“To Bailout or Not To Bailout, That is the Question”

Scott Beesley, Economics Instructor, University of Alberta,

Edmonton, Alberta, Canada September 26, 2008

I believe Mr. Paulson’s suggested bailout is nothing more than blackmail on a truly
grand scale. The claim is that the U.S. will have a banking panic, followed by something
approaching the Great Depression, if the proposed scheme is not passed, and quickly.
There is no moral justification for spending perhaps $1 trillion in taxpayer’s money,
which will either be borrowed or printed, to save the behinds of a group of
overwhelmingly high-income investors who will be burned otherwise by losses on
mortgage-backed bonds. Similarly, with respect to the loans that are held by banks
themselves, taxpayers should not have to bail out bank shareholders or debt holders
because the banks lent money like idiots.
The only government obligation, the only morally fair policy, and the best
macroeconomic policy is to have the government pay out deposit insurance only, under
the current limits and rules. That system pays $100,000 per depositor, per bank, and
$250,000 per institution on some retirement accounts.
If the U.S. government were to give up on this corrupt and ill-conceived plan today,
and announce that deposit insurance was the only amount that taxpayers would
guarantee, what would occur? I provide below a table that represents my predictions as to
the likely consequences of not bailing out the wealthy, via their banks and hedge funds.
Notice that many articles refer to this as a mortgage bailout, as if it was directly
assisting those who are having trouble paying for houses they could never really afford.
That would be unfairly subsidizing people who bought well beyond their means, and
speculators, at the expense of taxpayers. That would still be wrong, in my view, as well
as stupid macro policy, but it would make the package more palatable to the public. BUT
what is proposed is even worse – it purports to have the government buy mortgage-
backed bonds for far more than they are likely to be worth (over time), and have the
public eat the difference.
Who do you think holds these bonds? How many people in society are wealthy
enough to have invested $100,000 to millions in such securities? The top 5 or 10 percent
of the population, as ranked by wealth or income, owns most of the money in such
instruments. Why should average taxpayers cover their losses? This is, as I said earlier,
blackmail. There will be losses in pension funds, both directly as holders of mortgage-
backed securities, and indirectly as shareholders of banks, etc., but I do not believe that
justifies this giveaway.
The $700 billion figure, as many have noted, is not an upper limit on the amount
taxpayers must supposedly spend to buy this junk. It is a cap on the amount outstanding
at any one time. Thus, if the government buys bonds for $100 million and then resells
them later for $65 million, another $65 million is freed up to overpay for more shaky
bonds. That is why I referred to a total public outlay of perhaps a trillion above.
American citizens will be very lucky if, in the long term, they get back half of that trillion
dollars.
The fear mongering claim of Paulson (and Bernanke, who ought to know better as a
student of the Depression) is that in the absence of the big giveaway, there will be a
“To Bailout or Not to Bailout”

banking panic. Lines in the street, rioting, a dead economy, and all that fun stuff. This is a
complete crock. Imagine the government announcing that the only public funding will be
to cover deposit insurance, as of that instant. From that time onward any withdrawal
would count towards that person’s limit. There would be no reason to run to the bank and
grab your cash (though some people would anyway, and the Fed would have to be ready
with excess currency). If you have less than $100,000 in the bank (in each bank,
perhaps), then your deposits are safe. In fact, not only are they safe, but their real value
will increase in the deflation that would accompany this course of action. If you have
more than $100,000, the excess is lost, and that is regrettable, but not tragic. All of this of
course only occurs in the case of banks that fail, and most will not.
It is also certain that most wealthy depositors have already spread their money out
over many institutions, meaning their losses could be small or zero. If they literally have
far too much to park it in bank deposits, and lose some in other falling-value investments,
that is the risk part of risk vs. return that “unconstrained free-market” advocates love to
blather about. I cannot see why a janitor in Peoria should send money to a hedge fund
investor in San Francisco or New York, because that investor lost on a very dicey bet.
Another factor is the sheer nerve of the present lame-duck government in suggesting,
at the end of a miserable term, that the public commit to the greatest single peacetime
expenditure in history - with that money directed overwhelmingly to the friends and
financiers of the Republican Party.
There is the well-discussed moral hazard issue as well. We can hardly expect Wall
Street to rein in its lies, tax evasions, lobbying, excessive compensation, etc., and then
perhaps even move to a multi-year pay scheme (refer to Dr. Stiglitz), if they get away
with this round of thievery.
It has also been pointed out that many of the executives who created this orgy of
lending have taken home compensation in the tens and hundreds of millions. Many were
paid based on the volume of their unit’s business, or the gain in value of the assets they
managed, or the value of the transactions they carried out. All those valuations were
pumped to the sky by the credit bubble, and many are now falling like rocks. The
investors who bought bank shares, or some bought-out company, or whatever, have been
suffering huge losses. Yet the dollars that were granted to these individuals are gone, and
as Springsteen sang, “They ain’t comin’ back.”

