Fundamental Question, What Happens If There Is No Bailout !

[Gardnr]

I'll give one example of the types of questions that I've got: We had one money market fund "break the buck" last week. That was viewed as a catastrophe in the making. I don't see why.

I'm certainly no expert but...

Bank run. There's not enough liquidity to meet the cash demand that would come when "everybody" starts pulling their MM funds out in a panic. The cascading effects would blow things up.

 

[Gardnr]

Seriously if the treasury plan looks like it is going to fail. I am going to significantly raise my physical cash (i.e dead presidents) stash. I am not sure that having money in money markets, or CD is particularly prudent and I am willing to fore go the <2% interest.

Yep, and so would most people. Each of us acts in our own interests. I would too. And that's exactly the kind of reaction that if multiplied by the tens (hundreds?) of millions would cause a complete melt down of the economy. If people lose faith in the monetary system and it's instruments then it will fail. Once people start to panic it will spread like wildfire.

 

[ladelfina]

There was a nice comment in the WSJ the other day "financial markets work only when institutions have faith in each other's abiltiy to meet their obligations."

"nice"? Hmmm. The deeper question is: how long and far can we run on "faith-based" investing? We're about to find out.

This is a very revealing quote, probably unintentionally so. It gives more importance to magical thinking than to reality. There are real underlying values and mechanisms by which an institution might meet its obligations; "faith" may be necessary but may also not be sufficient.

I can have faith that I won't fly up into the air.. but it is gravity that keeps me on the ground, not faith. Stocks will have value when they produce commensurate earnings and dividends. Mortgage securities will have value when home prices are rising or stable, increasing job losses and increasing health costs and commodity price inflation don't impede ability to repay, and fraud hasn't tainted the well. These are just laws, and believing otherwise, bailout or no bailout, will not change the way the universe works.

 

[Helena]

That's the beauty of this bailout - no one knows. If you're against it and block it, and the economy fails, you won't get re-elected. If you're for it, and the economy fails, well you did your best. It's a rigged game.

If you vote for the unpopular bailout, you might not get re-elected.

And, they have set this game up just a few weeks before the election.

I hear two famous senators will not be voting


~

 

[tryan]

I hear two famous senators will not be voting

yeah, just when we need these people to show some kaunas and take a stand (or at LEAST understand the problem and vote accordingly) ... they RUN and HIDE.

 

[youbet]

best buy and wal mart don't have the money to buy up all their inventory for the holiday season so they issue short term bonds via the banks. if the banks fail then people only buy the safest assets. no inventory for the holiday season means a lot of layoffs.

.

I think that in this case, the Chinese will extend Best Buy the necessary credit to take their merchandise and put it on Best Buy shelves for the USA holiday season. IMO, China really can't afford to stop shipping to us.


Additionally, if USA citizens generally slow their consumpiton of this merchandise, it will be for the better in the long run.

 

[Independent]

best buy and wal mart don't have the money to buy up all their inventory for the holiday season so they issue short term bonds via the banks. if the banks fail then people only buy the safest assets. no inventory for the holiday season means a lot of layoffs.

and if the i banks fail a lot of assets will be dumped into the market and prices will fall. interest rates will go up, fear will go up. see above paragraph.

The reason MM funds are getting bailed out is because they finance commercial paper which large corporations use for short-term liquidity needs. We were starting to have a panicked stampede out of MM funds which would have shut down the commercial paper market. Then even solvent companies may have found themselves short on cash . . . not good.

These are slightly different explanations. The second is closer to my understanding. I thought that companies that issue commercial paper sell it directly to the money market funds. Maybe an investment bank acts as a broker, but that's a profitable function that will be bought by someone if the IB fails because it lost money by trading for its own account. I didn't think that IBs were borrowing money so they could buy commercial paper just to hold it in their own accounts.

