Wednesday, September 24, 2008

Why Any Bailout At All?

Here is one seemingly simple question to ask yourself about the looming promise of a bailout for those who created the current financial crisis.

Q: How would any bailout proposal actually help Main Street?

The sole credible answer I'm hearing to this one is that a bailout would somehow create liquidity that is threatening to dry up at the moment. Apparently, though, the current proposals are mainly aimed at having the Treasury buy up derivative contracts for which no one in the broader market seems to have the guts to even guess at a price. Or at least not a price that they're personally willing to risk actual money to buy. Here's a thought... perhaps this is because these contracts have no intrinsic value?

Let's look at what derivative contracts actually are:

Once upon a time, you could buy debt in a fairly simple form. It was called a bond, most of the time. The bond consisted of many things, mostly principal and interest, but its price was also a reflection of the market's collective guesses about how likely it was that the debtor would pay back both the capital borrowed, and the interest agreed upon.

The brilliant idea of derivatives was to treat this debt a little big like a pig carcass, only Wall Street boys being the creative sorts they've become in recent decades, they got the big idea of splitting up such obligations into finer and finer sub-divisions.

Carrying on with the pig metaphor, they figured, okay, we can sell the pig meat (the principle) as one derivative contract, and the extras (bone, fat, hooves, head and whatever is left) as a different derivative contract. Maybe we can even get more creative and sell each of the separate extras as a different derivative -- someone will be sure to buy them, right?

And if this bailout goes through, they will have been proven right, because the American Treasury, by which I mean mainly the American taxpayer, will have bought the rotting pig bones, hooves, exhaled pigsbreath and whatever else these imaginative titans managed to call a "product."

The question stands, why on earth would we do this?

Going back to the question I asked first off, how does buying a worthless asset create liquidity?

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