More bailout questions, more sort-of answers

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My attempt to answer a reader’s long list of questions about the bailout has been condensed into an article in the new TIME (with the soup line on the cover). Barbara also has a piece in the magazine about current consumer credit conditions, which is also condensed from something that ran first online. Meanwhile, the magazine also features an all-star lineup of articles on the crisis from Niall Ferguson, Michael Grunwald, Nancy Gibbs, and Dan Kadlec.

In the meantime, the reader with all those questions–her name is Charlene, and she’s from a suburb of Grand Rapids–has some more questions. And so do lots of other people. I don’t think I can possibly answer all of them, but here’s a selection culled from several reader emails. The first two sets are from Charlene:

I think the question in people’s minds, after ‘how did this happen?’, ‘how did it get so bad?’, and ‘will the bailout work?’ is ‘how can such a crisis be prevented from happening again?’

Crises like this have been happening ever since modern financial capitalism arose in the 18th century, so I don’t think they can be entirely prevented. In fact, you could make the argument that this meltdown is so bad because we haven’t had a serious financial shock in so long. That said, I do think the way we’ve organized financial regulation in this country is a mess. We came out of the Depression with a regulatory structure designed to keep each kind of financial institution in a narrow box, within which government dictated what it was allowed to do. When that began to break down in the 1970s, we kept all the boxes, but exempted new kinds of financial institutions and financial products from most of the old rules. Wouldn’t it be better to have a regulatory apparatus that allows for some change and innovation, but subjects the new and the untested to more–not less–oversight than the tried and true? Yeah, I know that’s kind of vague. But it’s something we’re going to be discussing for years, so I should have time to elaborate.

Do you agree that the bailout could or will create a moral hazard? Is the bailout fundamentally contrary to the concepts of ‘free’ markets?

Sure, it creates some moral hazard. But not as much as some critics say. The financial sector is going to shrink dramatically over the next few years, bailout or no. Lots of people will lose their jobs. Lots of shareholders will lose all their money. As for the bailout being contrary to the free market: First, it’s been done before (in the S&L crisis, in the 1930s). Second, free markets need rules. It’s generally best when they’re written up by market participants. But sometimes government can step in and make them better. It’s also capable of stepping in and making them a lot worse, but debt markets are such a mess right now that I just can’t get too worked up about a bit of government intervention.

Who will the Treasury hire to price and purchase these securities? Will the really “smart guys” from Wall street be hired to price these securities and then purchase them from the company they came from?

They will in fact probably hire (or contract with) some “smart guys” from Wall Street. But I’m betting that they’re far more likely to be looking for people from asset management firms like BlackRock and PIMCo–which have not made complete fools of themselves over the past couple of years–than from the banks that so desperately need to sell these securities. I could be wrong on that, though. So we should keep an eye on ’em.

Have you seen any quantitative forecasts of the probability of this plan actually working? Also how much of the $700 billion is the plan estimating to retain?

I haven’t seen any quantitative estimates. Too many variables, I guess. And the guesses as to how much of the $700 billion will be earned back are all over the place. Warren Buffett and former hedge fund manager Andy Kessler have predicted that it will turn a huge profit. Others, such as derivatives expert Janet Tavakoli, are concerned that many mortgage-related securities–particularly collateralized debt obligations–will turn out to be nearly worthless, so if Treasury doesn’t watch out, its losses could be huge.

Where’s the fine print in regards to the plan recouping losses in 5 years from wall street? How will they do this (stock, warrants, cash)?

Treasury is supposed to demand warrants or senior debt in exchange for buying more than $100 million worth of securities from any financial institution, but the law gives it a lot of leeway on how much of a stake to demand. That’s one way to recoup any losses on the securities it buys. The bill also says that if, after five years, the $700 billion hasn’t been earned back, the president is supposed to submit a legislative proposal to recoup the shortfall by charging some sort of fee to the financial industry. Congress can decide not to pass such a proposal, of course, but that seems unlikely. The bigger issue may be that the financial industry will surely raise the money by–you got it–taking it out of customers’ pockets.

I was wondering if you could explain who the winners and losers are if the bailout goes through, if it isn’t too early to tell.

If it meets or exceeds all expectations and the banking system quickly recovers, we’re all winners–but any investor currently buying bank stock or troubled assets wins biggest of all. If financial markets remain troubled, we may come to a situation where Treasury, the Fed and the FDIC have to decide on a mass scale which financial institutions survive and which don’t. Then it’s anybody’s guess who comes out a winner.

As a citizen, I am left wondering, how can the US government afford a $700 billion bailout and pay for not 1 but 2 wars? It doesn’t make sense.

Former Treasury Secretary Larry Summers wrote an interesting column in the FT a few days ago arguing that we shouldn’t worry all that much. For one thing:

Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

For another, he argued, deficit spending in an economic downturn can lessen the severity–and thus the economic cost–of the downturn.

It just all has to be paid for when the downturn is over. That will be a huge challenge over the next decade: Paying down the debt we’ve incurred fighting wars and fending off a depression, while dealing with the potentially far larger looming costs of Medicare and Social Security. Let’s just hope Hank Paulson & Co. make a big profit on that $700 billion investment.