Think Flat

Balaji,
Very nice and concise article. I have a few points to add to your view point:
- It is very interesting to note the timing of this Bail Out plan. One conspiracy theory points fingers at federal govt. as well as the role of bigwigs of Wall St. to achieve multiple objectives at one go.
- Conversion of Goldman and MS to bank holding companies just before the Bail Out was a very well coordinated move. Poor Lehman?

I believe the big money moving to the Wall St will help in stemming the crisis to some extent. Will this be enough?? No one knows!!

Dear Balaji,
This is an intersting article on economic slumping which provides the details from experts in a concise manner.
I seriously feel bail out plan targeted on infusion of funds directly into banks will further destabilise the economy in the long run. After all you are adding a burden to the taxpayers which is not affordable at any cost rather than placing of funds in a separate corpus fund and buying out of assets from this bank may turn unprofitable in near future by terms of capital appreciation and interest recovered which can be equalled towards the bail out money.

Dear Bala,

Nice article. My two cents.

What is the most significant event that has thawed up the credit markets ? This question must be dispassionately answered to understand the solution and effectiveness of the solution proposed.

I will make a simplistic effort; let's look at a couple of data points,

a) Bankruptcy of Bear & Lehman
Bear Stearns was saved from insolvency, as JPMorgan stood behind Bears liability with a Fed loan. Credit market spreads climbed up, but the market didn’t freeze.

Come the autumn, Lehman went down and the interest rate spreads just shot through the roof. Though Lehman filed for bankruptcy, I believe it was insolvent (Lehman bond got 8 cents a dollar in auctions).

b) Commercial Paper market.
After Lehman went down, the $1.5 trillion outstanding credit in the commercial paper market (both assets backed and unsecured) has not frozen up, of course for the coupons participants have to pay they will find Shark loan more kind.

For full dis-closure the outstanding commercial paper volumes have gone down by around $200 billion USD.

Fear of Counter-Party Insolvency Vs Lack of Liquidity(when Solvent) ?
This shows liquidity is available for the participants (it makes it easier, if you are not a financial entity) with the right credit rating and willingness to pay a higher coupon; but interbank lending just froze up after Lehman went insolvent.

This throws up the question, why has inter-bank lending just frozen up, after an insolvency ? I would argue it is the fear of counterparty insolvency; of course once the threshold trigger is reached each will start feeding the other and the inevitable downward spiral starts.

Trying to understand the solutions
Any solution to be effective must address to reduce the Fear of Counterparty Insolvency .

With the first draft of the plan Mr.Henry Paulson was trying to take out the fear of insolvency, by buying up toxic assets in the balance sheet of US banks. I think would be the most effective way to thaw up the inter-bank lending market.

How to make it operational and what are the risks ?
Though I trust it is the most effective intervention, the operational question on How to price the toxic assets, and from whom(all) to purchase? In the worst case scenario tax payer losing a lot is very high and it is not politically pragmatic to go down that lane.

Version 2.0 of US Bill
With version two of the plan the Fed is injecting capital, through preferred equity that brings an assured return and some management control. This solution allows banks (atleast some of them) to start lending again without requiring them to raise capital, however this doesn’t take away the toxic assets on the balance sheet.

Of course we know we can’t value these assets well enough and this will allow the Fear of Insolvency to remain albeit at a lower level.

Problem on my side of the Pond is different
I think though US , European ( and Global) markets are linked, the problem in Europe is quite different. It is the toxic assets in the balance sheet of the US banks (created by securitization ) that could make them in-solvent; where as in Europe the problem is drying up of short term credit market that has threatened to bring down other-wise solvent banks.

Let's take the example of UK,

After the bail-out announcement three (five in all) big banks have taken up the capital injection, these are solvent banks with very strong assets in their balance sheet. However their problem is loan to debt ratio is above 1 and hence require short term borrowing to keep the show running.

Surprise Surprise, nearly 1/3 of all outstanding commercial paper in US (both asset backed and unsecured) are with European financial institution. When they mature, I am sure they will not be re-financed, not at least in the near future.

Here is a case of solvent banks that have liquidity problem, because of the huge asset base they have built up in the balance sheet.

Hence the solution proposed by the UK government, I think is spot on for the problem in Europe.

Hindsight is such a lovely thing, but I believe the US will calibrate and come up with the model that suits it well.

PS : I am not a trained Finance person, and the analysis make be incorrect.

Great post, and with regards to the tangle we need to keep in mind that the bailout package still allows the banks to pay dividends to stockholders and on large debts. How this will pan out is anyone's guess, but the risk exists that the bailout will allow shareholders to protect capital with taxpayer's money.

Dear Balaji,
Excellent and concise post on the bail out plan. Though I prefer free market capitalism philosophy with self regulating markets, in the current context where there is a severe crunch on credit due to the locked in toxic assets of Banks, short term stimulus by US treasury to infuse funds into the banks would help avoid the credit freeze.

Well! We can keep discussing about the options and action taken but I am still searching for one answer. Lehman CEO helped me when he put it on record during his testimony with Congress,"until the day they put me in the ground, I will wonder why AIG was rescued and Lehman not."

It was very clear that free market created this mess but it was no way able to solve it on its own. So, what are the options left? All the SWFs and PE Funds kept a surprising distance from putting money in US Banks. It has to be government. And I feel UK led the way here. Mr. Gordon's approach was more sensible than what Mr. Bush administration had suggested. If taxpayer's money is on line, the government (protector of Taxpayer's Money) has to take control of the organizations otherwise who knows what these wise men will do next?

How can you assume that price of an asset keeps rising indefinitely and keep betting on it. If a market can't understand it, then it raises serious questions on the wisdom of the market.