When the government speculates

I’ve been listening to the Planet Money Podcast recently, since its recent cross-over broadcast on This American Life (375: Bad Bank). They’re doing a brilliant job at explaining the complicated financial strangeness that’s going on. In a recent episode, #23: In Search Of Bad Guys, about half-way through (14m 9s), they talk about solvency vs. liquidity. Check it out, and then come back.

The upshot is that the mortgages the banks are holding aren’t worth the full fair value, as not everyone is going to pay them. The banks want to sell them at as little loss as possible in exchange for reducing risk. The question is, is the price at which people will buy these (the bid price), artificially reduced by the market’s general lack of available funds to invest.
If we had prescient bean counters today, they would foretell that the real value is going to fall in one of these three segments.

• Above what the bank is willing to sell it for—This is a real win for all folks involved, though least for the banks. The banks take a loss to reduce risk, but remain solvent. The investor-taxpayers make money on their investment while also staving off general economic problems caused by the closing of an insolvent bank.


• Between what the bank is willing to sell the “toxic” asset and what the current market says it’s worth—This is the big hedge. The idea here is that the bank has already lost money on the investment, and the taxpayers are going to eat further losses in exchange for keeping the bank solvent, as insolvency presumably would cause even bigger losses than these across the whole economy. However, it’s still not as bad as the market currently looks (which is what the banks are currently arguing—whether it’s lack of liquidity or lack of good forecasting, the market is unnaturally depressed).


• Below even what the current market thinks—This is the true ugliness, where we, the taxpayers, are eating even more of the bank’s losses. The bank is, for all of its previous losses, getting a great deal here, basically being given taxpayer funds to pay for its bad bets. As these costs increase, it becomes harder and harder to justify keeping the bank alive vs. just letting it fail. (I suspect the FDIC costs would be pretty easy to calculate; it’d be the derivative issues in the economy that would be hard to figure.)

There is an awesome self-reinforcement built into this system. If the government produces a program to buy toxic assets and preserve the banking infrastructure, then the economy is likely to improve (or at least improve sooner) resulting in an increased likelihood that the mortgages that are so toxic will actually be paid on. Now, if only they could show how we’re going to pay all this back and how long it will take.