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Betting on the Bailout

How much you want to bet the sky's not really falling?

By Stephen Rose, Ph.D.

October 2, 2008

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Experts have convinced many leaders of the dire consequences if the financial mess is allowed to unravel more. Is this Chicken Little or an accurate forecast of what lies ahead?

In essence, the current crisis is based on not knowing what assets are worth. There is universal agreement that the immediate cause of the crisis is a large number of high-risk loans that the current owners are no longer able to afford.

Banks thought that they were protected because they could recoup most if not all of their loans by foreclosing and reselling the property. When the housing price bubble burst, banks were unable to get back as much as they anticipated. The best estimate is that the loss from these bad loans is somewhere between one-half and one trillion dollars.

While this is a lot of money, the problem is compounded by the fact that these loans were packaged into mortgage-based securities that were sold to all sorts of investors and financial institutions. These securities were bought with lots of borrowed money and were “protected” by insurance-type financial instruments (credit default swaps).

This arrangement means that it is very hard to know how much losses are embedded in each security and how much the insurance contracts will be forced to pay out. The effect of the losses is magnified because the investments were “leveraged” with debt. Consequently, in the last nine months, there has been a steady stream of announcements from financial institutions announcing “write-downs” on the value of their assets.

As the losses have mounted, the confidence in all of these instruments has plummeted — who knows what you are getting? Consequently the prices have gone way down. In many cases, there is no effective market because sellers aren’t willing to part with assets for only pennies on the dollar. It is this uncertainty that has magnified the effect of the losses and made the crisis what it is today.

What now?

The second type of uncertainty involves what we should do now. Are all the warnings of dire consequences Chicken Little or an accurate forecast of what lies ahead?

We don’t know.

It is eminently reasonable to argue that the steps that we have taken so far will lead to more disruptions whose effects will only lead to a typical recession.

It is also reasonable that doing nothing will make things worse but that we can wait and act later without substantially changing the long term course of the economy.

Finally, it is also reasonable that waiting will make the crisis much worse. The federal government has a lot of resources to deploy, but there is a limit of how much it can do.

The argument to act now is based on two principles: this is a rolling train wreck that can be stopped now with a $700 billion plan; and if the train wreck is not stopped now, we won’t be able to stop it later and the consequences will be severe.

There are certainly are signs that credit markets are tightening. To date, the effects of this tightening have been small. A key question is whether it is about to contract so much that normal business will be severely affected.

In simple terms, the issue is: will the unemployment rate go up slowly to 7-8 percent? Will the unemployment shoot up to 12 percent if we don’t act now? Or will the unemployment jump to levels approaching 20 percent because the negative snowballing of bad events will lead to multiple rounds of business closings and layoffs.

While few analysts believe that the last scenario will happen, the motivation behind the actions of Bush, Paulson, Bernanke, McCain, and Obama is based on the second scenario. More precisely, they don’t want to roll the dice and take the chance that the second scenario will occur.

The high-flying, highly paid financial experts got us into this crisis, but they can’t get us out of it. For better or worse, finance is necessary for smooth economic functioning, and we have chosen to let the financial reins remain in private hands.

The expanded Paulson play is based on buying up lots of assets to restore confidence and trust back into the market. Some Democrats have proposed a “bottom-up” approach that would help the homeowners pay their loans. While laudable, this is a slow moving option that will not affect the trust in credit markets in the near term. Some conservative Republicans want to create an insurance system for the financial institutions funded by payments from the companies themselves. While this tax increase on business is a surprise gambit from Republicans, the financial industry is not in position to pay enough taxes now to make a dent in the problem.

The question before us is very simple: how much risk of a prolonged downturn with a double digit unemployment rates are we willing to take? Personally, I think that the downside risk is too great to not act now.

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Dr. Stephen Rose is the principal at Rose Economic Consulting and is writing a book on changing social conditions (Mythonomics: Ten Things That You Think That You Know About The Economy That Are Wrong). This article was originally published by STATS, a nonprofit, nonpartisan research organization affiliated with the George Mason University.

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