President Bush is addressing the nation tonight about the current financial crisis. He will be selling the $700 billion bailout plan hard. There has already been great concern about this plan from the media, the Congress, and the general public. Much of the attention has been focused on rescuing Wall Street firms, and by extension, their leaders who helped create this mess. The outcry from these parties is missing a much larger, much scarier point, however, to be addressed in a moment.
I am not a fan of what these Wall Street firms have done. In an earlier post, I mentioned that blame for this mess lay at the feet of consumers first (who can’t or won’t save and love spending 110% of their income) and Wall Street second (who never met an investment that they couldn’t repackage into something with a sexy name, and who didn’t fully research mortgage-related products). So Wall Street should by all rights go down. I’ve worked for several of the bigger names, and as smart as they think they are, most didn’t foresee this coming, which means they aren’t that smart after all. They failed to consider counterparty risk, which is really at the heart of this crisis, not a bunch of bad mortgages.
What the President, Treasury Secretary, and Fed Chairman probably will not tell you is that the bailout plan is not meant to bailout Wall Street. It is meant to bailout the entire country from financial catastrophe, potentially far worse than anything seen during the Great Depression. They have to bailout Wall Street and some other large financial entities (like AIG, Fannie Mae, and Freddie Mac) to prevent a very ugly row of dominos, most yet unseen, from falling. Hank Paulson knows that if nothing is done, not only will Wall Street completely fail, but so will most financial companies in general. General Motors, Ford, and all credit card companies would be next up on the chopping block. Any firm with a significant financing arm is at serious risk right now. So is anyone whose business relies primarily on credit. In Paulson’s worst case scenario, over 300 of the Fortune 500 companies would be at or near bankruptcy in under 24 months. Unemployment would move from 6% to over 30% in the same time. Our overseas trading partners would pull out with a great sucking sound almost overnight.
Our entire financial system is based on counterparties making good on contracts. Every so often someone doesn’t make good, and a deal goes sour, and money gets lost and feelings get hurt. But we have never modeled scenarios in which many counterparties are unable to make good at the same time. That is what is happening now. When the credit markets freeze up, no one can trust anyone to make good on anything. Bear Stearns failed because all of its trading partners stopped doing business all at once. They were worried about Bear’s ability to make good on anything, and started demanding cash settlement.
Taking this counterparty idea a step further, there exists a popular security called Credit Default Swaps. You can look up the details on Wikipedia, but in a nutshell, they provide insurance on default of counterparties. If you do a deal with a company, and want to insure that you get paid even if they go under, this is a popular instrument. If they go belly up, you get made whole. Up until last year, they were incredibly cheap, because insurance on healthy companies is very low. Not so now. Many CDS are up 10x or 20x in the last 12 months. Insurance just got way more expensive because companies suddenly got very sick. But here’s the scary thing: Anyone can buy them on nearly any major company. It’s like buying life insurance, but not on you or your family, but on your neighbor, or some random guy in India, or anyone else. So as sick companies make it obvious that they are sick, everyone from around the world piles on and buys a CDS on that company. (Everyone looks for the sickest AIDS patient, so to speak.)
The cumulative notional value of these contracts worldwide is about $62 trillion. That is more than the market value of the entire planet. In a total collapse, much of this would come due, but there would be no one left to pay them off, and no money to pay them off anyway. The collapsed CDS market would wipe out the net worth of most of the big companies in the world. Because of the global economy, all the major overseas firms own these on each other and on US firms, meaning everyone is inexorably linked to everyone else, if not directly, then by no more than one or two links off. Once the dominos start falling quicker, nothing will be able to slow them down. When the companies fall, so will all the jobs. The FDIC will mean nothing, and there will be runs on banks like in the Depression.
Paulson and Bernanke (and now Bush) know this. They are trying to prevent it, but they are running out of tricks. It is for this reason that the bailout package must be passed. I don’t like it any more than you do, but you can’t look at it as bailing out fat cats on Wall Street. Credit and globalization have unintentionally tied everyone to everyone else. When enough dominos fall, everyone else will get dragged down unwillingly. The bailout package will kill the dollar and bury us deeper in debt, but it buys us time to deleverage. The entire country is leveraged to the hilt at every level, from households to companies to governments. In a best case scenario, it will take us years to get past this. Many companies will fail anyway, and the market is going down no matter what. But it won’t go to zero with the bailout package. Time is against us right now, and we need it to be in our favor for a little while.
I am an optimistic guy, but I have looked at this from every angle for months, and I don’t see any really good way out of this. The government has to make some very difficult choices, and very soon. The correct decision will definitely be the lesser of two evils.
I am interested in what others think.