Other than the usual outrage about private profits and socialized losses (entirely justified, but a waste of bits), I haven’t seen much analysis of the likely outcome of the proposals being outlined by the Fed and the Treasury. So I’ll try. First of all, the problem they are trying to solve is the lack of liquidity or reliable valuation of large amounts of debt owned by banks and brokers (and many others). This debt was originally valued by its rating from the various agencies, S&P, Moody’s, etc. These ratings claimed to predict default rates and loss severity, which allowed people to price the paper. The statistical models on which the ratings were built, however, turned out to be nonsense, basically because they assumed ever-increasing house prices. Which was in fact the case, throughout the period covered by the statistical database on which the models were based. Anyway, when the rating predictions had clearly been invalidated, no-one knew what the likely default rates and losses would be, and so no-one wanted to buy the paper without such a huge discount that that the risk was mitigated.

The owners of the paper feel that the bids for the paper are excessively low - and I’m sure they are, the potential buyers want to be confident of making a profit and the uncertainty is great. And if they sold the paper at those prices, it wouldn’t matter because they would be bankrupt. So they transferred the paper to the so-called “Level 3″ category, where they simply make up the valuation, and live in fear that the paper will actually trade, forcing them to mark theirs to the market price. The problem is that, given that large chunks of their balance sheet are of unknown value, almost certainly much less than that at which ithey are carried, no-one wants to deal with these companies because as recent events have shown (Bear Stearns, Lehman, AIG), they can claim financial health one day, and then literally disappear overnight.

So the government’s approach is to buy this paper from them, presumably at a price that leaves the companies in reasonable condition, and have the taxpayer shoulder any subsequent losses. Barney Frank of the House Banking Committee is already celebrating that this purchase of these obligations, together with its purchases of Fannie and Freddie, to say nothing of its takeover of Indymac, will allow the government to slow or halt foreclosures on the underlying mortgages, thus “keeping people in their homes.” Of course, if there is no foreclosure resulting from default, then defaults will surge and further devalue the mortgages underlying not only this paper, but the assets of the other government mortgage providers. Why pay if you can live for free, or at least reduce your payment at will? Not moral hazard at all, just a “business decision.”

We need to remember that we have been in a Ponzi bubble, where increases in debt have been used to service the existing debt, so the amount of debt outstanding has risen to historically unprecedented amounts. Total credit market debt now amounts to $50 trillion, or about 350% of GDP, according to the Fed. Of that, mortgages account for some $14 trillion. So the $700 billion cost of the bailout mentioned is not all that large, 5%, in proportion to just mortgage debt. On the other hand, it is quite large in relation to the current Federal deficit of about $410 billion for 2008. 

• The total amount is of the same order as the total level 3 assets (the most toxic waste) of the largest banks and brokers. It is therefore likely that the measures will allow the banking system to avert a liquidity crisis. This is a good thing. However, new credit will remain constrained and the amounts involved are insufficient to re-inflate the housing bubble. Housing prices will continue their decline and defaults will continue to increase, whether or not people are actually thrown out of their houses.
• Those level 3 assets are almost certainly overvalued in terms of their marks, but whether or not they are overvalued relative to their intrinsic value is unknowable. If you believe, as I do, that losses on this paper will continue to increase, it is reasonable to expect that the measures will be costly and significantly increase the Federal deficit. If other measures, e.g. another “stimulus package” or Mr Frank’s foreclosure moratorium are thrown into the pot for the election, then the cost will soar. This impact will show up in higher rates on government debt and other term credit, including mortgages, as competition increases for a shrinking or at best constant pool of credit.
• The negative impact on consumption from tight credit will continue. There is no scenario here which leads back to the recklessness of the last ten years. As I’ve said before, consumption has been boosted by the increase in credit and that won’t be happening. The impact of these measures will be to modestly slow the decline, not reverse it. This means that employment will continue to decline and incomes in the financial services industry are unlikely to return to the peaks of the Second Gilded Age.
• As the New York Times asks: “Most broadly, what are the long-term costs of the government stepping in to restore order after so many wealthy financiers became so much wealthier through what now seem like reckless bets on housing — bets now covered with public dollars?” No-one knows, but it is clear that the myth of free markets is now thoroughly debunked, and the rent-seeking of the financial services industry clearly exposed to any observer.

I’ve purposely avoided any opinion on the dollar, simply because other countries have similar problems and the outcome in a race to the bottom is hard to anticipate.