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Who's Afraid of a Big, Bad Bailout?, Part 1

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Why we need the bailout.

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"A tournament, a tournament, a tournament of lies.
Offer me solutions, offer me alternatives and I decline.
It's the end of the world as we know it and I feel fine.
(It's time I had some time alone.)"

-R.E.M.

Flying overnight from Cape Town to London last Tuesday, I read in the Financial Times that Republican Congressman Joe Barton of Texas said he had difficulty voting for a bailout plan. Why? His constituents didn't understand the problem, the need to bail out Wall Street, or why the government should spend $700 billion of taxpayer money to solve a crisis created by a lot of rich people.Minyanville's Why Wall Street Will Never Be the Same

As it happens, I know Joe. My office is in his congressional district. I sat on the Executive Committee for the Texas Republican Party representing much of the same district for eight years. The following is an open letter to Joe that explains how the financial problem impacts his constituents and why he has to hold his nose with one hand and vote for a bailout with the other.

It's the End of the World As We Know It

Dear Joe,

I understand your reluctance to vote for a bill that 90% of the people who voted for you are against. They don't understand why taxpayers should spend $700 billion to bail out rich guys on Wall Street who are now in trouble. But the media (apart from CNBC) simply hasn't gotten this story right. It's not just a crisis on Wall Street. Left unchecked, this will morph within a few weeks to a crisis on Main Street.

First, let's stop calling this a bailout plan. It's an economic stabilization plan. Run properly, it might even make the taxpayers some money. If it isn't enacted very soon, the losses to businesses, investors and homeowners all over the US (and the world) will be enormous. Unemployment will jump to rates approaching 10%. How did all this come to pass?

We all know about the subprime crisis. That's part of the problem, as banks and institutions are now having to write off a lot of bad loans. The second part of the problem is a little more complex. Because we were running a huge trade deficit, countries all over the world were selling us goods and taking our dollars. In turn, they invested those excess dollars in US bonds, helping to drive down interest rates.

It became easy to borrow money at low rates. Banks, and what Paul McCulley properly called the Shadow Banking System, used that ability to borrow and dramatically leverage up those bad loans (when everyone thought they were good). They created off-balance-sheet vehicles called Structured Investment Vehicles (SIVs) and put loans and other debt into them. Then they borrowed money on the short-term commercial paper market to fund the SIVs and made as profit the difference between the low short-term rates of commercial paper and the higher long-term rates on the loans in the SIV. And if a little leverage was good, why not use a lot of leverage and make even more money? Everyone knew these were AAA-rated securities.

And then the music stopped. It became evident that some of these SIVs contained subprime debt and other risky loans. Investors stopped buying the commercial paper of these SIVs. Large banks were basically forced to take the loans and other debt in the SIVs back onto their balance sheets last summer as the credit crisis started. Because of a new accounting rule (called FASB 157), banks had to mark their illiquid investments to the most recent market price of a similar security that actually had a trade. So far, over $500 billion has been written off, with credible estimates that there might be another $500 billion to go. That means these large banks have to get more capital, and it also means they have less to lend.
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No positions in stocks mentioned.

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