The OTHER Reason we may not have needed the [cash portions of the] bailout bill…

…even though we certainly need some bailing out.

Brad Setser notes the obvious:

Frankly the TARP is now starting to look small relative to the Fed’s balance sheet.

while including the reality:

The latest [H.4.1] data release should settle the question; absent enormous liquidity support from the Fed, a much broader set of financial institutions — including some that received equity investments from sovereign wealth funds — would have failed.

Which just brings us back to the question: if the TSLF, PDCF and related entities are doing their job—and there is no indication they are not—what will be the benefit of TARP? (That is, if I can loan a security to the TSLF for 28 days, and roll it over indefinitely [or at least until I get the price I want in the market], why would the Fed need to buy it, and why would I need the Fed to buy it?)

Continuing the thought, via Setser, Morris Goldstein lays out the four major issues of the current credit crisis [reformatted]:

  1. illiquidity for certain mortgage-backed securities,
  2. undercapitalization of the financial sector,
  3. an interruption in the flow of credit to households and nonfinancial businesses, and
  4. a rising foreclosure rate that threatens to produce a downward overshooting of housing prices.

The first is a problem for the same reason that GM not selling too many Hummers is a problem: it’s where the profits were made. Those “radioactive” tranches that were mostly sold to hedge funds were the most profitable part of the MBS. The argument that it isn’t so much a liquidity problem as a price problem (demand is significantly down, and prices rarely go up in those circumstances) may be viable, but that leads to:

The second problem, some portion of which was a direct result of Christopher Cox’s mismanagement of the SEC’s oversight of investment banks, not to mention a lot of off-balance sheet maneuvering that ended up impacting bottom lines. This is addressed fairly well by the TSLF, PDCF, etc. But the problem persists, which leads to

The third problem, or the crux of the matter, without which we wouldn’t see the former head of Goldman Sachs making plans to reward his friends the Treasury Secretary talking about how overvalued assets are “undervalued” (assuming they reach maturity without high default rates) and need to be bought for two years, after which time all will presumably be fine and dandy again,* unless…

The housing market oversells (this point has been well-covered by AI here).

So if we look at the four points, the optimistic version is that the bailout bill will form a “hedge fund” for the “radioactive” portions of MBSes that no one else is buying. (UPDATE: Daniel Gross made the same argument at Slate (h/t Mark Thoma).)

And we know this will work because hedge funds, as the Wall Street Journal editorial page keeps reminding us, are all doing fine, or at least not getting splashed across the front page of the Wall Street Journal when they fail.

The just appear in the FT and Bloomberg with graphic descriptions of them eating each other “because ‘investors have been unwinding trades that they otherwise believe make sense’.”

In the end, as Hilzoy noted, the saving grace of the bailout bill may well be its unfunded mandate that FDIC insurance be increased to $250,000.

The other problem, as even Martin Effing Feldstein notes, is the part of the bill that was sacrificed early: relief for homebuyers:

The financial rescue plan would bring back the confidence needed to revive the financial system only if the Treasury’s asset purchases could eliminate the current impaired securities now held by the financial institutions, and if the remaining securities could be counted on to remain healthy. The legislation will do neither.

But supporting the structures on Main Street itself, as noted here, was sacrificed early:

I think that the…bit of your crisis just got buried on a big news day. They gave up on support for low-income home owners as part of the negotiations. That was an expensive objective

The alternative may well be worse, especially if Goldstein is correct about the fourth part, which strongly implies that Feldstein will be correct about the securities based on those properties.

*It’s scary when the cynical version of events makes more sense than the official story. Does anyone really believe that the MBS market will be recovered in two years, when the TARP programme is scheduled to end? If so, on what evidence?