The financiers in question, therefore, have already inadvertently or deliberately stolen

a decade of extremely high incomes from investors in the aggregate. They are also
investors themselves, of course, and some will suffer large losses if their own bank,
investment bank, hedge fund etc. goes under. So what? That is the risk in capitalism, or
should be! Thus it is particularly brassy of them to not only keep the ill-gotten, obscene
compensation of the last few years, but to demand that the public minimize their personal
losses by bailing out their funds and firms.
The taxpayer would not get off scot-free in the absence of the Paulson theft, I mean,
bailout. I am not claiming that at all. If the bailout does not occur, house prices,
mortgage-backed security prices, and other asset prices will all fall further, down to the
level they should have been at all along (relative to incomes and rents and so on). They
have been hanging at current levels precisely because the industry has been lobbying for

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“To Bailout or Not to Bailout”

and getting case-by-case bailouts, and hoping for the big giveaway that Paulson is now
after.
Without the bailout, it is true that more banks will become insolvent. There would be a
second wave of jingle mail as house price declines drive more people to walk away from
their mortgages. (More are coming in any case because the adjustable-rate mortgage
resets are going to continue through 2009 and beyond.) There would be a consolidation in
the industry, which will occur even with a bailout, and there is certainly not enough
money in the FDIC to cover the deposit insurance payouts that will be necessary. It is
only a guess, but perhaps that would put taxpayers on the hook for $100 - $200 billion,
rather than double or triple that range. The scope of it depends on what fraction of overall
mortgage losses remains on the books of banks, as opposed to having been palmed off on
outside investors.
The economy will not be pretty in either case. I think the U.S. is looking at the “Great
Recession,” much worse than in, say, 1981, but nowhere near the Great Depression as far
as human suffering is concerned. I am certain that the no-bailout plan suggested herein
would lead to a quicker recovery, and far less family misery, than Paulson’s money grab.
It avoids the gross inequity of transferring money from the bottom and middle of the
income scale to the top. That inequity was bad enough already with the Bush tax cuts, but
the bailout would be truly immoral.
Paying only deposit insurance also has the desirable macroeconomic effect of leaving
spending power in the hands of those who will use it, thus helping to keep the economy
moving. It is a truism that the government should provide crisis assistance to those at the
bottom of the income scale, both for obvious moral reasons and because that group has
the highest marginal propensity to consume.
The process I am suggesting would have to be done as quickly as possible. Banks
would have to seriously negotiate the sale of foreclosed properties, getting those houses
out of limbo and into the hands of those who can live in them or rent them out. Rents
would fall, providing great assistance to a huge and vulnerable piece of the population.
Young singles and couples who have been completely priced out of the housing
market would finally get their chance to buy at a fair price. In a cautious way, they would
begin to furnish and improve their new homes, as always occurs when people become
owners. There would be a period of rapid turnover, as the second wave of foreclosures
occurs, and houses move to new owners at much lower prices.

When banks go under, it is not as if their buildings and computers and staff disappear.
There will be layoffs and consolidation, but the industry will not vanish. The stronger
banks will take over the assets of the dead, leaving bank common and preferred
shareholders with nothing. Again, I do not think that is a particular problem. The
remaining banks will have adequate capital, and will be able to lend again, using much
more conservative metrics. I do not see that as a problem either. It can hardly be argued
that the U.S. needs to somehow encourage & finance the creation of many more houses
and cars, when there is already a glut of both!
One argument for the bailout is that it would be immoral for the United States to shaft
the foreign investors who hold such huge amounts in mortgage-backed securities. First, I
would argue that they will take big losses, even under the bailout, as the U.S. dollar turns
into a wisp of its former self. Second, as some have suggested, there could be a bailout of

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“To Bailout or Not to Bailout”

foreign investors only, in which they are partially made good on their losses. (There
would be frantic attempts by Wall Street to relabel domestic holdings as foreign, but that
can be countered.) Note that in a no-bailout situation, the fall in U.S. housing and other
asset prices would lead to a strengthening of the currency, as investors would buy houses,
firms, sound bonds, etc. in large volumes. That seems to me like the least the U.S. could
do for those who have financed the trade and budget deficits, since they have already
taken a big hit on the dollar in the last few years.
Imagine that foreign and domestic investors refuse to lend the U.S. the money
necessary for the bailout, at prevailing low interest rates. One result could be a more
sudden run on the dollar, possible technical bankruptcy, and an emergency rise in interest
rates. That would cause a chaotic decline in asset and bond prices, bank runs, etc., i.e. all
the things the bailout is supposedly designed to avoid.

