Thursday, October 2, 2008

Bailout Can Work and At No Cost to Taxpayers

While I do think there are better alternatives than the current plan, something is needed. HOWEVER, I absolutely think this plan can help unfreeze the credit markets and recapitalize the financial institutions at a small or no cost to taxpayers. How? Let’s first rewind to see how we got into this mess using a very simple bank I'll call Bank A.


In mid 2007, Bank A was doing well with $100 in assets and $60 in liabilities, thus had equity of $40. Unfortunately all the assets bank A owned were subprime mortgages, which now have a market value of $50. Which means Bank A currently has negative equity of $10 and is insolvent. As such, no other bank will provide lending to Bank A as they will fold with no government intervention. This would be fine (and a natural part of capitalism), except Bank A is intertwined with Banks B, C, D, and E and if Bank A goes bankrupt, all these banks go bankrupt. Thus, credit markets are frozen (i.e. NOBODY can get a loan).

Under the bailout the Treasury buys the assets currently priced at $50 for $90 (I will explain later why this won’t cost taxpayers money), Bank A uses the proceeds to make $90 of loans to small businesses / individuals that need credit (for things such as payroll), Bank A’s equity rebounds to $30, Bank A is now solvent (and other Banks are once again willing to lend them money), and the credit markets are now functional (i.e. if you have decent credit, now you can get a loan - forgot the "old" days of easy money).


Won’t this cost taxpayers money you ask? After all, they did buy assets worth $50 from the bank for $90? Nope... fortunately for the U.S., the Treasury can borrow money on the cheap.

Value of Assets to Bank A
Assuming Bank A's subprime assets pay $4 coupons per year over 8 years and returns the $100 principal in year 8 (I understand this is not how subprime deals work, but lets keep this simple) and requires a return on capital of 15% (bank capital ain’t cheap these days), the assets are worth the $50 shown above (the NPV calculation is shown in the chart below).

Value of Assets to Treasury
However, the Treasury currently has the ability to borrow at less than 4% / year for 10 years (the current yield on the ten year bond is ~3.7%). Assuming the same cash flows as above, but discounting them at 4% per year instead of 15%, the assets are worth $100 (again the NPV is shown below). Lets assume the Treasury pays Bank A $90 for these subprime assets "worth" $100. In this case, it doesn't only not cost taxpayers a cent, but they “receive” $10.

The bailout will not solve all the economic problems we are currently facing. In fact, not even close. We still have a massive amount of leverage in the system that needs to be unwound. However, if this bailout is done right, it should help unfreeze credit markets (which are currently non-functioning) at little or no cost to taxpayers.