Saturday, April 11, 2009

Why it’s better to bail out borrowers than banks

Posted on Reuters by Felix Salmon:

Justin Fox does us all the favor of asking — again — why we’re bailing out banks rather than borrowers. If I had to give a simple answer, I’d say that it was because the failure of Lehman brothers has shown us that we simply can’t afford not to bail out the banks. If banks’ creditors in general, and their senior unsecured bondholders in particular, are forced to take massive haircuts on their holdings, we could suffer another sickening downward lurch in the fragile credit markets, with nasty knock-on effects for the economy.

But I’m not entirely convinced that the simple answer is necessarily the correct one. I just got a very smart question via email from Liaquat Ahamed, author of the excellent Lords of Finance :

Lehman had a balance sheet of around $800 billion, $30 billion of equity, $120 Billion of unsecured debt and $650 billion of secured debt (repo etc). The secured debt was fine, the unsecured debt got paid out at 20 cents on the dollar and the equity went to zero. Total loss was $100-120 billion.

As I understand it no counterparties in the US lost any significant amounts of money. Counterparties had been worried about Lehman for a while and had collected margin on unrelaized gains on outstanding trades. In the UK there were some losses from the practice of rehypothecation by the prime broker but even here the losses were only in the tens of billions.

The main impact of the Lehman failure was psychological. The Reserve fund broke the buck the next day from losses on Lehman commercial paper but even then the run on money market funds was contained. Everything the Fed then did that week was designed to contain the psychological damage from the Lehman collapse.

I sort of buy the John Taylor idea that it was the failure of Congress to approve Tarp on the first go around that really spooked everyone and raised the specter that the US would not bail out its banking system.

I’d add to this the fact that when Washington Mutual went bust with massive losses for unsecured bondholders, the systemic implications were relatively small: while it’s received opinion that the Lehman bankruptcy was devastating, very few people (other than John Hempton) think that of the WaMu implosion.

Politically, it’s extremely difficult to pass a bill giving hundreds of billions of dollars to people who borrowed money and now find themselves incapable of repaying it. But then again, it’s politically just as difficult to give that money to the banks who lent it, too. And as Steve Waldman notes, the alternative to not bailing people out is basically to force “prudent” investors and savers to take losses instead:

Don’t go all Rick Santelli on me about the injustice of paying for your asshole neighbor’s granite countertop. We are bailing out a banking system that served as a vast criminal conspiracy built around plausible deniability and limited liability. We are bailing out “savers”, who not only demand to be made whole by the government on risky loans they chose to make to banks for profit, but are smugly self-righteous about it, like it’s their “right” because after all they were the “prudent ones”. Of the three groups we might bail out, these crybabies and criminals are no more deserving than some nearly-broke bastard who believed his financial adviser, his banker, his mortgage broker, and the Wall Street Journal op-ed page when they told him that a cash-out refi was as good as money earned, and that granite countertops were a luxury that would pay for themselves. Don’t get me wrong — I’d rather we could bail out no one, just do a rip-off-the-band-aid kind of reset and let everybody take their lumps. But households and firms in debt are by far the most sympathetic villain in this horror show we wake up to every day.

So maybe we should be spending less time on the banks and more time on the borrowers. Yes, bail out the banks — but don’t do it directly; do it indirectly, instead, via the borrowers. Maybe the banks will take slightly more losses that way. Fine. That just means the banks creditors will be more bailed in than they have been to date, and the current market price of the debts will be justified. And at least it will be ordinary Americans getting the government bailout, rather than multi-billion-dollar corporations who utterly failed at their primary job of managing risk.

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