Bailout III: O! The Complexity!

You just knew the fix was in when the Idiot-in-Chief and his banker made the following statements on August 31:

A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. - Bush

It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. - Bernanke

Now the shoes are dropping. The biggest bank, Citigroup, is conniving with other banks and the U.S. Treasury to invent a $75 billion bailout. I especially like the $75 billion part, because if you read through the "Bailout II" essay on this blog, you'll see that before this thing was announced I had guesstimated the banks' immediate exposure to bad mortgages at $75 billion.

There's no word yet on how much the federal government will kick in, but you can bet it will be involved. How? We don't really know yet, but watch your wallet. And don't even bother objecting. The choice is between a bailout and a full-scale depression. Even if a bailout won't work, they're going to try. They don't have any other choice.

More moving parts than a reticulated python

The federal government has done plenty of financial bailouts. There was the so-called "Plunge Protection Team" that, on Tuesday, Oct. 20, 1987, intervened in the Major Market Index in Chicago. That bailout was led by Alan Greenspan, who used the Federal Reserve to buy stock index futures. It stopped the stock crash dead cold. Greenspan was proclaimed the new Wizard of Oz. The munchkins agreed not to look behind the curtain.

Shortly thereafter, Congress and the Fed bailed out banks, thrifts, and insurance companies to cover up their losses in Latin America and the U.S. commercial real estate market. Iraq was successfully invaded and oil prices fell below $20 a barrel, which helped quite a bit. Later in the '90s, the Fed bailed out the stock market by rescuing a big hedge fund, the hilariously misnamed Long-Term Capital Management. After 9/11, it propped up the U.S. economy with a big influx of new money.

Moral hazard abounded in those bailouts, yet they were relatively simple compared to what's ahead. Although the numbers on this one are just starting to take shape in the mist, I think the earlier rescues will wind up being smaller than what we're facing now. The necessary recipients of bailout money were easier to identify than they will be this time. All of us, including me, are going to be learning some lessons, and paying some prices.

Who holds $9 trillion in mortgages? We do!

Recall some basics from "Bailout II":

• $6 trillion in residential mortgage bonds outstanding, and another $3 trillion in bank-held residential mortgages, secured by about 60 million mortgaged dwelling units that house 150 million or so people.

• One-quarter of the mortgages -- 15 million units with about 40 million people -- are "non-prime," meaning that the loans were made to borrowers who didn't prove their income or who had bad credit.

• In an "optimistic disaster scenario," 20% of the non-prime loans go bad, forcing 3 million foreclosures that displace about 7.5 million people. Mortgage bondholders lose $150 billion, and banks will lose $75 billion. Homeowners lose a few trillion. There's an inflationary recession, and state and local governments have a new round of hard choices to make.
  

Why not just let the banks and bondholders eat the losses? After all, they're the ones who made the stupid loans, right? My inner populist wants to do exactly that, but my outer realist knows it won't happen. Why? Because banks and bondholders aren't aliens from outer space. There are us, whether we know it or not. In a future essay, I'll be hanging more specific numbers out there, but I can say this much: Most bonds, mortgage or otherwise, are owned by pension funds, mutual funds, insurance companies, and banks. And that's where our money is.

If those bonds go bad in a massive way, you'll see retirement funds go bust. You'll see insurance companies unable to pay claims, and raising rates in a major way. You'll see banks failing, which will mean that Federal Deposit Insurance Corp. -- guaranteed by the government -- will have to step in to pay off their depositors.

And that's only the beginning. When banks fail, businesses fail. When insurance companies close, people's hospital bills don't get paid and the hospitals close. Colleges pay a lot of their expenses from endowment funds that -- you guessed it -- hold mortgage bonds. It goes on and on and on. I really wish it was just a bunch of rich people in New York, Boston, Dallas, L.A., and San Francisco who were at risk. Unfortunately, the truth is very different.

Pretty much anyone or anything that has any money at all has mortgage investments, whether they know it or not. Mostly not, for now. Let them fail in a major way, and a whole lot of ordinary people are going to find out just how exposed they are and just how bad things can look. If the federal government can't contain this situation, "I love a surprise" will become an entire country's famous last words.

How do you bail out a whole country?

With great difficulty. If the federal government and the big banks can limit the losses to a few hundred billion dollars, I think they'll be able to pull it off. However, if the hatches aren't as watertight as we've been told, it's another story. It's a bit like the Titanic: As long as the gash wasn't too big, it really was unsinkable. And there was the matter of the watertight compartments, whose barriers stopped well below the deck.

When it comes to the mortgage crisis, the barriers are those loan classifications: prime, alt-a, and sub-prime. For now, we are told that they are entirely separate categories. But are they? As I noted in Bailout II, if things get dicey enough, some of those prime borrowers might start acting like alt-a and sub-prime borrowers. If enough of them do so, the game's over.

Even if a bailout works -- and I certainly have my doubts about that -- there is still the injustice of it all. Yes, we are all the holders of mortgages, but very few of us made the big bucks from writing fraudulent loans and using them to sell phony bonds. Even in an "optimistic disaster scenario" in which the bailout keeps the economy from falling off a cliff, millions of people will lose their houses and millions more will have paid too much to get in and will lose money getting out.

Jobs will be lost, services will be cut, dreams (and more than a few people) will die, lives will be changed for the worse. Even in an optimistic scenario, there's going to be plenty of pain. I think it ought to be spread around, especially to those at the top who concocted and profited from the fraud and irresponsibility that caused it. I'll be writing more about that in the months and years to come.