30 September, 2008

Bailout Exegesis

I wrote this trying to sort through the bailout issues in my own mind, but maybe someone else will get something out of this. Apologies for the length.

Why do we have a financial crisis? There are two reasons that a bank (or I-bank or insurer or any corporation) can fail: liquidity and solvency.

Every bank (and every company) has a balance sheet where they add up their total assets (what they are owed) on one side and their total liabilities (what they owe) on the other side. If liabilities are greater than assets, the bank is insolvent. At the same time, every day, week, or month, the firm receives some money from the people who have borrowed from them and they must also pay some money to the people to whom they owe money. If the firm does not receive enough from its debtors to pay its lenders, it is illiquid.

For example, take a small local bank. You deposit $1,000 with them. They loan out this $1,000 to someone who needs it for, say, their business. So on their balance sheet is a $1,000 asset, the loan, and a $1,000 liability, your deposit. Every month they get a payment from the business who took out the loan, and every once in a while you withdraw some money from your account. If, for some reason, you want to withdraw more cash than they currently have on hand or if the business misses a payment, then the bank is illiquid and cannot pay what they owe you, even though they may still be solvent. On the other hand, if the business that they loaned to fails entirely and goes bankrupt, the $1,000 loan disappears from the asset side of the bank's balance sheet. They are insolvent--they may have enough other loans to keep paying for your withdrawals for a while, but they will eventually go bankrupt because they owe $1,000 more than they are owed. So a bank can have solvency problems, liquidity problems, or both.

The key fact about the current crisis is that it is a solvency crisis, not a liquidity crisis. Why? The Fed has acted quickly and decisively to prevent a liquidity crisis (basically, what caused the Great Depression). If a bank needs temporary cash to service its debts, it can get a loan from the Fed at a very low interest rate. When the bank is able to call in some of its loans, it can pay the Fed back. So long as the Fed provides these cheap loans to financial institutions, we won't have a liquidity crisis.

Rather, we have a solvency crisis. For the banks, investment banks, brokers, and insurers involved, their assets are lower than liabilities. Why? They all made some investments that turned bad at the same time. They bought billions of dollars worth of mortgage-backed securities (MBS) (basically a way of purchasing thousands of mortgages at once), betting that house prices would continue to rise and that because house prices were rising, the number of people who defaulted on their mortgages would be lower than normal.

Unfortunately for them, a variety of factors led to a far higher-than-normal foreclosure rate. In a nutshell, many mortgages were given with little or no downpayment and were given to people with little means to make payments if they increased (the so-called subprime mortgages). Because of inflation scares, the Fed increased interest rates in 2005 and 2006, leading to much higher payments on adjustable-rate mortgages. Higher payments meant more defaults and more foreclosures. At the same time, the housing bubble burst and home prices fell substantially. So, when banks foreclosed and seized homes from people who went bankrupt, those houses were worth much less than they were when the mortgage was issued. Finally, the lack of transparency in the construction of MBS means that no one really knows which mortgages are owned by whom. Therefore, no one is willing to buy MBS any longer. These assets are not worthless--because many of the mortgage-holders will eventually pay off their loans--but they are valueless--because no one is willing to purchase them, they cannot be valued for the purposes of balance sheet accounting.

And so a huge chunk assets simply dropped off every investment bank's balance sheet. Each failing bank now has billions of dollars more liabilities than assets. They may be liquid--able to service their debt--for the time being, but over time they will eventually go bankrupt, leaving billions of dollars in unpaid debts. The institutions who loaned them money will in turn have billions of dollars of losses and many of them will go bankrupt as well. As the contagion spreads, the number of banks that can loan money for business, home-buying, foreign investment, and any number of other productive uses will shrink. And as credit dries up, so will economic activity. People will lose their jobs and businesses will close their doors. We're already going into a recession, but there's no question the recession will be much deeper and longer if the financial markets collapse entirely.

This is why we need a bailout. But which bailout package would be best?

This brings us to the problem of moral hazard. One way to solve the problem would be to simply give giant checks to each bank. But this would tell future banks that they could make whatever risky investments they wanted to and if these investments turned sour, the government would step in to guarantee their salaries. It is important to let banks fail if they made risky decisions that turned out poorly. In particular their stockholders and executives should not benefit.

