I'm in favor of the bailout. I'm siding with Barack Obama, Chris Dodd, Barney Frank, and Paul Krugman, among other people I have come to know and respect.
Am I an expert? No. I am a financial services professional, so I recognize the words and understand the concepts a little better than a complete layman, but this isn't my field.
What I want to do in this diary is give a description of the crisis and bailout in laymans terms which I hope will be useful for people who are even less well trained to understand it than I am.
After that, I'm going to explain why I think its better than our other choices.
Introductory reading
To understand the crisis and the bailout, I think it helps to have a little insight into the financial products that are at the heart of the mess. To that end, I wrote a diary yesterday to explain Credit Default Swaps and Collateralized Mortgage Obligations in terms simple enough to grasp, but with enough detail to understand how they affect the current situation: What is this stuff?. It was well received by the few who saw it.
The Crisis
The current crisis is a credit crunch. The economy relies on credit to run. I have seen people write that the economy is "addicted" to credit, but I think that a better analogy is that the economy is an engine and credit is the lubricant that makes the engine run smoothly. Without credit, we would not have the economic growth that we have had.
When banks extend credit to borrowers, they are required to keep a certain amount of assets in house as a reserve fund in case people do not pay them back. If they do not have enough in reserve, they can no longer make loans. The same is true of the non-bank entities in this crisis, although they are more loosely regulated, and have to keep reserves to make shareholders comfortable as opposed to federal regulators.
In the past 8 years, a lot of the lending in our economy has shifted away from banks and to the more loosely regulated companies, and away from simple loans and toward the more complex stuff. The companies involved managed to convince themselves that the stuff let them reduce the amount of risk that they were taking, so they held very low reserves compared to the amount of credit they were granting. That was fine as long as the market was rising, but as soon as it started falling, the stuff that they owned became worth less than they had paid for it, so they needed to hold on to more stuff to have enough reserves, and they wanted to charge more money to extend credit.
Right now, credit is very expensive. We can live with that. It slows economic growth, but is not a catastrophe. To go back to my engine analogy, it is like having very thick oil. The crisis is that the credit market may seize up entirely, like an enginge that runs out of oil. This is something that can happen suddenly, in a chain reaction throughout our financial system. There are some experts who think that this is likely to happen soon if there is no bailout, and others who think that the crisis is an illusion and we would experience no worse than a slowing of the economy if we did nothing. As I said in the intro, my personal expert is Paul Krugman, and as he said in criticising the original Paulson Plan, "Everyone agrees that something major must be done."
What is the bailout?
The bailout calls for the Federal Government to spend up to $700 Billion to buy the stuff that is currently sitting on the books of financial services companies with values lower than the companies originally bought it for. The government will pay something more than the companies would get by selling these assets on the free market so that the companies' reserves increase (If not, the bailout wouldn't actually do any good). The government will hold this stuff for a while and then sell it off, returning money to the treasury.
It is important to remember that the $700 Billion is the investment in the Bailout. To call it the cost of the bailout is misleading, since the assets the government is buying will not become worthless.
What is the true cost of the bailout. $700 Billion minus the amount that the government gets when it sells the assets. (Ignoring expenses, interest, etc for simplicity) There is reason to hope that the market is currently undervaluing the assets so that the government may actually make money in the long run. This scenario played itself out in the depression as Obama noted in last nights debate.
In a nutshell, then, we will buy stuff from the financial services companies. Some of the stuff will go up in price, and some will go down. In total, we hope that we will get back most if not all or more than we put in.
Why do I think this is a good idea?
First, I take heed of what the great depression meant to this country. If George Bush and Hank Paulson were alone in warning me that one was imminent if we didn't act, then I would thumb my nose at the lying crooks. They are not, however, alone. Many good and smart progressives agree that there is a reasonable possibility if not a certainty that we will be in grave trouble if we do not act.
Second, I understand that markets frequently over-react, especially when there is room for unbridled speculation. How much is the stuff that we will be buying worth? No one knows for sure. It depends on how many people and companies pay off their mortgages and other debts in the future. Recently the price has been dropping, and I think that negative market psychology and downside speculation have pushed the price well below the ultimate worth of this stuff. I think that there is room to buy things well above the current market price and still have a good chance of breaking even or making money.
Third, the deal as of Thursday had additional protection for the taxpayers, in the form of stock warrants that we would get so that we could recoup some of our losses or make money if the assets didn't recover in value and the company who sold us the assets was not bankrupt. (lilnev did a better job describing these yesterday than I could ever do)
Are there risks? Yes, with a spike in inflation being the most pronounced, but I think that the risk of inaction is worse.
Some Alternatives and Objections
Doing nothing is discussed above. I see too many smart people telling me something has to be done.
The original Paulson plan was DOA in congress for a reason. It is vital to remember this when looking at other comments about the bailout. Many people, including Krugman were highly critical of the Paulson plan, but support the bailout in its current form. What's the difference? There are 3 big ones: 1) The Paulson plan called for no oversight of the Treasury Secretary, but the current plan has bipartisan review. 2) The Paulson plan had no mechanism for stock warrants or other equity, and the current plan does. 3) The Paulson plan authorized the whole $700 Billion in one lump sum, this one requires further steps after the first $250 Billion.
Mortgage Insurance, Deregulation, and lower capital gains taxes which are the three things at the heart of the House Republican plan are not good ideas. If a Market based Insurance program could fix this crisis, then the market would have created it. Deregulation would just let the companies do more to rip off taxpayers without easing credit meaningfully, and lower capital gains taxes would enrich investors at the expense of the government while only modestly increasing capital flow into the system. This is typical Republican use of a crisis to try to get what they always wanted passed as a "cure." This is what Sen. Shelby is arguing for, and I get sick every time I see a Kossack quote him positively as opposing the bailout.
Direct aid to homeowners and/or government buying houses to increase housing prices are very attractive options to progressives, but there are two problems. 1) A lot of the crisis involves debt other than mortgages, and 2) The number of individual transactions required for this would greatly increase the expense of managing the bailout, and also slow it down, perhaps to the point where it would not be effective.
We're not against the concept, but we want transparency before we sign on. This seemed to me to be Kos's view as of Thursday. To steal from an old burlesque gag, "If I could walk that way, I wouldn't need this operation. We got into this mess by underregulating the complex new financial products. Since they didn't have reporting requirements no infrastructure was built to keep track of them. If you think that multi-billion dollar credit swaps would not be done on a handshake, without careful computerized record keeping, you underestimate the power of greed to trump caution. We can't get transparency in a hurry because this stuff is complicated and building the systems to really make it clear will take time.
This too, is why there is so much uncertainty about the size and scope of the problem, and why the Treasury department has admitted that the $700 Billion is essentially just a number that they picked to be really big.
Kos is a really smart guy and there are lots of other really smart people that would like to look at the same numbers that the government is looking at and voice their opinions. I absolutely agree that we should work toward building the 21st century information systems that would allow this, but we aren't their yet. The numbers that the government is looking at are fuzzy because that is what you get when you don't force companies to report meaningfully. We can do nothing until we get transparency, or we can trust our representatives.
Final Analogy
We're in a boat drifting downriver in a fog. Most of the people who know this part of the river think that there's a big waterfall ahead. The fog will not clear until we reach the waterfall if it is there. Maybe it isn't, and maybe we can survive going over it if it is, but I'm voting for taking drastic steps to restart our engine before we find out.