Treasury plan to bail out banks

September 19, 2008

We do not yet have the details of Treasury’s plan. With respect to its effectiveness, if they do plan to buy most the troubled paper from banks, there’s one crucial question that must be answered, as Benjamin Graham would say, how much? This is crucial, because it’s even now not impossible to find buyers for CDO’s and ABS; as long as the seller is satisfied with a price in the order of 10-20 cents on the dollar, such paper can be disposed off. But such a disposal doesn’t ease the problem, as it will only cause further writedowns for the capital-constrained institutions, contracting credit further.


We must wait to see what the details of the Treasury’s proposal are. There is a suggestion that the purchases will be at market prices – such a choice would be accepted by very few of the troubled banks.


The goverment is faced with an extremely difficult situation. I have written before that the psychological pressures, the disasters that an uncontrolled unwinding of today’s problems can create, do not allow policymakers much calm or peace as they formulate their responses. The speed at which they modified their vision, in a few days, from no bailout for AIG, to a general bailout for the entire banking industry, demonstrates the lack of direction and calm at the highest levels. 


There’s no justification for blaming the government for all that is unfolding, the heavier part of which, in my opinion, lies with Alan Greenspan, and the private sector. But the lack of a unified vision, the ad-hoc nature of the solutions, are likely to complicate the developments.


The markets are delighted at the Treasury’s announcement, and as I wrote on 16th September, we do have euphoria now. On the other hand, a deeper analysis shows that there’s no reason to expect that taking out CDO’s and some ABS will necessarily clear bank’s balance sheets. The problem is not a housing industry crisis anymore, it’s the collapse of the triangle of high debt, high leverage, and overspending that has been fueling growth and bubbles during the course of more than a decade. Of course, if we had not had the direction change in August 2007, the build up could have continued indefinitely.  But now that the direction has reversed, rising unemployment, collapse in confidence, and continued bankruptcies show that this structural disease needs more than a financial solution, and more than a few quarters, in order to be eradicated. In that sense, if the Treasury’s remedy had been applied 6-8 months ago, I believe that there would have been a very high chance of success; now however, with almost every source of credit and financing constricted or shutdown, the problem is not only banking sector losses or failures, but failures and bankruptcies on a universal level. As far as I’m concerned, this will probably prevent the Treasury’s plan from succeeding.


Eventually, the government has the means to defuse this crisis, but at a cost. By issuing more debt, the government is capable of paying off every household and bank’s delinquent debt, but the cost will almost certainly be high inflation. And what does high inflation mean? It means general turmoil and continued crises in emerging markets, which are the only pillar on which the limping world economy is leaning at the moment.









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