Companies like commercial paper because it has a slightly lower interest rate than a commercial bank loan (or a longer term bond). Savers like MM funds because they have slightly higher rates than bank checking/savings accounts. The reason the rates are better is that the MMF doesn't have the reserve requirements of a regulated bank. Both the companies and the savers are taking a risk to get their better deals. IMO, from time to time they have to actually lose some money to remind them there's no free lunch.

If we have a stampede out of MM funds, the money has to go somewhere. It seems to me that it goes to commercial banks. They have a sudden inflow of cash and can now make additional loans to the companies that aren't able to sell their commercial paper. There's some friction involved in the switch and some companies don't get as much money as they wanted. This will lead to a few layoffs, which contributes to a recession. But I don't see "complete melt down of the system". In fact, I see the system being healthier in the long term because everyone gets reminded of some risk/reward fundamentals.

Maybe the problem is that I figure a recession is inevitable following the housing binge. I'm fine with the gov't trying to head off a depression, but a recession seems like a lesser evil than trying to have the gov't bail everyone out of their risky decisions.

 

[Art G]

and leave it to Congress to gum up the works...

http://www.washingtontimes.com/news/2008/sep/23/student-car-debt-quietly-added/

 

[al_bundy]

These are slightly different explanations. The second is closer to my understanding. I thought that companies that issue commercial paper sell it directly to the money market funds. Maybe an investment bank acts as a broker, but that's a profitable function that will be bought by someone if the IB fails because it lost money by trading for its own account. I didn't think that IBs were borrowing money so they could buy commercial paper just to hold it in their own accounts.

Companies like commercial paper because it has a slightly lower interest rate than a commercial bank loan (or a longer term bond). Savers like MM funds because they have slightly higher rates than bank checking/savings accounts. The reason the rates are better is that the MMF doesn't have the reserve requirements of a regulated bank. Both the companies and the savers are taking a risk to get their better deals. IMO, from time to time they have to actually lose some money to remind them there's no free lunch.

If we have a stampede out of MM funds, the money has to go somewhere. It seems to me that it goes to commercial banks. They have a sudden inflow of cash and can now make additional loans to the companies that aren't able to sell their commercial paper. There's some friction involved in the switch and some companies don't get as much money as they wanted. This will lead to a few layoffs, which contributes to a recession. But I don't see "complete melt down of the system". In fact, I see the system being healthier in the long term because everyone gets reminded of some risk/reward fundamentals.

Maybe the problem is that I figure a recession is inevitable following the housing binge. I'm fine with the gov't trying to head off a depression, but a recession seems like a lesser evil than trying to have the gov't bail everyone out of their risky decisions.

the problem is perceived risk, same thing when worldcom and enron went belly up. the TED spread and all the other indicators went crazy because everyone stopped trusting everyone else because no one trusted the public financial info. everyone went into bunker mode and conserved cash and didn't lend it to anyone.

same thing happened last week. people started pulling money out of MM's because everyone believes it's as safe as cash and the details don't matter. what matters is the effect it has which is no short term lending and the possiblity of MM's going belly up which is even worse. If the Fed allowed the risk part to happen and MMs to go belly up it would have been very bad.

imagine the only people getting credit are only those with 800 or higher FICO's? fortune 500 corporations would have cash problems because everyone relies on short term financing for working capital. there is a formula i learned in finance classes that is used to figure this out, but i can't remember it. you can figure out a company's working capital requirements from it's public investor documents.

if you look at your average fortune 500 company the bonds usually yield around 4%. the way the libor was last week that might double. now imagine if the government allowed things to go on and institutions to keep on failing. at the minimum it could have been a recession like 1980 with 10% unemployment.

the meltdown comes from the fact that everyone is linked to everyone else via credit default swaps. rumor is that the bear stearns bailout was really a JP Morgan Chase bailout because Chase had around $80 trillion of CDS's with bear stearns. once institutions like AIG fail everyone calls in their IOU's via CDS's and forces everyone into bankruptcy as no one can pay up and each BK will cause more BK's down the line.

