Bailouts

Given the Coronavirus crisis, there will be bailouts. Should there be bailouts ? If so how should firms be bailed out ?

I think it is useful to look at the last round of bailouts from 2008-9 for lessons learned. First with the benefit of hindsight, does it seem that bailing out firms was a mistake ? On the one hand one can argue that it was necessary to prevent the Great Depression. It is hard to discuss whether it was worth the cost, because there was no cost. Instead, the US Federal Goverment obtained the highest profits recorded in human history by accident when focused on saving the financial system (and GM and Chrystler).

The many brilliant economists who argued that we should stick to laissez faire and that, in particular, socialism for bankers and ruthless capitalism for everyone else is no good, have not examined the outcomes. I think this is because the evidence is overwhelmingly damaging to their case.

OK so let’s bail out again. Looking back, can we decide on a better way to do it ? It is challenging. Preventing the second great depression while making hundreds of billions in profits is a good year’s work by any standard.

If things worked out rather well (and the bailouts did even if aggregate demand management was distorted by austerians) what can we learn ?

It seems to me that we learn that Treasuries should bear risk. Bearing risk is highly rewarded in expected value. Bearing risk is highly rewarded on long term average. This is what matters to Treasuries who are concerned about long term debt sustainability. Bearing risk is very very highly rewarded during crises, when it is buying at fire sale prices.

In general the riskier the positions taken by the US Federal Government in 2008/9 the more it helped the private sector and the more it profited.

An example — TARP. This was a relatively small program compared to interventions by the Federal Reserve System. The main aspect was buying from banks preferred shares with interest (or scheduled dividend) 5% In exhange they Treasury received warrants giving them a claim on the upper tail of outcomes. Also there were limits on bonuses and such. The result was profit. One bank had a problem — Citibank (why is it always Citibank ?) which could not meet the scheduled payments. This created the PR problem of trying to explain what a preferred share is (why that isn’t default). So to avoid that, the preferred shares were converted to common stock. The Federal Government made more money per dollar at risk while saving Citibank than while saving the other banks. The riskier asset was the better deal for an agent with essentially infinite risk bearing capacity.

More of the risk was born with the takeover of Fannie Mae, Freddie Mac, GM, Chrystler, and AIG. These firms were taken over because they were failing. It was considered necessary even if very costly. The Federal Government lost money on 3 of 5 transactions so adding up it … made tens of billions of dollars plus the value of its equity in Fannie Mae and Freddie Mac.

A very large program was the Federal Reserve Banks purchases of mortgage backed securities at the price which people had been willing to pay before the crisis (so much more than anyone else would pay during the crisis). The schedules interest payments averaged about 3.5% per year. The actual interest payments of that notorious junk averaged about 3.5% a year. The Fed could borrow as much as it wants at whatever interest rate it wants to pay. It chose, for some reason to pay 0.25% not 0. The result is, by far, the highest profits ever detected.

Because of the crisis, the Fed switched from buying extremely safe assets to buying risky assets (at well above whatever price would have cleared the market which had frozen entirely). The result was gigantic profit. It turned out to be mutually beneficial for entities with finite risk bearing capacity to sell risky assets to an entity with infinite risk bearing capacity.

The story of 2008 and 2009 could be entitled “How to succeed in Business without really trying”.

OK but that’s not the only time that states buy equities. There are also the horror stories of Norway and Singapore.

Well there must be a problem. If it is obvious, if the logic is simple, if the evidence is overwhelming, why hasn’t it been done ?

I don’t have an answer to that question.

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