I think it is worth repeating that this blackmail/bailout is being sold, frequently, as a

“mortgage bailout.” I think that is to make people believe that the government will help
struggling homeowners directly. But the plan is to buy up mortgage-backed bonds from
investors, paying them more than the true market value, and buy mortgages from shaky
banks, again recapitalizing them by paying more than market value. Then, as the new
mortgage holder, the government could indeed turn around and forgive some of the
principal owed by the homeowners, but that is a secondary goal. Even though that sounds
kind of the government, it would still imply a big transfer from responsible taxpayers to
those who went out on a limb and bought at crazy prices. Many of those are speculators.
There is still no justification for such transfers.

I encourage the reader to find the comments of the many economists and experts more
qualified than myself to address this issue. Articles by Yves Smith and Luigi Zingales are
particularly recommended. For other related articles, try patrick.net.

The table that follows is my fast attempt to predict the steps and consequences
involved in the event of the Paulson bailout/robbery, and in the event of a “deposit
insurance only” scenario. I call that the Chapter 11/no bailout scenario, as many banks
would enter that process, as suggested by Zingales (above).

I am an economist and economics instructor at the University of Alberta in Edmonton,

Alberta, Canada. I write as one who grew up on the U.S. border in British Columbia, and
travelled through Washington on a bicycle as a teenager. I like Americans and know they
are Canada’s greatest friend. I hope that this crisis comes to a fast and fair resolution, for
the good of all Americans and the world economy as a whole.

Good luck to everyone over the next five years – I am afraid we will need it no matter
how the financial questions are answered.

J. Scott Beesley Page 4 9/26/2008

 “To Bailout or Not to Bailout”

Variable or Factor With the Paulson Bailout With Chapter 11 workouts

or Group (but no mass bailout)
Wealthy MBS Holders Given free money No free money to this group
Paying for others' investment losses, perhaps $500
Taxpayers Paying for the deposit insurance outlays, much lower ($200 B?)
billion gone
Younger people Paying for decades Paying less, and for a shorter period
Losses now on mortgage-backed bonds, and on deposits over the
Old people Bailed out now
FDIC limits
A deflationary period as house prices fall to where they should
Inflation Very high inflation
have been all along
Strengthens as U.S. house and asset prices fall and outside money
U.S. dollar Falls, possibly much further
buys back in
Some losses, but taxpayers making a good part of it Could let them take investment losses, as investors in risky things
Foreign creditors
up for them should, OR could bail out foreign creditors only
Foreign creditors Repaid in less valuable dollars Larger nominal losses, but paid off in a stronger currency
All their existing dollar holdings lose real value Existing holdings increase in real value (the least the U.S. can do
Foreign creditors
because of the reflating of the bubble after what has happened to the dollar lately)
Relatively easier to find funding for the FDIC
Foreign creditors Could refuse to fund the bailout
(to pay out at the limits)
Falling to natural equilibrium at traditional price to income and
House prices Propped back up again
price to rent ratios
Young couple with
savings, but never able Completely ripped off by the bailout. Prices remain Hurrah! Prices finally drop to a level where such couples and
to buy a house during elevated or get even higher as newly printed money singles can buy a house from foreclosure and revitalize
the bubble (or smart flies around. Real value of their savings gone neighborhoods. Their savings have value
enough not to)
Flat or rising, thus lower-income renters, especially Houses circulated back into the hands of couples who will add
Rents without inflation-protected wages, would be in rental suites, or landlords who will be able to offer decent rents,
tough having bought at much lower prices
Nominal rates go higher, as investors demand Nominal rates fall somewhat, to very low levels, however
Interest rates
enough to cover inflation plus some real return. deflation implies that real interest remains positive (see below)

Rates also driven up, perhaps, by foreign investors That is, if you hold money that returns 0.5% for three months, but
Interest rates
who otherwise say to hell with buying U.S. debt asset prices fall 2.5%, your real return is approximately 2.0%
Inflates away much of the real value of existing
U.S. Government Deflation raises the real value of the existing debt.
debt
But has to add the $1 trillion to fund the bailout
U.S. Government A much smaller addition to the debt
itself
Banks Several dozen still become insolvent 100-200 insolvent, then taken over
Puts money into the hands of very well-off
Puts spending power into the hands of those who will spend
Spending Power investors, who have a low marginal propensity to
much more of what they have a keep the economy alive
consume
Faster transfers of houses to those who can keep them, once
Slow to change hands as the details of the
Empty houses banks see the bailout is not coming and drop their prices to fair
giveaway are worked out
levels
A criminal transfer from the average taxpayer to
A much more modest, legal transfer from the taxpayers to
Morality! those wealthy enough to have bought mortgage-
depositors once the FDIC's existing fund is exhausted
backed securities
Also an indefensible transfer to bank common and
If a bank invested depositors' funds in hopeless mortgages, why is
Morality! preferred shareholders and bank debt holders,
that the taxpayers' problem? Chapter 11!
again consisting of the top of the income scale

Finally, this would also bail out depositors with The no-bailout solution is morally right, and would not lead to a
Morality!
over FDIC-limit balances in their accounts panic. Depositors will know the money is there, to the limits

J. Scott Beesley Page 5 9/26/2008