The Bailout: A Primer

In the latest chapter of the credit crisis, the U.S. Government announced this week that it would take equity stakes in the country’s top financial institutions. As has been the case been throughout the crisis, there has been a huge amount written about whether the Treasury’s actions will be effective. Much of that writing, like the bank balance sheets that have helped cause the credit crisis, may be opaque to a non-expert reader.

To understand the crisis and to understand whether the solutions will work, it helps to look at a typical bank’s pre-crisis balance sheet.

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The bank’s business is to make loans (e.g., mortgages and corporate loans) and, sometimes, buy securities (e.g., mortgage-backed securities that have been so problematic). A typical bank financed every $100 of loans and securities with $70 of deposits, $10 of short-term debt, $10 of long-term debt and $10 of equity.

What happened? Banks and other financial institutions made bad loans and securities purchases. The losses on those investments have been meaningful relative to equity bases of levered institutions. So the true situation was more like:

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When equity capital is low, banks can do two things. They can raise more equity or sell assets. Banks usually sell assets, but only if they can sell assets for full book value. Doing so reduces leverage, because the bank has fewer loans on the same (lower) equity. Unfortunately, this depresses prices of other assets, which, in turn, reduces the equity capital of all banks. This is what has happened.

More unfortunately, if the value of loans declines enough, investors become concerned about whether the bank is solvent–i.e., whether the equity has any value and whether the bank will go bankrupt. Once this concern becomes apparent, bigger problems ensue.

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When the providers of the short-term debt and depositors begin to question the solvency of a financial institution, they stop lending, they stop transacting and they withdraw deposits. This is a particularly big problem if the bank or institution relies heavily on short-term debt, as Lehman did. So you can have a “bank run” even if the institution is solvent (or would be solvent) under normal conditions.

At the height of the crisis, everyone is suspicious of everyone else, because no one knows the real value of the equity. No one will provide short-term debt because they worry they will not get paid.

The key issue, at any point in time, is what the loans are worth relative to the liabilities. There are three basic scenarios:

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The loans are either worth 100% (meaning they are at or close to their book values); 90% (where equity is worth roughly zero, but the bank can pay its debt holders); or 80% (where equity is zero and the bank cannot pay its debt holders).

Now let’s look at the policy responses. The Treasury plan initially called for buying back loans at market prices. This made sense if the loans were really worth 100%, but were not trading at 100% because of some market failure or fear. As we know, that initial Treasury plan was not well-received by the markets. This suggests that the market believes that the bank loans are not worth 100%, but are really worth in the low 90s or lower.

The new Treasury plan (as well as the interventions by the European governments) puts equity capital back into the banks. It also guarantees short-term debt to banks.

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Notice what this does. Guaranteeing the short-term debt leaves the value of the short-term debt at 10% no matter what the loans are worth. This will encourage banks to trade with each other

Whether the plan solves the problem, however, depends vitally on the value of the loans. If the value of the loans is at or above 90%, then the Treasury plan is very helpful. The bank in our example is solvent and should be able to recover.

If, however, the value of the loans is below 90%, much of the value of the new equity will go to pay off the long-term debt investors, and the bank still will be close to insolvent. In that case, there are two possible solutions. One is to put in more equity, but this only subsidizes the long-term debt investors. The second and more appropriate solution is to force the long-term debt to convert into equity, leaving the bank solvent.

The new Treasury plan, then, is clearly a step in the right direction. The initial plan did not solve the problem, and that is why we had a crisis. The key (and unresolved) question, is whether the new plan goes far enough.

11 Responses to "The Bailout: A Primer"

  1. TooBigToFail   October 17, 2008 at 6:12 pm

    But nobody really knows what the value of the loans are, right? Because this is some shadowy stuff that is traded OTC? So this plan will just be throwing more taxpayer money down the toilet. Even at best the banks will lend money to people that can’t afford to pay it back? This isn’t an investment, it’s just gambling. Am I way off here?

  2. Nouriel Roubini   October 17, 2008 at 7:23 pm

    Steve, a most excellent analysis. Great having you on the RGE Finance Blog. Nouriel

  3. Guest   October 17, 2008 at 7:31 pm

    Good idea to convert long term debt into equity. But how do you do that without destroying the ability of banks to raise such debt again and without creating a further run on banks’ liabilities? Debt holders were wacked in the Wamu case and we ended up with a run on Wachovia. Or are such debtholders better off with the swap?

    • Guest   October 20, 2008 at 9:13 pm

      Case by case basis I guess. If the bank is going under without the debt conversion and debt holders perceive good long term value in equity in the bank then it’s in their interest to convert. If any of these conditions don’t hold (e..g they hope the gov will bailout the bank or they don’t want to be equity holders or they hope the bank will survive) then they won’t want to convert. I guess at the moment with baiouts occuring it will take some serious pressure on long term debt holders to result in debt conversion to equity. The bailouts are defiantely reducing the chance of this happening but maybe for smaller banks that are not deemed important enough to bail out this will occur.

  4. Guest   October 19, 2008 at 5:19 pm

    Thanks, this is really helpful. Here’s a related question: 10-12 months ago, I kept reading that the driver for this crisis was securitization. Small banks could sell the loans they originated to packagers. This insulated them from the consequences of bad loans, passing that risk on to the packagers who resold different tranches of a CDO to meet the risk/yield requirements of various buyers. So the originating banks had no incentive to deny loans based on suspicion that in the long run a mortgage holder wouldn’t be able to pay. My question is, is that really what happened? If so, what coin were they paid in for their mortgages, and also if so, why are small banks so on the hook for bad loans now? Didn’t the successfully transfer the risk?

    • Guest   October 20, 2008 at 9:16 pm

      I understand some banks held onto a propertion of assets they wrote loans for eitehr through choice or because at the tail end of the boom they were probably stuck with laons they had written but could no longer sell becuase the market collapsed.

  5. Dieselm   October 19, 2008 at 5:47 pm

    Didn’t the Lehman failure drill through a lot of the debt? like 90% of it?Is the valuation of their assets in liquidation a similar reflection on the true value of other banks’ balance sheets?It also seems like it’s in the interest of banks to keep up the charade as long as possible until time inflates them out of this mess. What’s their interest in coming clean? That’s a serious question. Is there any interest or other check on them inflating their asset values?

    • Guest   October 20, 2008 at 9:07 pm

      I think their interest in coming clean is if everyoen comes clean then the overall sytem which they are part of will be mor etransparent so solvent bansk will have access to capital and credit and good terms. As a group the bnaks appear to be not keen to come clean suggesting that a lot of them have serious problems. The treasury appears to know this and encourage thsi as they suspended mark to market rules which is supposed to result in assets appearing on the balance sheet at realistic prices.

  6. d beller   October 20, 2008 at 1:01 pm

    I have a related question: if the u.s. treasury buys 250 billion of preferred stock of banks, must it sell 250 billion of u.s. debt to raise the money to buy, and, all other things being equal, does it increase the u.s. current account deficit and require the use of other countries current account surplus?

    • Guest   October 20, 2008 at 9:02 pm

      yes

  7. James   April 8, 2009 at 12:36 pm

    It is imperative to realise that the problem is unsolvable by creating liquidity. The root cause of the systemic failure of the system is not so much the exact figures involved but rather that the banking system counts *loans* as assets. These loans are then deposited into another (or the same) bank and become a liability to that bank. The net effect across the banking system is that tiny perturnations in the value of the ‘Assets’ causes large effects by the very nature of the feedback of the debt-asset-liability cycleThe reason the bailout will always fail regardless of its scale is it does nothing to address the source of instability inherant in this type of system.