box of Jack

Karan

The deal to bail out the banks was by no means a blank cheque; the conditions tacked on to it over the last couple of days put in place some restrictions – Executive pay was to be limited, the Govt would get share warrants (i.e. the option to buy new shares in the banks) for every bank which took part, allowing the Govt to participate in price rises when the shares recovered. The intent also was to follow it with tougher regulation in future.

The idea was to restore liquidity and confidence – at the moment, the banks can do little but write down loans which are potentially still good because no one is willing to buy debt. The erosion of a functioning and liquid credit market ultimately means higher lending costs, which means less investment capital for companies, and that’s a precursor to recession.

It’s a domino effect that Paulson and Bernanke are working to avoid; for once, the plan looked half-way sensible, but it appears to have been voted down out of sheer politicism. Not sure what “other options” appear to be on the table when there’s been a total breakdown of trust in the banking industry.

Karan

Absolutely; the initial plan had no checks and balances, and was rightly derided. The legislation that got voted down though had the capital delivered in tranches of $250 billion, $100 billion on application, and then a re-vote on the final $350 billion. I didn’t see the full final legislation, but I hope the clause allowing Paulson free reign without review by courts or legislators was taken out.

The problem is in the funding model of many of the collapsing banks – they lend long-term, and borrow short-term. Lending long term is the only way that makes sense for mortgages, and borrowing short-term makes a lot of sense in a liquid market, as it lets you take advantage of fluctuating rates.

When the credit markets seize up, however, suddenly these banks are stuck – they can’t refinance their loan-book, they can’t afford to pay their staff – they can’t keep doing business. The typical deposit-to-loan ratio is 10-to-1, so they can’t call on deposit reserves for everything.

Their credit rating drops, making it even more difficult to get credit. Counterparty risk rises – other banks don’t trust that they’ll be able to get their money back even at usurious rates. They can’t raise capital because their lower credit rating increases their bankruptcy risk. There’s a vicious cycle that erodes trust among banks first, and then creeps into the rest of the economy.

The problem with the capitalist system is that it’s only interested in the next quarter. Paulson’s idea is to take the money off the books of the banks, restoring liquidity and allowing banks to keep doing business. If mortgage rates stabilise and people pay off their loans, the loans taken off the books of the banks (for less than face-value) show a profit – but only in the long term.

A government-sponsored bailout is not the only solution, but it’s the quickest one.

Jack

And similarly, the problem with the American democratic system is that it’s only interested in the next election. When faced with economic crisis, it’s always more popular to push the problem into the future than it is to solve the problem now.

I understand the domino effect here across all these institutions but I don’t understand how you go from saying ‘no’ to Lehman Brothers to bailing out AIG to asking to bail out the entire market.

Other of my sticking points is that there’s not enough talk of actual people and their mortgages. We should be talking about buying back mortgages and avoiding foreclosure for those that are capable to pay. It’s this bullshit “trickle down” theory that’s helped justify all the tax cuts for the rich over the years.