Then you have the problem with the Federal Reserve stretching it's balance sheet with all the junk they took on over the last year from the banks. this bailout will go forward because it's as much a Federal Reserve bailout as wall street. no one has the money to pay the Fed back for the loans they made over the last year and this is how it's going to work out.

i bet if you add up all the lending facilities over the last year it will add up to around $700 billion. and you can't seriously say we should let the Federal Reserve fail? Last time we got rid of a central bank it turned into a 20 some year depression, a war with mexico, and hatred between the states that later turned into the civil war.

 

[Running_Man]

the problem is perceived risk, same thing when worldcom and enron went belly up. the TED spread and all the other indicators went crazy because everyone stopped trusting everyone else because no one trusted the public financial info. everyone went into bunker mode and conserved cash and didn't lend it to anyone.

same thing happened last week. people started pulling money out of MM's because everyone believes it's as safe as cash and the details don't matter. what matters is the effect it has which is no short term lending and the possiblity of MM's going belly up which is even worse. If the Fed allowed the risk part to happen and MMs to go belly up it would have been very bad.

imagine the only people getting credit are only those with 800 or higher FICO's? fortune 500 corporations would have cash problems because everyone relies on short term financing for working capital. there is a formula i learned in finance classes that is used to figure this out, but i can't remember it. you can figure out a company's working capital requirements from it's public investor documents.

if you look at your average fortune 500 company the bonds usually yield around 4%. the way the libor was last week that might double. now imagine if the government allowed things to go on and institutions to keep on failing. at the minimum it could have been a recession like 1980 with 10% unemployment.

the meltdown comes from the fact that everyone is linked to everyone else via credit default swaps. rumor is that the bear stearns bailout was really a JP Morgan Chase bailout because Chase had around $80 trillion of CDS's with bear stearns. once institutions like AIG fail everyone calls in their IOU's via CDS's and forces everyone into bankruptcy as no one can pay up and each BK will cause more BK's down the line.

Then you have the problem with the Federal Reserve stretching it's balance sheet with all the junk they took on over the last year from the banks. this bailout will go forward because it's as much a Federal Reserve bailout as wall street. no one has the money to pay the Fed back for the loans they made over the last year and this is how it's going to work out.

i bet if you add up all the lending facilities over the last year it will add up to around $700 billion. and you can't seriously say we should let the Federal Reserve fail? Last time we got rid of a central bank it turned into a 20 some year depression, a war with mexico, and hatred between the states that later turned into the civil war.

The whole logic is convoluted. Who will bail out the US after it bails out the Fed when the US government continues to prop up an unstable pyramid of debt? The idea that this 700 billion will solve the problem is wholly unknown and unlikely if home price continue to decline. We built a debt pyramid supported by 5 percent of homeowners who had no financial recources to buy the homes they wanted. Transferring the loss to the US government was probably inevitable but by no means a solution, any more than all the Fed actions of the past year.

18 months ago when I set up my signature I noted the problems the housing was called and look where the highway has led to this point. We are literally burning down the house.

 

[al_bundy]

Our total debt is not that bad compared to GDP and most other countries in the world.

compared to the initial RTC estimates in 1990, $700 billion in 2008 dollars is pocket change. back then the deficit was a lot higher as a percentage of GDP.

RTC wasn't a magical fix either. Back then Citi almost went belly up in 1994 and home prices were flat for most of the decade with a lot of 1987-1990 buyers being upside down until 2000 or so.

the goal is to make any downturn controlled and gradual so that asset prices don't go in crazy directions very fast.

 

[FIREd]

I think the bailout is unpopular with people because they haven't suffered enough themselves. So far a few fat cats got run over by a bus, big deal! But wait until unemployment explodes, incomes fall, people's 401Ks plummet, retirees start eating cat food, and shanty towns start burgeoning all over, and I bet you that you'll start to see people clamoring for congress' mercy... We will spend that $700B, it's just a matter of time. But the more we wait, the harder it will be to avoid some severe damage to our economy. History shows that in similar crises, inaction or belated action by the government has always resulted in deep and prolonged recessions.

