A Glance at the Fed Bailout

To all the readers in the northeast, how bout that rain all weekend? Thanks Mother Nature for really driving home the fact that times are tough. She always has a way of doing that. I think she was also warning us about the first Presidential debate. How bad was that? I think a total of zero questions were actually answered. At one point, I went outside and looked at a patch of grass. Yes, I thought watching grass grow was more fun than watching two more politicians avoid directly answering straightforward questions. Speaking of politics, let's talk about this bailout package.

Over the past several months, we have seen many unprecedented things happen on Wall Street. Bear Stearns was on the brink of bankruptcy, so JPMorgan bought the company for next to nothing with the support of the Federal Reserve. We have seen large banks such as Indymac go out of business. As stated in the previous post, Fannie Mae and Freddie Mac were bailed out and are now controlled by the government. Lehman Brothers then began to have problems. At this point, the Fed wanted to try and drive home the point that not everyone is going to get bailed out. So what happened? Lehman filed for bankruptcy. That same weekend, Merrill Lynch was basically forced into a buyout by Bank of America. Wall Street then focused on AIG, the largest insurance company in the world. Unlike Lehman Brothers, the Fed believed that AIG was too big to fail and hence agreed to an $85 billion bailout.

(http://www.federalreserve.gov/newsevents/press/other/20080916a.htm)

On Friday, Washington Mutual was taken over by the FDIC. This happens to be the largest bank failure in American history. Thankfully JPMorgan will be taking control of the WaMu deposits, so the FDIC and taxpayer will not be on the hook for this bailout. Typically only a few of these large events happen each decade. This year, they seem to be happening on a weekly basis. We are truly living through unprecedented times. In summary, a lot of shit has been going down on Wall Street this year.

So what exactly is this $700 billion bailout that Congress will be voting on tomorrow? Nobody really knows the full details of the bailout, but I will try to explain the basics. Before this bailout was proposed, the Fed was basically dealing with large problems on a case by case basis. They helped support the merger of JPMorgan and Bear Stearns and bailed out AIG. On the other hand, they let Lehman Brothers fail. They have come to the realization that the problem is too large and the system too interconnected and complicated to deal with the issues on a case by case basis. Hence the proposal for a huge bailout.

In my previous post, I talked about the mortgages and mortgage related products that are on bank's balance sheets. These mortgages have proven to be very difficult to price and are now very illiquid. The banks are basically stuck with massive mortgage portfolios that they have had to mark down in value and that nobody wants to buy. Recall that if the banks are stuck with these products, they have less capital to lend. That means it is more difficult for individuals and businesses to get loans and that the banks make less money. The $700 billion that the Fed and Treasury are asking for is going to be used to buy these securities from the banks to free up capital for them. The idea is that banks will have more money to lend, hence helping ease the credit crunch we are in. Since the government will become a player in the secondary mortgage market, other investors who have been sitting on the sideline with lots of cash will also start to buy up some of these assets. The main goal is to bring liquidity back into the system.

As stated above, one of the problems with these mortgage portfolios is that the products are very difficult to price. Many banks have aggressively written down these securities. Let's look at a hypothetical example. Let's bring back Greed E. Bank and assume they own one of those fancy shmancy MBS that they purchased at $100. Since the purchase, lots has happened and they have been forced to value the security at $30. The security is still making just as much money as before, but the risks in the market have increased dramatically. Is the security really only worth $30 now even though it is still making the same amount of money? That is the quandry we are in. Either way, Greed E. Bank now has $70 less and other banks are hesitant to lend them money since their mortgage portfolio looks risky and their asset base has dropped significantly. This is a huge problem for the banks. So in comes the Fed. They will buy this MBS from Greed E. Bank at the price that they think is fair. I imagine part of the bailout will include using experts in the industry to help more accurately estimate the fair value of the securities. Let's say they purcase it at $40. Greed E. Bank has now successfully gotten rid of a very illiquid asset and in turn received $10 more than expected. They are happy to have this security off of their balance sheet. The government is also happy because they have purchased this security at a massive discount. If the mortgage market stabilizes, the government and taxpayer will more than likely make a profit. Other banks that hold similar MBS are also happy because they may be able to sell their securities to the government or other investor at a higher value than expected.

With all of the bank failures and issues with the holdings in many bank's portfolios, banks are very hesitant to do business with each other. Did I mention that there is a massive overnight lending market between banks? When you deposit money in a bank, they are allowed to lend out a portion of the money, but not all of it. They are required to have a specific number of reserves to cover their liabilities (your deposits). At the end of the day, some banks are short and some have excess reserves. The banks with excess reserves lend money to those who are short and make interest on this loan that typically lasts overnight. The interest rates on these loans has skyrocketed since banks are hesitant to loan money to each other, even for 1 day. If the Fed comes in and starts buying these illiquid assets from the banks, the idea is that confidence will come back into the system. Everyone knows that confidence is sexy. Banks will be more willing to lend money to each other once these illiquid assets have been sold to the Fed.

In the words of Forest Gump, that's all I have to say about that. I will update the blog as more information on the bailout comes to light this week. Until next time.