The Bailout

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution? 

1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.

2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).

(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)

3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.

4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities,  corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!

I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market.