I hope people have been studying how the Scandinavians handled their own credit crisis in the 1990's. It was eerily similar to ours. The root causes were a real estate bubble coupled with loose lending practices which resulted in a financial market crisis... Sounds familiar? At one point, interest rates spiked to 500% in Sweden. Unemployment shot up to almost 20% in Finland. Scandinavian governments intervened swiftly and decidedly to stabilize the markets using a scheme not unlike the one proposed by Paulson. There were massive nationalizations of banks and financial institutions. It is said that, in the end, the Swedish government actually managed to make a profit out of the bailout. But economists generally credit the swift government action for the relatively "quick" recovery of Nordic economies. The government bailout did not have an immediate impact on the economy however. Scandinavian countries still went through 3-5 years of a deep, nasty recession before things started to improve. In Japan, the government waited many years before intervening and I think it is pretty safe to say that Japan has still not recovered from the 1989 crisis. And, after reading about it, I think that the great depression in the US was probably caused by an unwillingness for the government to step in at the onset of the crisis, and then the government's decision to step in much later with sweeping reforms and programs that just made the situation worse.

 

[ladelfina]

What political brinksmanship disallows a rational-sounding appeal like yours, FIREdreamer, from coming out of Bush's mouth, or Paulson's?? Or from any congressional leader so far?

(I heard Obama answered some questions on the economy and need to find a video link to that.. at least he is out there and not "sequestered")

It appears that the Rs in particular are blocked from saying the "R" word.. much less the "D" word.

That being so.. I'm still not convinced that the ills you describe won't come to pass all the same in the US, though I will study the Scandinavians as you suggest. Don't forget in all this that they have much stronger social safety nets (esp. universal health care) and less income inequality.. Whatever their ills, I wonder whether an extreme dog-eat-dog scenario was ever going to be in the cards (shantytowns and cat food.. tho' I hear the Scandinavians eat some pretty alarming fish products as a matter of course).

 

[socca]

I hope people have been studying how the Scandinavians handled their own credit crisis in the 1990's. It was eerily similar to ours. ... Scandinavian governments intervened swiftly and decidedly to stabilize the markets using a scheme not unlike the one proposed by Paulson. There were massive nationalizations of banks and financial institutions.

I seriously doubt that the Scandinavian crisis was similar to ours. Do you have a good primary reference from an unbiased source (this does not include Fox News )? Also, Paulson is not proposing a massive nationalization of U.S. banks and financial institutions. In Paulson's plan, the U.S. gov't (i.e. the taxpayer) gets no ownership stake in the companies bailed out.

 

[FIREd]

That's the thing ladelfina, all the ills I described will probably come to pass anyways. There are already reports of people living in tents on the outskirts of many large cities, people are already seeing their 401Ks dwindle, and unemployment is already on the rise. It will probably get worse in the short term no matter what congress does. As I said, the early government intervention in Scandinavia did not prevent a deep recession that ultimately hurt people. But what it did, was to make for a speedier recovery.

 

[FIREd]

I seriously doubt that the Scandinavian crisis was similar to ours. Do you have a good primary reference from an unbiased source (this does not include Fox News )? Also, Paulson is not proposing a massive nationalization of U.S. banks and financial institutions. In Paulson's plan, the U.S. gov't (i.e. the taxpayer) gets no ownership stake in the companies bailed out.

My original source was Bloomberg. Do your own research. I don't do Fox News. And I said the plan was "not unlike" paulson's, I did not say it was identical.

Oh and by the way is it a coincidence that the Scandinavians are on a "lecture tour" in the US to explain how they handled the crisis back in the 90's? I think not...

 

[OAG]

I am itching to buy my neighbors $400K Ferrari for $20K (Cash) when he has to sell it to eat post-collapse.

