Why the Bailout Solves Nothing

The votes are in. The ink from the president's signature has dried. The massive bailout bill is now the law of the land. Congratulations -- you've just been sold an extremely expensive pig in a poke that you'll be paying for throughout the rest of your life.

If this ill-conceived, hastily passed, and pork-laden disaster had even a remote chance of helping the economy and credit market recover, it'd be one thing. But it doesn't, and in many cases, it will simply make things worse.

Hyperinflation or further slowdown?
The bailout itself has an estimated price tag in the neighborhood of $700 billion. To pick up that tab, the government can either print money or borrow it. If it runs the printing presses to create that cash, we run the risk of turning into the world's next Zimbabwe. If, on the other hand, the government borrows that cash, it'll learn a very painful lesson in the law of supply and demand.

While the government can certainly raise $700 billion in the debt market, the money to buy that debt has to come from somewhere. That somewhere will very likely be cash that investors could otherwise have used to finance productive, private-sector companies looking to help grow the economy. As a result, borrowing costs for companies other than the politically privileged recipients of the bailout cash will likely rise as they have to pay more interest to attract investors. That doesn't exactly spur economic growth.

Pretty much since Federal Reserve Chairman Ben Bernanke's first round of panicked rate cuts in January, cheap and plentiful federal cash has resulted in higher borrowing costs for businesses. This round won't be any different. Government investments in commercial affairs have the tendency to crowd out private capital.

You saw it happen with the extension of Bernanke's "Primary Dealer Credit Facility." With that program, the Fed essentially opened its lending window to brokers like Morgan Stanley (NYSE: MS  ) , Merrill Lynch (NYSE: MER  ) , and Goldman Sachs (NYSE: GS  ) . Once they got hooked on that virtually unlimited source of cheap federal cash, there was no turning back. We all know how that saga ended. And thanks to the $700 billion worth of government ammunition now aimed at the private sector, it'll probably happen again, on an even bigger scale.

Digging a deeper hole
Add to that mess the "sweetener" provision of the bailout that increases the FDIC insurance limit to $250,000 from $100,000. On the surface, that seems like a smart way to entice people to keep more cash in what might otherwise be struggling banks. Unfortunately, however, the FDIC is already quite strapped for cash. To preserve what little capital it has, in fact, the FDIC is willing to jeopardize the very fabric of the capital market when it takes over larger banks.

Even when it doesn't actively attack the financial system, that agency has proved itself to be a terrible negotiator. The plan it brokered with Citigroup (NYSE: C  ) to take over Wachovia's (NYSE: WB  ) banking operations, for instance, left significant value on the table. Until Wells Fargo (NYSE: WFC  ) stepped in and offered a far better deal, it looked like Wachovia would've been the next bank hastily sold off to protect the FDIC's dwindling assets.

With the FDIC now on the hook for significantly more cash in any given bank failure, it'll likely have to raise the premiums it charges for that insurance. Of course, with so many banks already teetering on the edge, those additional mandatory charges won't exactly help them stay solvent. At this point, though, what are a few more bank failures or forced bargain-basement sales among friends?

The infinite moral hazard
Perhaps most worryingly of all, however, is what the bailout is intended to do. It's intended to hand over cash to banks that overleveraged themselves and gorged on toxic derivatives of risky mortgages back when that superficially looked like a profitable business model. Why anyone would want to reward such ill-conceived behavior with taxpayer money and thus encourage more of it in the future is beyond rational comprehension.

Seriously, for around three years, there has been plenty of evidence that the housing market that underpinned those derivatives was a bubble at risk of bursting. Any investment or commercial banker who ignored that data has no business running anyone else's money, much less receiving a windfall from taxpayers. It would have been better to let those disasters fail and fill the gaps they left behind with more intelligently managed banks like BB&T (NYSE: BBT  ) that largely avoided this mess.

Instead, we're now paying through the nose to subsidize failure and make life tougher for all who followed the rules. This situation won't end well, and by design, the bailout only makes things worse.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. BB&T is a Motley Fool Income Investor selection. The Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (36)

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  • Report this Comment On October 06, 2008, at 3:19 PM, TMFFischer wrote:

