Saturday, September 27, 2008

Real reason for the Paulson bailout proposal?

NPR had an interesting analysis of the possible motivation for the bailout proposal (sorry, can't find the link), which was based on what happened in the money market space when Lehman went under. I know I'll do a poor job summarizing, so if you want more info, google around a bit.

Basically, when Lehman went under, there was a minor run on money market accounts; something like $80 billion was pulled out in one day. Now, money markets buy short term commercial paper, like what companies issue to fund daily operations until they can liquidate their assets to cover it. When Lehman went under, some money market funds "broke the buck", and that caused a massive withdraw.

Now, if you're a financial institution running a money market fund, and you get massive redemptions, your money isn't liquid (it's in short term commercial paper, or bonds, or other lending), so you need to borrow in the same manner. However, on that day there was no money to borrow, so basically the system froze for about 12 hours until people could redeem enough debts to pay out the money. Scary situation for the financial industry and the government; if it happens for days, the country basically shuts down.

Now, this got me thinking... don't we have a mechanism to front short-term cash to banks to prevent this kind of liquidity crisis? Why yes, it turns out we do: it's called the Federal Reserve. They have about a trillion dollars of cash, and they are supposed to front it to banks to cover withdraws while the banks liquidate positions, thus ensuring that this kind of thing doesn't happen. It's pretty much the main reason that the Fed exists. So what happened?

Well, it turns out the Fed has been lending out their cash to the banks already for toilet paper securities as collateral, basically to keep them alive long after they would have perished in a free market. As a result, the Fed doesn't have much currency left to lend out, so they can't do their job. Basically, their market manipulation and funneling money to the banks has put them in a position where they cannot help the market when it's really needed, and are not going to be able to recover without unwinding all their junk loans (which, of course, would cause the insolvent banks to get their due, which the Fed is trying to prevent at all costs).

So basically, as far as I can tell, the Paulson plan exists solely to have the taxpayers buy the toilet paper from the banks which is currently being held by the Fed, so the Fed can get its cash back, and actually be able to prevent the entire credit system in the financial markets from grinding to a halt the next time there's a revelation about the real state of the system. They view it as essential because the Fed can't back out of the mess they have created for themselves without collapsing all the insolvent banks, and they can't save the market if the banks collapse because they have exchanged all their cash which they were entrusted with for that purpose with toilet paper securities from the insolvent banks. Way to go, solid plan that was.

The sad part is, when presented like that, you can see where the government comes to the conclusion that this must be done, even though it's insane to 99% of the people in the country. A much better solution would have been to stop the Fed months ago from creating this situation, if not abolish the organization as a whole; but that would have taken intelligence and political fortitude, attributes which are currently in short supply amongst our politicians. For reference, I still don't think it's a good idea to pass the payoff plan, but given the current situation at the Fed, I'd have a backup plan ready to go if it doesn't pass, and it sure as hell should incorporate some measures to prevent the Federal Reserve from creating another credit crisis with their ridiculously irresponsible policies.

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