 

[ladelfina]

Wondering why someone can't come out with an explanation is also Krugman:

The two striking things about the Paulson push since last Friday have been (1) demands for complete discretion, with zero accountability and (2) a complete refusal to explain the theory of the case — to explain why this thing is supposed to work, so that we can have an open discussion of whether he’s right.

The trust problem - Paul Krugman - Op-Ed Columnist - New York Times Blog

 

[tmm99]

Someone posted this link on diehards.org forum...

10/26/98 JAPAN'S BANK BAILOUT: PAINKILLER OR REAL REFORM? (int'l edition)

This is what Japan did in 1998 and it sounds like what US is *thinking* of doing now...

History should not repeat itself if we all know the dire consequences.......?

 

[Independent]

the problem is perceived risk, same thing when worldcom and enron went belly up. the TED spread and all the other indicators went crazy because everyone stopped trusting everyone else because no one trusted the public financial info. everyone went into bunker mode and conserved cash and didn't lend it to anyone.

same thing happened last week. people started pulling money out of MM's because everyone believes it's as safe as cash and the details don't matter. what matters is the effect it has which is no short term lending and the possiblity of MM's going belly up which is even worse. If the Fed allowed the risk part to happen and MMs to go belly up it would have been very bad.

imagine the only people getting credit are only those with 800 or higher FICO's? fortune 500 corporations would have cash problems because everyone relies on short term financing for working capital. there is a formula i learned in finance classes that is used to figure this out, but i can't remember it. you can figure out a company's working capital requirements from it's public investor documents.

if you look at your average fortune 500 company the bonds usually yield around 4%. the way the libor was last week that might double. now imagine if the government allowed things to go on and institutions to keep on failing. at the minimum it could have been a recession like 1980 with 10% unemployment.

the meltdown comes from the fact that everyone is linked to everyone else via credit default swaps. rumor is that the bear stearns bailout was really a JP Morgan Chase bailout because Chase had around $80 trillion of CDS's with bear stearns. once institutions like AIG fail everyone calls in their IOU's via CDS's and forces everyone into bankruptcy as no one can pay up and each BK will cause more BK's down the line.

Then you have the problem with the Federal Reserve stretching it's balance sheet with all the junk they took on over the last year from the banks. this bailout will go forward because it's as much a Federal Reserve bailout as wall street. no one has the money to pay the Fed back for the loans they made over the last year and this is how it's going to work out.

i bet if you add up all the lending facilities over the last year it will add up to around $700 billion. and you can't seriously say we should let the Federal Reserve fail? Last time we got rid of a central bank it turned into a 20 some year depression, a war with mexico, and hatred between the states that later turned into the civil war.

(My bold) I don't think that "everyone" relies on short term financing. See this, for example: www.latimes.com/technology/la-fi-microsoft23-2008sep23,0,1847736.story?track=rss You can look at public documents and figure out how much working capital a firm had in the past, and see if the curent amount is high or low relative its history, but I don't think there's a formula that tells you what they "should" have.

I'm picking on this point because it's a good example of choices. Businesses make a choice on how much leverage they are going to use, and how much of the debt will be short term. Firms that use lots of short term debt will show better profits in good times and worse in bad. An occaisional "credit crunch" keeps people from going overboard. The firms that emphasized equity ride out the storm and expand at the expense of those that were heavy with debt. Our root problem may well be that we've had good times for businesses with low interest rates for a long time, so perceptions of "safe" levels of debt have become pretty high.

I understand that when things go bad people get conservative and try to build cash. This effectively shrinks the money supply and the Fed should do something to offset it.

