My Two Cents - "Bailouts - A Historical Perspective"

3/16/2007

Throughout the course of history, the term bailout has popped onto the radar screen on a couple of very notable occasions. Generally speaking a bailout is a government-sponsored activity that usually results from the general mismanagement of money to the point where the ramifications of that mismanagement can no longer be avoided. It is like the little kid who steals an occasional cookie from the jar. For a while, the level of cookies can be disguised, but eventually, there are no cookies left and the child can no longer cover up the fact that they have been eating the cookies all along. In the case of a bailout, the money is like the cookies only we are talking about a much bigger jar.

The reason I decided to write on this topic is probably already obvious. This week a number of prominent politicians have begun to mention that the government might have to 'do something' about the problems in the subprime lending market. The first obvious question that I have is where does a institution that is for all intent and purposes already insolvent itself obtain the billions that will be required to bailout an entire industry? Don't forget also that this same institution must also be poised to provide a bailout to perhaps the last bastion of manufacturing strength in the United States in the form of the automotive industry. I'll leave that question simmer while we take a short walk down memory lane....

Savings and Loan Bailout - 1981-1989
In short, the Savings and Loan crisis was brought about by the combination of high inflation and recession in the late 1970' and early 80's. S&L's made fixed-rate mortgage loans to consumers, but began to lose their CD deposits and other reserves to higher paying instruments as the prime-rate soared through the early 80's. They were forced to raise the rates on their Certificates of Deposit to remain competitive. Keep in mind that they collective fixed interest payments (at relatively low rates) on their mortgages. It is obvious to see the problem here. This problem was further compounded by the fact that due to the recession defaults began to rise. Sound familiar folks? S&L's began to go bankrupt. After the Great Depression the government had created insurance programs to guarantee deposits in the event of a bank failure. If acted upon immediately, the insurance money in all likelihood would have been enough to cover the losses. However, the S&L's were allowed to fight insolvency and gamble on riskier and riskier investments. This resulted in the need for a massive bailout far in excess of the insurance funds available to cover depositor losses. A good estimate of the amount required to bailout the S&L's in 1989 was around $200B. Money is still being spent to this day to mitigate those losses. Early action would have avoided a good deal of this. The American taxpayer footed the bill for this mismanagement.

Long-Term Capital Management - 1998 - 2000
LTCM emerged as a leading hedge fund in the 1990's found by two Nobel Prize winning Economists Myron Scholes and Robert Merton. The fund was based on arbitrage, fancy option-pricing strategies, computer models and other such 'new-age' finance gizmos. LTCM was funded in 1993 and was eventually liquidated in 2000. From 1994 until 1998, the fund saw spectacular successes. However, when Russia defaulted on its debt in 1998, the market went against the previously favorable conditions that LTCM relied on for its continued success. The fund nearly went belly up and ended up requiring a massive bailout sponsored by the Federal Reserve Bank of New York through its creditor banks. The Fed bank's rationale was fairly simple: Bailout the fund or reap the ripple effects of a financial crisis. The Fed Bank brokered the bailout through 14 banks totaling $3.65 billion. In this instance at least action was taken rather quickly to avoid a much bigger price tag later.

Subprime Mortgage Bailout - 2007 - ?
After the stock market collapse of 2000-2002, the economy faced a stiff headwind and the Federal Reserve reacted by creating the most credit-friendly monetary policy in American history with low interest rates and liquidity abound. However, the tragic flaw of easy money is that it leads to speculation, and ultimately, malinvestment. Low interest rates caused speculation in the residential real-estate market to a level that has been unprecedented. Double-digit home appreciation led lenders to make more and more risky loans based on the faulty assumption that appreciation was infinite and could always be relied on to make the payments when the borrowers were unable to do so. Developers took the cue and built a massive inventory of spec homes, creating a glut looking for a reason to happen. That reason came mostly in the form of 18 consecutive rate hikes by the Fed from 2004 - 2006. Mortgage gimmicks designed to allow fast-food workers to buy half million dollar homes began resetting at much higher rates and the defaults and foreclosures began. We are now seeing only the tip of the iceberg. While the media chooses to pretend this is a non-issue, the snowball gathers speed.

The fact that there will be a bailout is a foregone conclusion. We should be more interested in the timing and ultimately the cost of any such bailout and who is going to bear the cost. It is my guess that most of the people reading this column will not like the answer to the last question.

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. This article and other information is located at http://www.my2centsonline.com Please feel free to distribute, copy or otherwise disseminate this information.