The Paulson plan will would have provided a market for MBS, with the government setting a price (or running an reverse auction) and buying MBS from everyone who was willing to sell at that price. What would this do? Remember that every bank has tons of MBS just sitting on its balance sheet. Since there's no market, the MBS is a big "ZERO" on the assets side. But a lot of the money invested in mortgages will eventually be recouped because many who got a mortgage will not default. And banks will get a lot of money back from reselling houses that have been foreclosed upon. If the government buys the MBS, the banks get to replace that "ZERO" with the amount of money the government paid for them. This will make some banks solvent that weren't before, but many (most?) banks will still be insolvent, because the price the government pays will certainly be less than the banks paid originally.

The question with this plan has always been what price the government will pay. If they overpay, more banks survive but there's more moral hazard and the government lose money. If they underpay, a lot of banks would go under that should not have. The Dodd-Frank version of this plan that just failed the vote in the House would have prevented overpayment by requiring banks to provide stock equal to the amount of overpayment, once we figured out what that amount was. But the basic problem with this plan is that it doesn't do enough--most banks will still be insolvent even after they get some cash back for these otherwise valueless assets.

The Krugman-DeLong-Yglesias plan that has been kicking around the blogosphere (otherwise known as "the Swedish plan") is that the government should basically nationalize failing banks by buying large amounts of stock in them. How would this help? Companies sell stock (or equity) to raise capital. Equity is different from debt. Debt is an agreement between the lender and the company that the company make a specified series of payments at some point in the future. Stock is ownership of the company. Owning stock entitles you to a share of the company's profits as well as votes on the company's Board, which hires and fires the company's management. During an IPO or when a company wants to make a major new investment, they sell new shares in return for capital. For example, let's say I start a company. I sell stock in my company and raise $10,000,000. I now have $10,000,000 in assets and my liabilities are zero. The difference between assets and liabilities is known as equity.

The problem for these banks is that total liabilities is greater than total assets--equity is negative. But the banks can issue more stock--this is how firms raise capital. No one out there wants to buy it right now because everyone is scared of what's under the hood, but the government could purchase said newly issues stock. Every share of stock purchased makes the assets side of the balance sheet higher and so the government can purchase enough stock to make every bank solvent again. Voila! Crisis averted. Not only that, but the taxpayers do not lose any money. If the banks are successful, they can be sold off later for a profit. This still leaves many problems. What are MBS worth? What will the government do with the banks that it purchases? Will they be politicized in some way?

So I think neither plan is perfect. The Paulson plan may not stop the crisis. The Swedish plan will definitely end the crisis but may lead to bigger problems down the road. And there are countless more possible plans that could be enacted.


Elliot said...

Good breakdown of what's going on. I think I had gotten the gist of it, but its really helpful to have it all summarized and explained in relatively simple terms.

A broader point that needs to be discussed as well (and I think Obama talked a bit about this in the debate) is the set of policies that led to this juncture in the first place. From what I gather, what is mostly to blame is financial deregulation (what I have heard talked about specifically is the 1999 Financial Modernization Act, or something to that effect) that allowed for the mortgages to be securitized in the first place. This was of course a boon to the traders, but the bundling of high-risk mortgages in with other, safer investments, is in part what led to them getting "lost" and contaminating the market when they started to fail.

So the broader lesson is that we should re-implement oversight that better separates high and low risk investments. Right?

spencer said...

Mortgage-backed securities have been around since Fannie Mae was chartered in 1938. Its purpose was provide liquidity in the mortgage market by buying up mortgages and packaging them together for easy distribution. So MBS is nothing new.

I haven't really thought enough about what regulations could have prevented the crisis and could prevent a future crisis. I guess I would only say that MBS seemed like a very low-risk investment of the time. Is there a regulatory body that would have seen things different than Wall Street?

Elliot said...

I guess I thought that sub-prime mortgages being traded like that was a relatively new phenomenon, and that's what I meant about the high risk investment being lost among the low risk.

I'll try to find what I was reading on it instead of poking around in the dark.