Theoretically, it's possible that so many firms are so highly leveraged that there would be a chain reaction of bankruptcies. That worries me more than Money Market funds. I'm questioning whether we're in that situation. Are most firms really that dependent on that much debt? or are we at a point where some highly leveraged firms are going to fail while the others endure a bump in the road? The problem is that the "experts" who should know those answers seem to be the same people who will profit from the bailout. I'm not sure if we're getting an impartial analysis. I haven't seen a poll of the academic "experts", but I happened to hear one "free market fan" last night who says we shouldn't panic (see Meltzer at: www.pbs.org/newshour/bb/business/july-dec08/bailouttalk_09-23.html

(I'm not worried about the Fed - it owns the printing presses.)

I notice that Lehman seems to be finding buyers for its parts. Merrill and GS are doing painful things that don't involve bankruptcy. I hope we find out soon if most of the pieces of AIG turn out to be sellable.

I can remember the 10% unemployment rate in the 80's. It wasn't a good thing, but it was the cost of squeezing decades of inflationary psychology out of the system. In the long run, it seems to have been worth it. I hope we don't get that high this time (I've got a family with jobs on the line, and the US has more economic inequality now then we did then.), but maybe it's time to squeeze the "it doesn't matter how much you borrow" psychology out of the system.

 

[FIREd]

Someone posted this link on diehards.org forum...

10/26/98 JAPAN'S BANK BAILOUT: PAINKILLER OR REAL REFORM? (int'l edition)

This is what Japan did in 1998 and it sounds like what US is *thinking* of doing now...

History should not repeat itself if we all know the dire consequences.......?

Off course, in the case of Japan, the patient had been in the ER for 9 years before they finally decided to give him a "morphine injection".

And I think that Paulson has made it abundantly clear that his bailout plan is just a morphine injection. Real reforms will have to follow. On its own, the bailout plan won't cure the problem. But it might stabilize the financial system enough so that we have time to treat the real, underlying problems. At least that's my understanding.

 

[Gone4Good]

If we have a stampede out of MM funds, the money has to go somewhere. It seems to me that it goes to commercial banks.

So out of the frying pan and into the fire? You take your money out of a MM fund because you think it might fail and put it in a commercial bank that might fail? Sure you have FDIC insurance, but only up to $100K. I don't have a statistic about the composition of MM deposits, but I strongly suspect a very high percentage of total deposits are in accounts that exceed FDIC insurance limits.

Also the "friction" in moving from a predominately market based financing system back to a commercial bank lending model is huge. Right now banks aren't lending. And even if they got a good fraction of the MM withdrawals back in deposits, it would take a long while for them to turn around and lend that money back out.

Sure over the "long-term" we'd adjust but people forget how long the long-term can be . . . we came out of the Great Depression too, over the long-term.

 

[Gone4Good]

"nice"? Hmmm. The deeper question is: how long and far can we run on "faith-based" investing? We're about to find out.

It's called "fiat currency" and I'm afraid you're going to have to get used to it.

 

[Gone4Good]

Someone posted this link on diehards.org forum...

10/26/98 JAPAN'S BANK BAILOUT: PAINKILLER OR REAL REFORM? (int'l edition)

This is what Japan did in 1998 and it sounds like what US is *thinking* of doing now...

History should not repeat itself if we all know the dire consequences.......?

My understanding of Japan's situation is that many banks continued to hold bad loans at face value (never wrote them down). The banks appeared solvent, but really weren't. They wouldn't die, but couldn't lend and became known as Zombie banks. They plagued Japan for years.

Our banks are very rapidly writing down assets (some suggest too much, others aren't so sure). In either case, Paulson's plan will result in banks selling assets for far below their face value. But once the assets are sold the banks can hopefully move forward as more normalized (non-zombie) institutions.

 

[samclem]

Sure you have FDIC insurance, but only up to $100K.

I'm not sure why people keep saying this. An individual can have an unlimited amount of money in FDIC-insured accounts, this limit is 100K per registration-type per bank. So, a couple could have $300K in a single bank (his, hers, theirs) and do the same thing at as many banks as necessary.

Just open accounts in multiple banks, it's as easy as that.