For Those Against the Bailout

How did we get here?

Companies held these mortgage-backed securities (Derivatives). The mortgages went down in value, so the securities went down in value. According to the matching principle in accounting, you need to adjust the value of your asset when this happens. This changed company’s current ratios. That made debt holders and equity holders nervous.

Meanwhile, some other companies used extreme leverage to buy these securities. If you have a million dollars and borrow another 19 million to buy securities, you are extremely leveraged. You know have 20 million in securities and only 1 million of your own principal was used. If the value of the securities drops 5%, you just lost your million and want to sell fast. The first time there were other leveraged buyers who thought it was a great deal. Then prices dropped 5% for them and they had to sell. This continued until no one wanted to buy. The securities were extremely devalued.

Now back to the original companies. They just lost a chunk of their asset value. The debt holders want them to raise cash to cover it (raise their current ratio), but don’t want to lend them money because they are now more risky. So how does the company get cash? Borrow from the banks? No, they are not lending due to increased risk and reserve requirements. Sell more stock? Well no, the company is now worth less and more risky. The shareholders are selling, not buying. This further devalues the company.

At this point, you either sell your company to another (more conservative) company that did not invest as heavily in mortgage-backed securities, or you go the way of Lehman Brothers.

Where are we going from here?

How does this affect our economy? Production is reduced because companies can’t borrow money. In conjunction, people are nervous so they aren’t buying anyway. Demand falls, the economy shrinks. Company’s lay people off. Demand shrinks more because less people have income to buy things. Companies need to produce less and lay more people off. This process continues until we are in a deep recession or worse.

Eventually this brings down prices and demand starts to tick up. Companies start hiring again so they can produce more. Oh wait; they can’t borrow money to ramp up production so they don’t hire people back. The deflationary cycle continues. There is mass unrest and extremely high unemployment. Cushy life as we know it comes to an end.

Should Wall Street be bailed out for making bad investments?

If you say no, ask yourself how long you can be unemployed. Did Wall Street make billions on bad investments? You bet. Do they deserve to be punished? Yes indeed. Should they be punished to the point where we all suffer severely? No.

This is why the bailout is a good thing if the plan works. Worst case, it stops the deflationary cycle. Best case, it kicks off a new growth cycle. Much as I hate the idea of it, we need it or life as we know (growing economy / increasing standard of living) will likely cease to exist. Also, if foreign governments lose faith in the dollar, they won’t lend us money. Although I have yet to take International Finance, my understanding is foreign governments finance our trade deficit. What happens if that line of credit dries up? Very bad things.

The good thing about all this turmoil is, in the long run, the securities will increase in value when the housing market turns around. And it will turn around. Economics is a self-sustaining pendulum. The bailout is just trying to accelerate the swing without years of pain.

The bailout could actually make money as long as the securities are bought below the current value of the hold to maturity annuities that back them. If you disagree with the bailout, read the Macro Economics section in the very well written book Economics for Dummies. I am not picking the title out of sarcasm. This book was extremely helpful in my MBA economics class.

The politicians know we need this, but many of their constituents are against it. Therefore, it got voted down today (9/29/08). After the constituents lose their jobs and the economy is in an even worse death spiral, it may be to late for the bailout plan to help. If you are against the plan, please do some research on macro economics and re-evaluate your position.