qualify. If not exactly unscripted, they are poorly thought out and are mainly a matter of trying to manipulate markets. And they are certainly unrealistic. Hence, they are good candidates for being made into regular TV episodes, perhaps as “Survivor—American Economy” or “Last Bank Standing.” Something like that.

However, if they were made into a TV serial, they would be subject to the judgment of Comic-Book Man from The Simpsons, and this latest installment would likely earn from him his oft repeated honorific, “Worst...episode...ever!” First, let us see how these new “public-private partnerships” are supposed to work. The best explanation comes from Nouriel Roubini's RGE Monitor site:

Sample Investment Under the Legacy Loans Program:
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Sample Investment Under the Legacy Securities Program:
Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

Note that in the first case, the “investor” puts up $6 dollars for every $84 dollars of “assets” being purchased, while in the second he puts in as little $25. True, these 12-to-1 and 4-to-1 leverage ratios are much lower than the 30-, 50-, or 80-to-1 leverages that the banks and hedge funds are used to. Nevertheless, the leverage is all from public money. Supposedly, this “shares” the risk between the public and private sector, and allows the so-called private sector to price the toxic assets. But for every dollar at risk from the private sector, the public has from $3 to $12 at risk. So much for sharing. Further, the loans are “non-recourse.” That means that if the investment fails and the loan can't be repaid, the public takes the full loss, while the investor only loses the amount of money he put up initially; he has no liability to repay the public.

This is supposed to establish a “market price” for the toxic waste, but it will not. Rather, it will allow select investors to play the toxic-waste market with public money. This will not lead to market behavior. People play the market differently with their own money than with other people's money. And the program does nothing to address the underlying problem. Either the investors will offer enough money to clear the banks' balance sheets, which might mean that they've paid too much, or they won't, which means that the banks won't sell. But in either case this is a huge commitment of public funds for a problem which has a simpler and time-tested solution.

A few of the money-center banks, some insurance companies and many hedge funds made a series of bad bets. They are insolvent. There is a procedure for insolvency. The banks should be go into receivership and be broken up. The losses should be written off, and that's that. Nothing new or radical in that solution, it happens time and again.

So why not use it? Two reasons. These are no ordinary banks. They are huge behemoths so complex that even the managers and directors do not understand them. This, in fact, is the complaint of the man who took over AIG. That whole company was brought down by the activities occurring in one small division of about 400 employees, the very ones who are now getting the bonuses. But the very size of these institutions grants them great power over the economy. Further, their counter-parties, the people on the other side of the bets, tend to be powerful governments and institutions. Between them, they have the power to help themselves to a few trillion of the taxpayer's money. You will note that there is never enough money for such luxuries as health-care or education, but they can't print it fast enough for war or bankers.

Even if the plan works, it will fail, because it doesn't address the underlying problem. And that problem is that we no longer make what we consume. Unless we restore the real economy, the economy that makes real things and provides real services, we cannot restore the banks. Even solvent banks require productive enterprises to which they can lend money. But we ran out of these a long time ago. There simply isn't enough demand, even in good times, for loans from our diminishing productive sector. Hence, the banks turned to lending it for houses people couldn't afford and credit they shouldn't be using, but must because the wages are too low.

Making the big banks solvent again will not provide them with solvent customers. That can only come from a restructuring of the economy that shifts us back to real production rather than financial black magic. If we restore the economy, restoring the banks will be a trivial problem. If we do not restore the economy, it simply will not matter how “sound” the banks are.