As government officials flounder trying to explain why the most important fiscal maneuver in U.S. history is so necessary, I offer a potential Presidential speech. With footnotes.
I come to you as a President at the end of his term, who suddenly must deal with the largest issue of his Presidency. I have already had the difficult responsibility of leading this nation during other historic crises, and I am aware that the country is quite divided on my legacy and performance. It will be up to history to give the final verdict.
But the current crisis before us now is too large, too immediate, and too catastrophic to be trivialized with partisanship, blame, or scapegoating. If all goes well, there will be time for that later. Senators Obama and McCain have agreed to temporarily suspend their campaign to work within Congress, and they are to be commended for that; but, indeed, they had no choice. If quick, decisive and herculean action is not taken in the next few days, then the country they seek to lead will cease to exist as they know it.
A summary of the events are these:
Financial institutions over the course of decades took on greater and greater leverage in order to maximize their profits.(1)
Simultaneously, every day Americans, in pursuit of the American dream, worked and saved money to buy a house. In recent times-- the past two years-- housing prices had risen so dramatically that many could not afford the house of their dreams-- except for the availability of credit, of low rate mortgages. Some of these mortgages required no money down, an offer too tempting for many trying to put down roots for their families.
As is inevitable, cycles end; and housing prices began to fall. For many, the price of the house fell below their mortgaged amount-- they owed the bank more than the house was worth. In effect, not only could they not afford to live there anymore, but it made some economic sense simply to let the bank foreclose.
Critically, for most Americans who work day to day and live off of their incomes, who have little savings and perhaps even considerable debt, their entire financial wealth is in the value of their homes. Why this should be the case in a nation as prosperous as our own is another matter that will need to be addressed. But it cannot be now; there is no time.
And the two worlds collided. Mortgage defaults meant that financial institutions that relied on those mortgages no longer could count on that money; but worse, they had leveraged and invested that money at 10 times, 20 times.(8) If they lost a dollar, they really lost 20. On paper, with the mortgages essentially valueless, these institutions were bankrupt.
And the spiral continues.
- Lacking even the money to cover their own leverage, they are unable to make new loans, or the loans will come with prohibitively high interest rates.
- So mortgage rates go up, not down; and there will be more defaults. And housing prices fall further, worsening the cycle.
- As property values fall, so too do the property taxes which pay for the schools which educate the community's children.
- No car loans, no school loans. No personal loans.
- No loans to help with medical bills, the chief cause of bankruptcy in this country/
- Small business will be unable to get short or long term loans-- to get mortgages, to pay their leases, to make down payments-- to pay their employees.
- Unemployment rises; economists believe the rate could go as high as 25%.(3)
- More people will default on their credit cards-- how would they be able to pay them? And credit limits would contract dramatically, if not completely vanish. On the one hand people lose their jobs, and on the other hand there is no credit available to tie them over.
- Pensions, 401(k)s, own shares of these financial companies. There are millions of retirees right now, at this moment, who are worrying how they will make it now that their 401(k)s have been cut in half. If we do not provide a bailout plan for these financial institutions now, we will be bailing out millions of retirees later.
Without immediate action, lenders will be too suspicious that borrowers will default; and citizens will be suspicious that their banks, their mutual funds, their 401(k)s, will not be solvent. The credit markets will freeze; banks will fail. Months ago, IndyMac, a small bank, failed. If a larger, well known bank fails-- Wachovia, Washington Mutual, or any number of others-- the public may indeed panic about their own savings. There will be a run on the banks. This is not hyperbole, and I say it again: there will be a run on the banks.
To be clear: this is also a national security threat. We-- both the government and private institutions-- send aid and do business all over the world. All of this is threatened. The crisis has spilled over to many of our European allies, who only months ago worried about possible inflation as their economies grew robustly. But no more. Meanwhile, Iran has announced the end of America, and other countries lie in wait, hoping to pick at the American carcass, at firesale prices.
Perhaps some of you can't believe the crisis is that bad, and are of the opinion that, as with every other crisis this nation has ever faced, we will come out ok, even on top. You believe this because you believe in America.
It's a safe bet, but I remind you that we have overcome these past crises not by waiting, not by debate, but by commitment, action. We have been fortunate that in most cases, the burden has been borne by some who accepted the responsibility, and has not been generalized to everyone; indeed, that is one of the strengths of this nation.
Indeed, Secretary Paulson, Chairman Bernanke, and countless others assured me and the American people that the financial system was sound, that it would recover on its own. Perhaps more aggressive action a year ago could have prevented this. They were wrong, in retrospect. I was wrong.
But this may not be the case now. I have come to you now because I believe that you, the American people need to, and are strong enough to, hear the facts. And it is imperative that all Americans-- including those in the government-- understand that the stakes are real, and are not just high, but ultimate. There is no time to debate blame, history, or social policy. All personal or partisan motives must be set aside.
But we have a plan, a good one, not without drawbacks. But it can be implemented immediately and fine tuned over time. And it is the only plan available to us.
Secretary Paulson has shown considerable leadership on this issue, and it is this country's good fortune to have a former Wall Streeter working now for our side. He understands the complexities of the problem, and has carfted a plan which will likely succeed.
The specifics of the plan are these:
The bailout plan will cost $700 billion dollars, but three things must be understood.