    Well, I unfortunately agree that the bail-out more or less just moves bad risk from corporations and banks and puts it on the entire country. In other words, now that the U.S. government has gone "all in" to try to fix this mess, it better accomplish its goal, otherwise it will lose even more stature in the eyes of the world and the consequences will multiply. Much of the long-term success or failure of the rescue plan may come down to the price the government pays for the toxic loans. Because let's agree on this: home prices don't behave like stocks (in normal times): meaning, they don't bounce. Once they stabilize, they typically increase very, very slowly over the years. I don't think this will be any different. There will be an abundance of inventory and relatively few available buyers, so there's no reason on the horizon for home prices to make healthy gains again. They'll probably fall well into 2009 and then sit and spin, possibly for years. Meanwhile, the era of easy credit is over, and the whole Western world, especially the U.S., must now deleverage, a process that takes years. The end result will be an economy that looks very different from the one that was driven by relatively easy credit -- and then absurdly easy credit -- the past few decades. We're probably still closer to the beginning of this crisis, from an economic standpoint, than any sort of middle or end. The next logical steps are a decline in commercial real estate markets, more foreclosures next year as home prices continue to fall and more ARMs reset, more layoffs, unfortunately, and lower tax receipts all across the country... while the U.S. government faces its greatest deficit and debt in at least a generation. We're still in the "contracting" period of all this. And that will be followed, IMHO, by a very long "churning" period -- unless we get leadership who really knows how to invest in the future (assuming it can afford to) and get people back to work en masse, in which case the churn could be shorter than otherwise. Finally, to be hopeful, much will rise from the ashes of this latest lesson, but we'll still be seeing that, and talking about it, 5, 10, 15 years from now.

  • Report this Comment On October 06, 2008, at 3:39 PM, AlreadyBeenTaken wrote:

    Seems to me this article's author is contradicting the eMail I received from Tom Gardner 9/25.

    "Treasury Secretary Henry Paulson has put together a plan that is actively under debate and allows the Treasury to invest in assets that are crushing bank balance sheets. We view this plan as being an important step in allowing the global financial system to recapitalize itself. We agree with financial intellectual titans Warren Buffett and Bill Gross, as well as both presidential candidates, that the Paulson Plan needs to be passed and will benefit Main Street. "

    Am I missing something here?

  • Report this Comment On October 06, 2008, at 3:40 PM, bwshook wrote:

    WHO added WHAT to the bill? I haven't been able to find that out yet. Would like to know who to blame in addition to the authors of the bill itself. Please send me this info! Thank you.

  • Report this Comment On October 06, 2008, at 3:50 PM, jsl4980 wrote:

    Thanks for finally writing something that makes sense the week after the bailout passed. We needed more people like you who thought clearly last week. Its a little late today.

  • Report this Comment On October 06, 2008, at 3:57 PM, mlaursen wrote:

    Maybe not too late. The funds have been authorized, but they haven't been spent yet.

  • Report this Comment On October 06, 2008, at 7:39 PM, pmajmudar wrote:

    nice article.. agree with the gist

  • Report this Comment On October 06, 2008, at 8:33 PM, TMFBigFrog wrote:

    Hi AlreadyBeenTaken,

    .

    One of the things I appreciate the most about writing for The Motley Fool is the fact that there is no official "party line" that we all must follow. Tom Gardner has his opinion and I have mine. As long as we can back our financial and economic opinions with data, we can present them for publication.

    .

    Much like the stock market does, macroeconomic events have a lot of different moving parts. Making a change in one part can affect a whole bunch of others. At the end of the day, the net impact of any action incorporates both the plusses of the action and the negatives.

    .

    For this article, I referenced several different external sources along with the Fool articles you see linked. The combination of references and opinion passed editorial muster, and so it was published.

    .

    The truth is that nobody knows with 100% certainty what will happen. In fact, the odds are that the bailout will have some benefits somewhere in the economic chain. I'm just of the opinion that the negatives will far outweigh the positives and have written accordingly.

    .

    Best regards,

    -Chuck

  • Report this Comment On October 06, 2008, at 8:45 PM, TMFBigFrog wrote:

    Hi jsl4980,

    .

    Rest assured, this wasn't the first piece I've written talking about the dangers of the bailout. In fact, one of the earliest pieces I wrote opposing what turned into this wave of bailouts was "A Bailout's Opportunity Cost", in December of 2007: http://www.fool.com/investing/dividends-income/2007/12/07/a-... .

    .

    On the topic of this specific bailout, I did write against it two weeks ago: http://www.fool.com/investing/dividends-income/2008/09/22/wh... and perhaps in even starker terms the week before that on some of the other boneheaded things the government has been doing to "help": http://www.fool.com/investing/dividends-income/2008/09/19/wi...

    .

    Amidst a herd-driven panic, however, the voice of the opposite perspective often goes unnoticed or unheeded...

    .

    Best regards,

    -Chuck

  • Report this Comment On October 06, 2008, at 11:58 PM, vv234 wrote:

    Very good analysis and article! I hope more and more people could realize the potential danger the bailout will bring us in the not too distant future.

  • Report this Comment On October 07, 2008, at 1:39 AM, militauro wrote:

    Just as I was reading this article thinking "Wait, wasn't the Motley Fool FOR this bill?", fellow fools were already on it. I appreciate the fact that everyone has their opinion, it did seem as if this opinion was a bit hidden though.

  • Report this Comment On October 07, 2008, at 1:53 AM, MarkInSF wrote:

    Where will the money come from? It will come from the banks selling their bad debts mostly. They'll have cash to spend and guess what everybody wants?

