12:45 pm
The Margin Call
Is it me, or is the proposed bailout (whether the Paulson plan, the Dodd plan, a hybrid, or another version we don’t know about yet) sound increasingly like a really, really bad idea? I’m getting this queasy feeling in the pit of my stomach, like nobody — not Paulson or Bernanke, not Bush or Dodd or Frank or Shelby, not even McCain or Obama have any freaking clue what to do.
Lindsay Beyerstein over at Majikthise has many of the same doubts I’ve been having.
I’m troubled by the instant bipartisan consensus that the the government must bail out the investment banks. It reminds me of the run-up to the Iraq war when every discussion was framed in terms what should be allowed to happen before we invaded, not whether overthrowing Saddam Hussein could solve anything.
Remember that the Democrats are just as beholden to the financial services sector as the Republicans. It’s not coincidental that the options on the table all involve bailing out these companies. At this point, the Democrats are arguing for a bailout, plus executive pay controls, mortgage-related bankruptcy reforms, and maybe an economic stimulus package.
My question is this: What if the government were to take the $700 billion to $1.5 trillion set aside for the bailout and put that money into programs to help those hardest-hit by the meltdown and Americans in general[?]
For example, progressives often note that pension plans would be decimated without a bailout. If that’s the worry, why not invest in retirement security for our people directly? An extra $700 billion in the Social Security trust fund would cushion a lot of retirements.
These are our tax dollars. We can either invest them for our future, or we can buy a lot of worthless paper to bail out reckless banks. Ultimately, bailouts just set us up for more crises by proving, once again, that the government will cover the losses of big business. Maybe a bailout is necessary, but I troubled that no one seems to be articulating the case explicitly or considering alternative options.
I don’t want this country’s economy to collapse, but do we have any guarantees that the bailout will prevent that? Yesterday we had some indication of what might happen if the bailout does go through — oil had it’s biggest one-day jump ever, gold also went up significantly, and the dollar declined to a level close to its all-time low against the Euro.
If I’m not mistaken, those numbers were not the product not of jitters over a bailout not happening, but rather over fears that a bailout will happen. If we print $1 trillion in new money to fund the Paulson plan (and let’s not kid ourselves, that’s what we’re talking about here), we would seriously cut into the value of the dollar. That in turn means that the price of commodities would skyrocket. In other words, serious inflation.
But if we don’t pursue a bailout, the economy collapses, credit disappears, and, I presume, trillions of dollars of value disappear overnight. That probably will bring on massive deflation, a run on banks, and the biggest economic crisis since the 1930s.
But wouldn’t the latter option at least leave us with the capital to try to restore the system? Wouldn’t that $1 trillion then be available to fix the systemic problems in a way that dropping it into the black hole we’re calling the bailout can’t?
We have no guarantees that the bailout will solve the problems we face. The people telling us it will are the same ones who, six months ago, went on national television and assured people, post-Bear Stearns, that the economy was sound.
I had hoped today to attend a meeting put together by Steve Clemons that is looking at these questions. Unfortunately, some obligations on the consulting side of my life prevented me from doing so. One of the people I wanted to hear was my friend Leo Hindery, one of the smarter guys around on these issues and an economic advisor to the Obama campaign. Yesterday, Steve released a portion of what Leo plans to say today:
As we all know, the Bush administration is asking Congress to let the government buy $700 billion in troubled mortgages, which would raise the statutory limit on the national debt to $11.3 trillion from $10.6 trillion. This $700 billion is over and above the $85 billion already committed to AIG, the $29 billion related to Bear Stearns, and the very conservative $25 billion associated with the bailouts of Fannie Mae and Freddie Mac.
The solutions being proposed are the most expensive combined bailout in the nation’s history and will sharply curtail the ability of the next president to push for tax cuts or new spending. And yet I believe they are not nearly enough, since they do not adequately cover the exposure associated with leveraged loans and, especially, the credit-default swaps market which has ballooned to a nearly unimaginable $45.5 trillion, from $900 billion in 2001.
This credit-default swaps market, which was developed by financiers who hired the best lobbyists they could to keep regulators away, is essentially nothing more than insurance on debt, but because there are now many more credit-default swaps outstanding than there are bonds for them to cover, it could potentially be a black hole of distress at least as large as the sub-prime mortgage crisis. Tens of trillions of dollars ago these swaps became nothing more than a way to gamble with almost no money down.
Leo clearly thinks that $1 trillion is little more than a shot in the dark We’re standing on the edge of a cliff, throwing a rope over the edge, and hoping that it’s long enough to get us to the bottom. But we really have no idea whether that’s true.
About eighteen months ago, I had dinner with Leo, Steve and a few others. I told Leo that, sooner or later, we as a nation were going to face the equivalent of another margin call — some event that would demonstrate just how much trouble we were in. Here’s a good short description of what that meant in 1929:
Margin calls played a role in the Great Depression. Speculators used leverage to play the market. They borrowed money, bought stocks, and put the stocks up as collateral. This only works when the stocks do not lose in value, so their price better go up. If it goes down, the value of the collateral will eventually fall below that of the loan. This is when the bank gets worried and sends you a margin call so that you close the gap.
Sound familiar?
Eighteen months ago I said that something would happen to produce a similar result. I didn’t know what it was going to be — an end to the real estate buble, a collapse of the dollar, another terrorist attack, China calling in its marker — but something was going to catch up with us and we would face real trouble when it did.
I think we’re there. This is our margin call. Not literally, of course, but the impact on the economy is going to be essentially no different from what happened in 1929.
If Paulson and Bernanke are wrong — again — and Hindrey is right, dropping $1 trillion now isn’t going to make a difference. We would still have a meltdown, except we won’t have that $1 trillion available to fix the underlying structural problems that have caused this mess.
In addition, we would have a dollar worth considerably less than it is now. We would still be dependent on foreign oil that now will cost much more than it does now. We would still be stuck paying for a war in Iraq that is in the process of sucking an additional $1 trillion out of the economy. And we have no money to fix all the other problems we face — like a crumbling infrastructure, health care, a failing educational system, and social security and medicare insolvency, to name just four.
In other words, if the bailout fails to prevent the crisis, we would face an even worse scenario than what we do now: massive inflation, a collapsing economy, and no way to fix it. We’re talking Zimbabwe, Argentina, Germany in the 1920s. That way lies madness and most likely dictatorship.
I’m not an economist, but it sure seems like we’re between a rock and a hard place here. Tell me I’m wrong.
Tell me that these guys — the same guys who got us into this mess — know what they’re doing.
Tell me that we’re better off bailing these crooks out than we would be putting the money into saving social security and pension funds, investing in clean energy, fixing our infrastructure, developing a better health care system, and all the other things that are going to fall by the wayside if we use this good money to chase after bad.
Tell me.
I’ll try to believe you.
Photo: via Wikipedia, photo in the public domain
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