Financial Crisis #2: What the government can do about it.

Government

We left off noting that there is a mass of illiquid assets on the books of various banks and mortgage institutions. These assets are not worthless, but they are not tradable. This leaves these banks and mortgage companies without enough capital to invest and make a profit. If the banks could sell these securities even for a significant loss, they would be able to write it off and remain solvent. As it is, those banks that were most exposed find themselves dragged down by this mass of immovable assets on their books.

The Bailout

This is where the government can step in. The problem is a lack of buyers for these securities. The government provides that buyer. The bailout package proposes to spend 700b to 1t dollars to purchase these securities from the banks. The banks would take a loss on this transaction but it would free up a portion of that illiquid capital to be reinvested. This should allow the financial organs that were most exposed to persist.

Effectively the treasury would then become the owner of about $1t worth of home mortgages. It should be noted that the government isn't exactly "spending" money to bail out the banks. Hypothetically some of these mortgages will be paid so the securities that were created on top of the "bad loans" should retain some value. It's not impossible to think that a decent chunk of the money that the government might make available might make its way back to the treasury eventually. As such we have no idea how much a bail out would actually cost in the long term. Suffice to say a lot, but it should be significantly less than $1 trillion.

Why would the government assume the risk on these illiquid securities? Because the consolidation of mortgage companies and banks have made them too big to allow to fail. This is the government's own doing. The subsidies and preference given to lenders giving cheap loans to buy houses by both parties made it easier for someone to buy a home, but also made the home mortgage business so big that if it were to fail the loss of capital would cause a panic that would have drastic consequences on the entire economy.

So this week we're likely to see some sort of bailout come out of the congress that authorizes the treasury to buy the illiquid securities and administer them until they hopefully can be liquidated later. The details of this plan are being worked out in congress now. Until there is an announcement of exactly what congress will do the markets will be racked with uncertainty and will likely continue their retreat. Until stocks are secure, investors who do have capital are going to hold it in commodities as a guard against both dropping stock prices and inflation.

Problems

The problem with this bailout is government debt and inflation. The only way for the government to raise the $1t of capital required for this is to borrow it or print it. No doubt they'll do both. This is particularly bad timing for the US economy because the inflationary pressures of having 2% or lower interest rates for almost a decade is starting to be seen. While the treasury is reporting inflation at a rate of around 5% most independent organs place it somewhere nearer 10%. This bailout is gong to make that even worse.

Inflation is a real killer of wealth. We're dealing with a circumstance where people's savings are in jeopardy and businesses will be unable to make new investments because the previous revenues no longer cover the new costs at the new prices. I'm not rightly sure there's anything that can be done about this in the short term. The investment sector really is too big to fail. However, the economic policy going forward is going to be very touchy. I've not yet thought, read or learned about it enough to prescribe anything yet... but I'm confident in saying that we're going to have to raise interest rates, and soon. Or risk a real inflation trap.

More tomorrow on how this effects the presidential race.