There seems to be a concerted effort to get Republicans on board with the bailout by claiming that it will actually be a profitable investment for the government.
Think about this. The troubled assets purchased by the Treasury right now are likely to be very under-priced because of the chaotic and frozen market conditions. But over time, through monthly cash-flow payments or through loan sales, taxpayers will get all their money back and in great likelihood a handsome profit.Now, I'm no economist, but this strikes me as borderline violating-the-rules-of-physics speculation.
Surely, if the "toxic assets" in question were a good deal at the price the banks are willing to sell them at to the government, the banks would just hold on to them instead. Right? Please tell me if there is some reason the banks would knowingly sell assets for less than their actual value.
It's not like the government is going to be more effective at collecting on bad debts than the banks... maybe the bailout should consist of giving debt collection agencies the money to buy the bad loans - at least they might do something productive with them.
Maybe I should just shut up and start working on my perpetual motion machine to submit for funding from Obama's "energy independence" initiative.
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Is there some reason the banks would knowingly sell assets for less than their actual value? Yes. For a bank, the most valuable asset is people's trust that it will be able to meet its financial obligations, and they'll be willing to lose some money to meet those obligations.
Imagine a bank that has $100B in deposits and is owed $120B. Imagine it has $2.2B in cash to maintain operating expenses. Imagine that it typically gets $1B a day in new deposits, $1B in withdrawals, $1.2 in loan repayments, and gives $1.2B in new loans expecting to get back more than $1.2B. Obviously, I'm just making these numbers up. Normally, if one day, it gets fewer deposits than expected, it'll just borrow money at the end of the day from another bank so that it can maintain its $2.2B in cash to be prepared for the next day. (This is why there's a LIBOR, which has been in the news lately.) The bank can expect that it'll get more deposits the next day to make up for the shortfall the previous day, and then pay off the overnight loan (at an interest rate lower than it lends to regular people so that both it and the bank that lent to it make a profit). If not, and the bank gets fewer deposits the next day it can again take out another over-night loan, and decide that on the third day, it'll cut back on new loans, so that it's no longer losing money, can pay off its overnight loans, and start making money on the debts which it is owed.
Without being able to get such overnight loans, the bank would be unable to do business on the second day, people would hear that branches weren't able to honour requests for withdrawals by depositers. All the depositers, including the ones that would not otherwise have made a withdrawal, would run from branch to branch trying to get whatever money they could out, and the bank would go bankrupt.
[Of course, now people don't really use physical cash that much, so there's this problem for both physical money and electronic, notional money. I'm not sure how it exactly works, but I think it's something like that if a bank has a huge pile of proper, electronic money, not just outstanding loans or something else, then the federal reserve will literally fly out helicopters of cash in exchange for that electronic money, so that when some small town columnist writes about the idea of a run on the bank, and everyone panics, the small town's bank branch has enough physical money to back up it's deposits -true story! Apparently the columnist then got a call from the fed chairman asking him not to do that again.]
Now imagine that some economic problem caused the shortfall in deposits or loans repayments, so that all the banks are looking for a loan. Again, I'm a bit fuzzy here, but my understanding is that this is where the 'federal reserve overnight window' comes in, since it will be willing to make the overnight loans needed to keep the banks functioning in the morning, and stopping many of them from going bankrupt. In the last year, the central banks have been increasing the amount of money available to this system (and its siblings in other countries have done similarly), since the banking system has been needing bigger overnight loans.
[The central banks also impose reserve requirements, in which the banks maintain significantly more money just the amount they need for the next day, so that's it doesn't need to constantly be saving them from crisis.]
Now imagine that the first bank in my example suffers a shortfall in loan repayments instead of a shortfall in deposits. On the first day, it's exactly the same as with the the shortfall in deposits, in that the bank can hope the next day will be back to normal, and it'll be able to pay off on overnight loan. If the trend continues for a few days, it will need to reduce its loans. Imagine that much of the shortfall is coming from people who are falling behind on their loans, but who will pay, with interest, eventually. In essence, the bank is being forced here to make loans that it doesn't want to. Rather than making these forced loans, the bank would rather sell the right to collect these delinquent loans to another bank. Here, the bank is selling the loans for less than it will collect from them since it needs the money now. Similarly, it might sell off perfectly good loans at an amount equal to the value it expects to collect minus some fraction of the interest rate on its overnight loans. This would profit both the buyer and the seller, since the bank selling no longer has to pay back interest on the overnight loans and immediately gets back the money it expected to collect in cash. It's good for the bank which buys because it gets to effectively make a new loan at a higher rate than normal -since it's getting the regular revenue from the loan at a price which is lower than the standard price, because of the fraction of the LIBOR which was subtracted off. Because of an immediate shortfall in its cash flow, the first bank has to lose some of its long term profits, and the second bank effectively makes an extra profitable, long-term loan.
Now imagine that, as we're seeing now, all the banks are facing a problem involving a shortfall in loan repayments, so that none of them want to buy them from each other. This case could be really terrible, since, once the banks go bankrupt, there's no credit available for the general economy, and many people would lose their deposits. The federal reserve could make longer-term loans at a higher interest rate, accepting the banks' outstanding loans as collateral instead of the more secure cash it normal accepts, which it has already started to do. It could also decide to buy up some of the banks' outstanding loans, thus allowing the banks to solve their short-term cash flow problem and the federal reserve to profit, over the long term, in the way that other banks would normally.
Sure, in theory, the federal reserve could profit, in the long-term, from a major bail-out of the banks.
Now imagine that the big banks are skillful enough to sell failing loans for more than they are worth, or that the federal reserve is willing to give money to the banks and accept worthless loans because it's worried that the banking system may collapse and bring the rest of the economy with it, or that both are true. In this case, the federal reserve simply spends its bail-out money to make sure the banks do better. At least the worst abuses should be stopped by the new equity clause, giving the federal reserve partial ownership of companies accepting bail-out money.
Holy house of cards, Batman!
Thanks Pieter; as you can see, I haven't reached the "banking system" portion of Basic Economics yet (as if there is anything basic about this...).
I presume that the Federal Reserve sets the maximum accepted leverage on bank assets? And by guaranteeing loans on daily shortfalls they can be sure that the official limit will be used, regardless of whether it is safe.
Based on your description, this problem sounds fairly self correcting. If the Reserve continues to make the daily loans, but at higher interest rates, and also mandates reduced leverage on assets, it seems like after a couple weeks the system would be working again, but with a slightly higher interest rate spread.
I can't believe that I forgot to say this earlier: Like the invasion of Iraq, the Wall Street bail-out will pay for itself.
(In answer to your question, yes, the Federal Reserve sets the reserve requirement/ maximum leverage rate. Many people are saying that a relaxation of this requirement (to 30 to 1) was a major factor in the current problem. The Federal Reserve normally doesn't want to interfere in the market, so it sets its overnight interest higher than other rates. Normally, this means banks will borrow from each other, rather than turning to the Federal Reserve. Last year, when these problems were first starting to appear, although the Federal Reserve (and its international cousins) increased the amount of money available for the overnight window to convince investors that there'd be enough money for the banks, at that time, the banks didn't want to take it, since by taking higher interest loans, they'd be admitting they were weak. Over course, now that the crisis is so much more severe, they're much more desperate for money.)
LIBOR is the London InterBank Offered Rate, not overnight rate as I'd previously thought. It contains many rates, including but not only, overnight rates. Otherwise, I think what I wrote before remains correct.
http://www.lrb.co.uk/v30/n18/mack01_.html
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