- First, the money will not be spent all at once. It will take months, perhaps years to spend it, a little at a time, as needed. While $700 billion will be budgeted for this crisis, not all of it may actually be spent. (4)
- Second, the money will be used to buy assets, such as mortgages, that no one else wants to buy now. These assets still have considerable value-- just not today, not this week.(2) It is reasonable to assume that at least 70%, if not much more of this money will be recovered as real estate stabilizes. This will be done with warrants, a key requirement of the Democrats, which will assure that the government gets paid first, before the banks. Consequently, the burden to taxpayers may be very small, if indeed there is any. It is entirely likely that the government could realize a profit over the years, though this is not the purpose of the bailout, The U.S. Government is not a hedge fund-- it has more important work to do.
- Third, $700 billion is not just the price of the assets, but the price of confidence. A lesser amount would not convince the American financial system that there is plenty of credit available should they need it-- for an emergency, to conduct business. To know that they can take a calculated risk and begin lending again. Indeed, with the restoration of confidence, with the flowing of the credit markets, troubled financial institutions may-- will likely-- try to raise their own capital to fix their own balance sheet.
Americans want to know how this will be prevented from happening again; indeed, many worry that a government bailout poses moral hazard, only gives license to overleverage again. This will not happen, and part of the long term solution is an entire overhaul of financial regulations, compelling increased transparency and limits on leverage. Congress is highly motivated in this regard as well.
Why would we want to bail out the very bankers and executives who caused this in the first place? In some instances they were complicit in a Ponzi scheme; in some cases they were outright fraudulent. These people will be held accountable, but that is not today.
Punishing the arsonists can only happen after putting out the fire.
It is entirely understandable that Americans want the CEOs responsible for overleveraging, for lack of transparency, and for poor judgment to be punished. Indeed, many of them have been, in the only ways that matter to them. They have lost their jobs, and they have been publicly shamed. The FBI is also investigating certain institutions for improper actions.
Some, like Ron Paul, see this plan bailing out the very institutions which, by the hand of the free market, should fail. Unfortunately, the problem is much larger than just a few institutions-- nearly all institutions will be affected by this. We are not saving the CEO of AIG; we are saving your money, which is in AIG.(6)
Why should you be punished because of the mistakes, or even misdeeds, of others? Should you lose your home, your savings, because some on Wall Street had poor judgment?
The time for blame is later.
Because as I am both the leader and the representative of the people, I will support the overwhelming desire of the American public and not allow CEOs a golden parachute in the government bailout. It is morally outrageous to allow them to be paid more money for leaving than the entire company is now worth.
But our anger has to be temporarily held. There will be time for that later-- there is none for it now.
Many worry that such a plan will lead inevitably to inflation. We are undergoing one of the largest deflationary periods in our nation's history. Money is evaporating from the system; credit is disappearing. People are losing their homes, their personal savings. Businesses are not growing. This plan is replacing the money that has disappeared (5), (7) and, over time, should prevent further deflation while simultaneously checking inflation. The lung has collapsed almost to nothing; the plan is to inflate it enough so that the patient can breathe.
Others scoff at the appearance of socialism, that we are nationalizing the financial institutions. This could not be more wrong; nationalization is what will occur if we do not implement this plan immediately.
I call on Congress to approve this plan. In the past months, there has been much talk about which institutions are too big to fail. In truth, there is only one: the united States of America. And we must do anything necessary to save it.
This is what is at stake.
My fellow Americans, good night, and God bless us all.
1. For every dollar they had in reserve, they would lend out or invest $5. For this leverage they would earn rates of return on the order of 10%; this meant, however, that their actual return on the $1 they actually possessed was quite low; put another way, the only way they could get 10% return on their $1 was to borrow four more to invest.
Every other financial institution, hedge fund and brokerage had to be leveraged in greater and greater amounts, just to keep up. Now, leverage ratios are on the order of ten to twenty times.
2. An analogy might be to owning a Picasso, previously bought for one million dollars. One could try to sell it tonight on Ebay, but in the current climate perhaps no one bids-- so the price never goes above $10. Is the Picasso really worth $10? The bailout plan is to buy the Picasso at $30, and wait.
3. 9/25/08: jobless claims at 493000, the highest level since 9/11. Continuing claims-- 3.542 million-- is the highest since 10/03.
4. Neither does it significantly increase the deficit. As the money will be financing these failing institutions, the budget will show only the interest costs, and any actual losses, if any.
5. Money reinjected into the banking system, by new rules as well as fear, will not be able to leverage it out at 20x as before. e.g. Goldman Sachs, under its new "bank" status, can only leverage 10x, as opposed to the 30x in the past. This is clearly deflationary.
6. Since the governments acquisition of 80% of AIG for $80B, AIG's stock price has doubled. And the terms of the bailout were quite steep for AIG: 2% "gross commitment fee" ($1.7B upfront) and 8.5% interest. This is quite an incentive to raise capital some other way.
7. In July 2007 there was $2.2T in commercial paper; that number is now $1.7T. $500B has disappeared.
8. In 2004 the SEC loosened the leverage restrictions for certain institutions from 12x to up to 40x. Not coincidentally, all of those institutions either are now gone, or in a dramatically different form.
1/16/09 Update: I was wrong. First, the obvious: the TARP passed, and nothing much has changed. Credit spreads aren't as wide, treasuries look like a bubble, but hardly the effect $400B was supposed to have. But the thing that I was most wrong about-- in retrospect, how could I not have assumed this was going to happen-- was that the money wasn't used as it was supposed to be used. Rather than the govt. giving the banks money to lend out, the banks kept it. BAC bought some bank in China, etc. And then BAC implodes further. Yet everyone who works at BAC got paid... a conspiracy theorist might say this is enterprise corruption. Maybe it shouldn't just be conspiracy theorists.