The US bail-out plan

I was reading the latest issue of the Economist yesterday evening, and found it very interesting. The main story was on the proposed US bail-out of the banks and financial institutions. I was surprised at first to see that the magazine believed that the plan was a good idea, and could help the economy.

I was in two minds when I originally heard about the US bailout plan. I hadn't read all of the details yet, and I couldn't see how it could help the financial system. From what I could tell, the plan was that the US Treasury would spend $700 billion to buy "toxic" debt, i.e. securities guaranteed by sub-prime mortgages which were unlikely to be repaid in full. The current market price for some of these securities is about $35 per $100 of nominal amount, so for every $100 of the original loan, the market now expects that only about $35 will actually be repaid in future. Banks and financial institutions that own these assets are in trouble, as their value has dropped from the original price of $100 to a current value of only $35. What I couldn't understand was, if the government was going to buy the securities for $35 each, how would this benefit the institutions holding them? The institutions would still be subject to a huge loss, and in fact the money they would receive would be the same as the current value of their securities, so their financial position would not really improve significantly. Or was the government going to overpay, giving the banks maybe $80 for each of these securities, knowing that they are only worth (and are only likely to repay in future) $35? Was the plan to take the taxpayers' money and give it to the banks to keep them from becoming insolvent? That certainly didn't sound like a very good idea.

Besides, wouldn't this plan destroy investors' faith in the US dollar and the creditworthiness of the United States? Was the US government just going to print off money to save the banks, creating inflation, and reducing the value of US debt (held to a large extent by overseas governments and institutions)? Should I be moving more and more of my money into gold and precious metals?

The only positive thing I could see about the whole plan was that at least the US authorities were trying to do something about the huge problems that their economy and financial system were facing. They were prepared to act quickly and decisively. If Japan had acted quickly and decisively when their own problems started in the early 90's, maybe the recovery process wouldn't have taken as long, or been as painful for the country as it has been. But was the quick and decisive action of the Fed going to cause a lot of pain for non-US investors and institutions holding US bonds, by reducing the true value of these assets? Was another fiat currency about to become worthless?

The articles in the Economist certainly provided some useful insight and information, and I have to say that I'm now a lot more relaxed about the proposed bailout plan, and, dare I say, even optimistic about it! (Well, in a pessimistic kind of way...)

So how is the plan supposed to work? Well, the idea goes something like this...

If we were to use realistic, best-estimate assumptions to value the "toxic" securities I mentioned earlier, we might decide that they are worth something like $65 per $100 nominal. However, because the market is particularly worried about risk at the moment, and is using worst-case scenarios to value these securities (instead of trying to assess the most likely future outcome), it's placing a value of only $35 instead of $65. So if the government can step in and start buying these securities at $65, this will increase the value of these assets, strengthen the balance sheet of banks and financial institutions holding them, allowing banks to start lending money again, and restoring proper market conditions in the global financial markets. And if the securities turn out to be worth $65 in the end, the taxpayer hasn't even lost any money in the process.

It all sounds good, and there is some logic to the plan. Unfortunately, we have to rely on some pretty brave assumptions. Most importantly, we have to assume that the market is taking an extremely pessimistic view of the future, placing a value on these securities that is significantly below their true worth. If it turns out that the market was right, and the securities are only worth $35, then the taxpayer will have overpaid for them, and will end up losing significant amounts of money. In fact, what if things turn out even worse than the market is currently expecting? What if the taxpayer only gets back $20 or $10 for each security? Remember that, not very long ago, the market was placing a value of $100 on these same securities!

But wasting a few hundred billion dollars of taxpayers' money may be a price worth paying, if it's going to save the global financial system from collapse. Because a possible collapse of the financial system could have catastrophic consequences for every aspect of the world economy. If companies and people cannot borrow money, economic activity would slow to a standstill. Companies would be forced to scale down their operations or close down completely, unemployment would rise to extremely high levels, and we'd all struggle to make a living. It could be the 1930's Depression all over again. I only know about the Great Depression from books and movies, but I know it's not something we'd want to go through at any point in our lives.

