by rdf
Sun Jan 18th, 2009 at 01:01:12 PM EST
With all the talk of "toxic" assets no one ever asks where the money has gone. I'm going to lay out an oversimplified scenario and hope this will explain why the bailout plan won't help the general public.
Even thought I think housing was a small part of the problem, I'll use this since it is easy to visualize. A similar story can be told about commodities, and counterparty insurance schemes. The difference being that nothing tangible is behind these transactions.
Joe Homebuyer buys a house that costs $200,000 and puts in $10,000. The bank lends him the rest which he uses to payoff the prior owner in full. The bank had to get the money to lend so it either uses deposits, or, more frequently lately, issued bonds to the public. The "public" in this case was most frequently mutual funds, pension funds and other allegedly prudent investors.
The score at the end of round 1:
Prior owner - $200,000.
Joe - 1 house, -$10,000 in cash, $190,000 in new debt.
The bank - a claim on one house, $190,000 in "assets"
The bond holders - $190,000 in bonds and a promise of interest and eventual repayment
The "public" - their retirement funds $190,000 via the bond holders
Now the price of the home declines and the homeowner gets foreclosed. Suppose the bank can resell the house for $100K.
The score at the end of round 2:
Prior owner - unchanged
Joe - no house, -$10,000 in cash, liability for unpaid debt $90,000
The bank - $100,000 in cash from the foreclosure sale, a bad debt of $90,000
The bond holders - $190,000 of bonds, worth really $100,000, impaired interest stream
The "public" - retirement funds worth $100,000 although they may not know it (yet)
At this point the story can go two ways. Let's take the case where the homeowner goes bust. He will never repay the $90,000
The score at the end of round 3a:
Prior owner - unchanged
Joe - no house, -$10,000 in cash, no debt, no assets
The bank - $100,000 in cash, a permanent write down of $90,000
The bond holders - $100,000 real worth in bonds, impaired interest stream
The "public" - a retirement fund now worth $100,000
$90,000 has permanently "vanished" and it is never coming back. Even if the house goes up in value sometime in the future that will only benefit the new owner, not Joe, nor the bank, nor the bond holders.
Another possibility is that Joe enters into some sort of adjustment with the bank and promises to pay back the lost $90,000 (although it is usually only a faction of this).
The score at the end of round 3b:
Prior owner- unchanged
Joe - no house, $10,000 in cash, paying $90,000 out of future earnings "forever".
The bank - $100,000 in cash, a revenue stream to recover the missing $90,000 spread over many years.
The bond holders - $100,000 real worth in bonds (maturity value is less important than current prospects), slightly less impaired interest stream
The "public" - a retirement fund worth $100,000 with lower income for the foreseeable future
Now the "public" is not all saving for retirement, some are already retired and expecting the investments to yield the promised return and to be available to redeem at the issued price. Their income is now impaired in either step 3 scenario. The money has "vanished" from their savings.
The bailout is trying to shift as much as possible from 3a to 3b, on the theory that getting your money back later is better than not getting it back at all. But this can only be partially successful. The home is not going to appreciate in the near future and even if it does it doesn't help Joe or the bank. Joe paying off the debt will lower economic activity for decades to come since he can't use his earnings for new purchases but must turn it over to the bank, which in turn has to set it aside to repay the bond holders.
Making the process go slowly may avoid a panic and the need for some to sell even on more distressed conditions, but the money is not really going to come back.
So "toxic" assets, aren't toxic, they are worthless (or worth less, if you prefer). Whether these assets are held by the bank, the government or sold off to new speculators makes no difference. Their value is permanently diminished.
One of the ideas was for the government to buy these as if they were still worth their original value. This would help the banks, the bond holders and the "public". But in order to do this the government would need to print money to pay for them. Printing money lowers the value of all the existing money. This is the inflation that no one wants to talk about. So the permanent losses get spread over the entire population as their savings become worth less. Usually banks don't like inflation since they get paid back on their loans with watered money. But in this case get the full value now and avoiding bankruptcy is seen as a good gamble compared to the risk of inflation later. In fact since the are selling the "toxic" assets to the government, they aren't even the lenders anymore.
This plan was killed off because it was too expensive, no one could determine which assets should be covered, and how they should be priced. It may resurface if things keep getting worse, however.
Currently there is another plan being promoted - to have the banks suspend the interest on the bonds that they have issued. The idea is that since the income stream from Joe doesn't exist or is impaired then they can't really afford to keep up the payments. They must be getting the money to do so from the bailout, and why should the government pay interest to the bondholders? Of course the bondholders are really us, in our retirement funds so stopping the interest payments will lower the value of these bonds even further, force mutual funds to dump them and cut income available for payouts. (Technically most of the talk has been about preferred stocks, many of which permit suspending dividends, but even so if this happens there are implications for the firm, usually restrictions on raising new funds and sometimes the requirement to add stockholders to the board). It isn't greedy bankers, but investors that will be harmed just like all the other scenarios. This one will just unfold faster.
So what's the bottom line: In every scenario the ultimate losers are the public. Their retirement funds are diminished and/or their buying power will decline in the future due to the issuance of excessive new money.
Is there any way out besides the public taking the hit? No, and the fact that the politicians won't discuss this shows whose side they really are on - the banks.
