If anyone still thought that the Wall Street bailout was a good idea, I would hereby like to put that sentiment into some perspective. When the bailout was approved in the house of representatives, Wall Street yawned, already knowing that in the near future it would be able to carry out the strategy that it had had from the very beginning when it started to promote the bailout: to take the money and run. The stock market did not rally after the vote, as anyone who knows anything about Wall Street knew that it would not, and on Monday of this week, it seemed that the stock market was heading for a crash before it recovered. The politicians must be so confused by now, because they were told that this bailout was going to solve everything. What they did not know was that they were being lied to repeatedly. If the Bush years have taught us anything, it is that, sometimes, ridiculous conspiracy theories are true.
The biggest problem with the bailout is that it is wholly inadequate and directed incorrectly. As we all know, these toxic securities are worthless because there is no market for them. Apparently, a lot of people who previously bought them, and even the people who sold them, knew that too back in the day. This is evident because investors bought insurance against losses on them, called credit default swaps. The reason that these products are not called insurance is that that would require…. you guessed it: regulation. It turns out that the companies who sold the toxic securities, like Lehman Brothers and Bear Sterns, also sold insurance against losses on them. In such a case, you can think of it as the extended warranty that you can buy for a new computer.
Now, most of what we have heard as of yet in this financial crisis is how these securities are worthless, and how much of a problem that is for those who own them. What Wall Street is not talking about, and may not be fully aware of, is the fact that, in many cases, that’s someone else’s problem.
Imagine if Dell had sold 100 million computers in the United States in one year. Every one of the customers also bought an extended warranty with their new computer. Then imagine that there is a completely fatal error on the motherboard of every one of the 100 million computers, which makes the whole machine completely unusable after one year. Dell would then have to pay about $100 billion to replace all the computers, which is something that it could obviously never do.
This is a SMALL-SCALE example of what type of problem awaits us with the credit default swaps. The companies who sold both securities and credit default swaps had to buy the swaps from a different company (as if Dell had insured its own computers with Hewlett Packard insurance and vice versa). Nobody knows how much of this insurance money will have to be paid, because the companies who sold the “swaps” do not have to disclose any details about them. However, according to voluntary surveys (which only some companies responded to) there is over 50 TRILLION dollars worth of them. Then count the companies that did not respond, and the companies that were less than truthful about the size, and it is not improbable that the number in reality is close to $100 trillion. Now consider the wisdom in throwing away $700 billion of taxpayer money into this black hole. It turns out that the black hole was insured! I have said it before, and I’ll say it again: banks and Wall Street firms are hiding how many bad assets they actually have. Why would they insure the assets for $100 trillion if there are only $700 billion dollars worth of them in existence???
Very few people know exactly how these insurance policies work. It is plausible, however, that we will see much bigger effects of them when the bailout program actually starts buying the toxic securities. As companies start realizing their losses by selling securities to the government, money will start pouring in from all directions:
1.Taxpayers will have to grossly overpay for the securities (which I will return to another day)
2. Companies can use the loss of the sale to decrease their taxable income
3. The credit default swap mechanism should pay money to the company selling the securities to taxpayers
The third step will be the hardest, because the companies who sold the credit default swaps definitely do not have the money to cover all the losses. They wouldn’t even have been able to cover smaller losses, because they did not keep capital reserves to be able to do so (because they were not regulated). In other words, the companies who sold both securities and credit default swaps will first be flush with taxpayer cash because of the bailout, then go bankrupt because of the swaps. After that, panic will ensue when people realize the magnitude of the problem.
All we can do now is to let it all happen, and pick up the pieces when it's done.