Bailouts for Fun and Profit

OK, this pisses me off. David Stout, writing a Q&A in The New York Times (“The Wall Street Bailout Plan, Explained”):

Q. Who, really, is going to come up with the $700 billion?

A. American taxpayers will come up with the money, although if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion. After the Treasury buys up those troubled mortgages, it will try to resell them to investors. The Treasury’s involvement in the crisis and the speed with which Congress is responding could generate long-range optimism and raise the value of those mortgages, although it is impossible to say by how much.

First of all, today’s taxpayers are certainly not going to come up with the money, not by any stretch of the imagination. There are no plans to raise taxes to pay for this bailout, nor, in my opinion, should there be. (That’s not necessarily to say that taxes shouldn’t be raised, just that this bailout should not be the deciding factor.) People (and institutions mostly, really) who buy Treasury securities will come up with the money. The Treasury will issue new Treasury securities to raise the money to pay for the distressed securities that it buys. Most likely the banks that sold those distressed securities will buy the new Treasury securities with the proceeds from the sale, so nobody really has to come up with the money, except for a few minutes while the deals are being done. In effect the Treasury will be paying for the distressed securities by creating its own securities to use as payment.

Someone is going to say, “Well, of course today’s taxpayers aren’t going to come up with the money, but the Treasury securities eventually mature and have to be paid off, and when that time comes, those future taxpayers will have to come up with the money.” I will attack that straw man immediately by pointing out that the debt can be rolled over. Maybe eventually, after rolling over the debt several times, the government will be forced by circumstances to raise taxes to make those payments. But maybe not. I’ll have to do another post on why the “maybe not” case is more reasonable than you might think.

But let’s suppose that those Treasury securities do eventually have to be paid off with taxes and cannot be rolled over indefinitely. Does that mean that future taxpayers will have to come up with $700 billion plus interest? There is a tiny chance that that will be the case. Which brings me to what mostly pisses me off. I repeat from above:

...if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion.

Reason to hope? That the tab will be less than $700 billion? Holy crap! I would sure as hell hope that at least a few of the mortgages in the pools bought by the government don’t default! OK, I’m being a little disingenuous, since much of what the government buys will be lower tranches that can become worthless even if there are only a moderate number of defaults. Some of the securities very likely will become worthless. But in all probability, unless there is a severe, prolonged recession (which is to say, a depression) and a much further decline in housing prices, the government’s whole portfolio will still be worth something.

And – here’s my main point – the Treasury will not be paying full price for these securities. It won’t be paying anything remotely close to the price that the securities were issued at. It will be paying whatever price desperate banks are willing to accept in order to get the securities off their books and replace them with things that can be easily sold when they need cash. These are motivated sellers we’re talking about. In all probability, many banks will be willing to sell these securities for less than they think the securities are really worth. Because they don’t want to take the risk that, when the government bailout is over, they will have some need for cash and won’t be able to sell the securities then.

Granted, there may be some banks that figure out ways to game the system and sell their securities for more than they are worth. But all in all, we should expect the Treasury to get these securities at something close to fair value. The Treasury is not just throwing money away; it’s buying valuable (though quite risky) assets and paying roughly what those assets are worth. [EDIT: I was wrong about this, because I didn't take into account the moral hazard faced by bankers who can fudge their asset values. I discuss this among other topics in the post where I change my mind about the bailout. It is still true, though, that the Treasury will not be paying full price, and it is likely to recover much of its investment and possibly even turn a profit, but unfortunately not a large enough profit to justify the risk.]

And it’s important to understand that “fair value” includes the expectation of a substantial risk premium. The fair value of a junk bond is considerably less than the fair value of an otherwise similar investment grade bond, but when they mature, both bonds are redeemed at par. The junk bond has a larger chance of default, but even when you take that chance into account, the expected return on the junk bond is considerably higher. People don’t buy junk bonds because they’re stupid; they buy them because they expect, on average, a high return. Similarly, the Treasury should expect, on average, a high return from its purchases of distressed securities.

So, while there is (in theory, at least) quite a large risk to (future) taxpayers (a risk of up to $700 billion – plus the meager interest that the government has to pay), the expected return is not only positive but rather large. And since the interest paid on Treasury securities is quite small, that return, if it materializes, will be a huge windfall for whatever future taxpayers get the benefit.

So this “bailout” is not about the Treasury paying $700 billion and hoping to recover some of it in a best case scenario. It is about the Treasury paying $700 billion dollars, risking losing up to the whole amount, but expecting not just to recover the entire amount but to emerge with a large profit. The Treasury is, in a sense, gambling with taxpayers’ money, but the gamble is a good bet, kind of like if you had inside information about the horse. Of course, making a profit is not the point of the operation, but it might be a pleasant side effect.