An audience of two

Sunday September 28, 2008

The bailout bill.
I've been trying to wrap my head around this whole financial meltdown thing and whether this $700 billion "bailout" is a good thing, or if it'll even work. Now everybody is blaming the problems with the US "subprime mortgage" market. In terms that I understand, people were encouraged to take out mortgages that in the long term they couldn't afford, with low "teaser" rates; when the initial rate expired they were planning to refinance at another low rate, or sell the property and keep the profits. And like all good pyramid schemes, it worked fine as long as the market kept going up. When the bubble burst, housing prices started to fall and the teaser rate mortgages dried up. As a result people couldn't pay their bills and the banks foreclosed. A market full of foreclosures drove the price of housing spiralling down.

From figures I've heard quoted recently my estimate is that there's somewhere around 75 million houses in the USA. The average price is around $200K, which values the total housing market of the order of $15 trillion. (Someone else I was chatting with claimed that the housing value is in fact around $47 trillion, of which the mortgage market represents about half, making $24 trillion, but I have no way of verifying that. With an average value of $200K that would mean almost one house per person - man, woman or child. I find that a little hard to believe even if some of us do have more houses than we can count, so I'm guessing the real figure is between the two.) Most of that debt is perfectly good debt; there was a time when you needed to have a 20% deposit or equivalent in equity to get a loan, otherwise you had to take on a higher rate second mortgage or pay PMI. So how much of that is bad debt?

Well one article I read that was dated February of this year quoted the national reposession rate at around 2%. Let's say it's higher now; call it 3%. 3% of $15T is $450B of loans in default. But of course those houses aren't worthless, they are simply worth less than the outstanding debt. Let's say that they are worth only 50% of the value; that's probably a huge undervaluation, but it puts a price on the "subprime crisis" of $225 billion.

$225B might seem like a lot of money (because it is) but Washington Mutual alone was worth $300B. The simple fact is that if this was simply a matter of the housing bubble bursting with $225B of debt then the market would easily be able to absorb that.

So what's the problem? Well apparently it begins something called Credit Default Swaps (CDS). The idea is that if a bank takes on a loan that ends up being defaulted on they can use CDS to offset the risk of that, as a kind of hedge or insurance. Which is all well and good. Except that there's no requirement that you actually hold a debt in order to take out a CDS. Put it this way: I have a Toyota that's insured for $20K. If I have an accident, the insurance pays me the value of the car. A CDS is rather like you taking out an insurance policy on my car. If I have an accident, you get paid. And you can insure my car for any amount you like. So in effect it's an open-ended bet that I won't crash. So the actual problem is, instead of hedging against bad debts, Banks have been using CDS as a speculation tool.

Was all of this legal? I have no idea. It seems odd that something which has had such a catastrophic effect on the world economy should be legal, but then that's the Free Market for you. But when the government talk about the "toxic debt" they aren't talking about the defaulted mortgages, they are talking about these bad speculative bets. So if nothing else, surely someone has been criminally negligent if not downright fraudulent.

Knowing this, what I find frustrating is comments putting the blame on anything other than the banks. One target is Property speculators. Certainly there was a lot of this going on, but that's your Free Market at work. At least these people were buying real, tangible assets and gambling with their own credit. Another target is too much regulation (whaaa?) for which the solution is yet more deregulation (Whaaa?). John Boehner claimed that private capital can be drawn into the market by removing regulatory and tax barriers that are currently blocking private capital formation. Too much private capital is sitting on the sidelines during this crisis. Of course it is, they could see that it's a disaster and they pulled out in time. And yet Warren Buffet has invested $5B in Goldman Sachs, so clearly it can't be that bad and there can't be that much regulation. If there really was money to be made you can bet they'd be lining up to get some.

Anyway, the first draft of the bailout bill has been published and you can read it here. It's 110 pages of the usual legal bullsh!t jargon and I can barely understand a word of it. From what I can gather it doesn't seem to go far enough in reducing foreclosures and there's nothing that stops the kind of sickening $20,000,000 "golden parachute" payoff that Alan Fishman got from Washington Mutual, but it looks like that's what's going to happen. Let's just hope it works

Update Bradford and Bingley was nationalised this morning. I really don't like the sound of this quote: But many banking analysts argue that the nationalization of the bank could be a boon to taxpayers one day, unlike the U.S. bailout plan, in which the government is simply buying up bad debts. Permalink | | | | Comments [1]
Tags: bailout capitalism credit_crunch crisis disaster end_of_days fat_cats financial_meltdown free_market