According to Yves Smith, the bailout plan is not going to work:
By way of background, banks had created off balance sheet entities called structured investment vehicles (SIVs) which contained subprime (and sometimes other) assets, funded by commercial paper and short-term debt. Like a regular bank, the economics worked because the assets were of longer maturity (3-5 years) than the funding sources, and short term money is generally cheaper than long-term funding.
Then the subprime crisis hit, lenders became very leery of funding subprime related assets, and the SIVs looked pretty certain, as it indeed played out, to produce losses. The banks had assumed they could simply let the SIVs fail, but were told in no uncertain terms by the debt investors that There Would Be Consequences if the SIVs went bust. Suddenly an off balance sheet exposure was not off balance sheet at all.
Hank Paulson attempted to ride to the rescue with an idea, the so called Master Liquidity Enhancement Conduit, that we said virtually from the get-go would not work. He wanted to set up a vehicle, to be managed by a third party that would buy the junky SIV holdings, which included risky real estate assets and murky stuff like collateralized debt obligations, and be funded by private investors. The problem was that there was no price which would solve the basic conundrum: investors were not willing to pay above market prices, and the banks were unwilling to sell at market. Paulson & Co. wasted nearly two months trying to breathe life into this stillborn idea, then abandoned the effort.
For the non-financial types the gist of this is: banks set up independent businesses that invested in long term assets paying high interests rates with money that they borrowed at low interests and pocketed the difference. Think of it as writing a 0% interest check from you’re credit card company for $10,000 and investing it in the stock market. If you’re stocks go up say 10%, you sell you position for $11000, pay off the $10000 loan from the credit card company, and pocket $1000. You just made yourself money using other people’s money. As long as your stock goes up you’re smart. But if it goes down instead of making money, you have to pay out of your own pocket.
For a bank, that scenario plays out like as follows: When this separate company is profitable, it has its own balance sheet – read: check book. Its parent adds the profits to its balance sheet and therefore looks sound. But, when the separate company is not profitable, the parent intended to just let the separate company file for bankruptcy. That way the parent would not have to pay for its losses, keep those losses off its balance sheet, and continue to look sound. However, in this case they were forced to not let these separate companies go bankrupt, and therefore, pay for the losses.
Enter Paulson, his bright idea is to buy the long term investments purchased by these separate companies at a higher price than any other buyer is willing to pay so the separate company does not show a loss at all and the parent company does not have to claim a loss on its balance, thus making the parent’s financial sitution look better than it is.
Apparently, this did not work a year ago, when the crisis was not as deep as it is now. But we are going to try it again anyway. Can anyone guess what the result will be?