But are things really that desperate? Are we facing a possible collapse of the global financial system? Well, it's certainly not looking very good at the moment. We've had problems with Freddie Mac and Fannie Mae, the collapse of Lehman Brothers, the near-collapse of AIG, institutions which were previously thought to be too big and / or too safe to fail. And yet they did. (Or almost did.) Over the last few months, and to an even greater extent over the last few weeks, banks had almost completely stopped lending money to each other, and even money market funds were starting to get into trouble. Money market funds are supposed to be extremely safe investments, equivalent to cash. They lend to banks and other institutions on very short durations, and play an important role in the financial system. Some of these funds were holding Lehman Brothers debt when the company collapsed, so they started losing money. This was not supposed to happen. Money market funds were supposed to be as safe as cash in the bank. (Hmm...) And once investors realised that these funds were not 100% safe, they started taking their money out. If this process had continued, another very important source of liquidity for the global financial system would have dried up. So things were getting pretty bad. The Fed had to do something.

And they did. They came up with the bail-out plan. It's not going to be easy to get out of this mess, but we have to try. Could the bailout plan end up costing billions of dollars to the US taxpayer? Yes. Could it lead to a de-valuation of the US dollar? Yes. Is it going to magically sort out all the problems in the global economy? No. But by acting quickly, we may avoid seeing the worse of this crisis.

During recessions, governments need to spend money to re-start the economy. They need to spend money to provide jobs for the unemployed, to buy products from companies that may otherwise find no buyers. That's the only way the government can stop the economy from coming to a standstill. So now is not the time for governments to suddenly remember that they need to be prudent and careful about spending taxpayers' money. Now is not the time to try to address the budget deficit. Now is the time to spend. Now is the time to build roads, repair electricity networks, spend huge amounts of money on infrastructure projects, wind or solar energy systems, and generally do whatever is necessary to keep the economy moving.

The bail-out plan is a start. By helping the financial system to continue to operate, we may be able to prevent some of the most pessimistic scenarios from becoming reality. But let's not kid ourselves, the bailout plan on its own is not going to fix all of the problems in the economy. House prices are likely to continue to fall, a lot of people employed in the financial services industry may still lose their jobs, unemployment may still rise, and company profits may still fall. We'll probably still experience a recession. But we may avoid the worst-case scenarios. 30% unemployment, a collapse in companies' profits. More bailout plans and more spending may be necessary in the future. More taxpayers' money may have to be spent. The budget deficit may have to increase even further.

None of these things are good. I'm very fond of capitalism, and would prefer the state to have a much much smaller role in the economy. I would prefer taxes to be reduced, I would prefer the public sector to contract significantly. I would prefer the Treasury to have a budget surplus instead of a budget deficit. But now is not the time to address all of these issues. Now is the time for the government to play its role in stabilising the financial system and re-starting the economy. Because the alternative could be disastrous...


PS1. Things are moving pretty fast, and it's difficult to keep up with all the news these days. By the time I'd finished editing this article, the US Congress had already rejected the bail-out plan, and it wasn't clear what the next steps would be. I suspect we haven't seen the last of the bail-out plan yet.

PS2. As always, none of the above (or below) is to be taken as advice on investments or any other matters. I've used terms like "government", "the Treasury", "the Fed", etc. interchangeably. You know what I mean. Although I'm referring to US practices, events, and institutions, Britain faces similar challenges, and probably needs to address them in a similar way. You may find that I've over-simplified things here and there, but I think the general ideas still stand. Governments need to spend money to cure recessions. Ideally the money should be spent on productive and worthwhile projects which will benefit our society for years to come (infrastructure, research and investment on developing alternative sources of energy, etc.).

PS3. Because the accumulation of debt has contributed to a lot of the problems we are now facing, some people now seem to think that debt is a bad thing that should be avoided at all costs. My view is that there is bad debt and good debt. Bad debt sounds something like this: "My salary is low, I can barely make ends meet every month, but I want to take my family on a round-the-world holiday this summer, so I'll borrow £20,000 from the bank to finance my holidays." Bad debt is usually a very bad idea. Good debt sounds something like this: "I'm 18 years old, and want to become an actuary/lawyer/engineer. I've researched the industry, and it seems that there is a lot of demand for actuarial/legal/engineering skills. I believe I have the skills and abilities needed to become an actuary/lawyer/engineer. I need to borrow £25,000 to finance 3 years of university studies to acquire the skills necessary to achieve my goals." Good debt can be a risk as well, but it's usually a risk worth taking. The return on the original investment can be very substantial. Unfortunately, distinguishing between good debt and bad debt is not always as straightforward as in the examples above.

PS4. I have no doubt in my mind that the best investment I've made in my life was my university / actuarial education. I don't expect my investments in shares or precious metals to ever provide a better return. And I'm grateful to my parents for helping to finance my university education, so that I didn't have to take out any loans to pay for it...