    This plan could have the Treasury not selling their bonds through dealers at all. They would just exchange them for the securities owned by sickly banks, like 'value' for like value, and nobody has to go to any open market. It's just a debt for debt swap.

    Also forgotten is that taxpayers wont have to cough up the money to pay coupons on those new T bills. Homeowners will. That's the theory anyway.

    Of course the Treasury will overpay, which brings up all the other problems noted. Really this should be a debt-for-equity swap, giving taxpayers preferred shares for their treasuries, just like Warren buffet is getting for his $5B investment in Goldman. Why are taxpayers getting such a lousy deal out of this?

  • Report this Comment On October 07, 2008, at 9:00 AM, OurCreation wrote:

    Under the guise of the Great Bailout of the U.S. economy, Paulnankebush and Congress are stealing over $700 billion from U.S. taxpayers to bail out people around the world who chose to gamble on the financial industry. Paulnankebush and Congress are giving this stolen money to investors in, and management and employees of, financial companies who made risky bets and lost...well, they lost until they were bailed out. By the way, the investors, management, employees, and financial companies who are receiving this stolen U.S. taxpayer money are all over the world, not just in the U.S.!

    Are you ready to give up, or to rise up and "convict" the perpetrators?

    Go to http://I-mMadAsHell.com .

  • Report this Comment On October 07, 2008, at 10:33 PM, MyDonkey wrote:

    I agree completely with this article.

    The House got it right the first time by voting No to the bailout. Too bad it couldn't withstand the onslaught of fear-based propaganda and greed-based bribes. Those who changed their vote to Yes allowed fear and greed to overcome intelligent reasoning. Stupidity won; smartness lost.

    This will make the rich richer and everyone else poorer. And it probably won't stop there. Numerous civilizations throughout history have vanished as a result of collective and cumulative stupid decisions.

    Never underestimate the power of stupidity.

  • Report this Comment On October 08, 2008, at 8:59 AM, theeconomicsguy wrote:

    I agree with your analysis of the bailout 100%. Glad to see everyone has not thrown their support behind this bailout.

  • Report this Comment On October 08, 2008, at 8:19 PM, grovecpa wrote:

    All last week I was searching for a forum to share my thoughts on the bailout. I finally realized today - AHA - The Motley Fool. I share with you the note I sent to all Florida legislators.

    VOTE NO ON THE BAILOUT

    This is the biggest terrorist plot perpetrated on the American people. We are being held hostage by our own government, and the ransom price is $700B.

    The Bush gang is taking their last chance to extract massive amounts of cash from the American people. For 8 years we’ve had a regressive flow of cash from workers to oil executives. Now $700B will go financial execs.

    Chapter 11 is not a bad alternative. Each company that declares bankruptcy under Chapter 11 has an opportunity to financially reorganize responsibly, carefully and with the oversight of a bankruptcy board. That is the level of oversight that is needed and is available under our current laws.

  • Report this Comment On October 10, 2008, at 6:40 PM, leikhe wrote:

    This will bail out nothing, it will not help the nation's economy. Why is it so difficult to see what is and has been going on here? Dwight D. Eisenhower tried to warn of it.

    Have we not sat idly by watching this administration pipe money to myriad corporate interests? Has not the so-called "war on terrorism" been a manufactured enterprise through which billions upon billions of dollars could be justified expenditures? How much money has gone to unneeded weaponry, to weapon research, to plans for more weaponry all in the name of national defense, for a nation that needs no defense if only it left other nations to their own devices?

    If there had been an effort to arrest the criminal plotters who flew those planes into the trade towers there would have been no further reason to lay out the available resources of this country.

    This 'bailout' is only the last great grab of the bush administration; the last big payout to all of the cronies who placed that man and that system into position to steal from us. It would not surprise me to find that it had been planned years ago.

    We have to suffer this, and our heirs do. There's only one thing that could put a stop to it.

  • Report this Comment On October 14, 2008, at 1:01 PM, ozzie wrote:

    The Bailout does 2 things that are critical:

    1) It will (or should) address mark-to-market valuation. This was a recently legislated requirement with good intent - to force financial companies to fairly value their reserves. However, nobody perceived a day when markets for a particular asset class would virtually dry up completely! There should have been provisions, and now will be, for companies who intend to hold assets to maturity to fairly value those assets even when no market exists for them.

    2) The government has promised to buy Commercial Paper. The lack of liquidity in the CP market brought even behemoth GE to its knees. Making necessary investments in highest-quality companies to make the CP markets more liquid benefits us all!

  • Report this Comment On March 06, 2009, at 8:29 PM, rwk2008 wrote:

    This seems to be the standard Republican line being pushed by Limbaugh, O'Reilly, and the pack of R senators. The reasoning seems to be that if I'm OK, then don't spend public money making sure others are OK. A selfish, greedy approach but what we've come to expect from the far right.

    A lot of mistakes have been made by governemt, largely in eschewing regulation and in abandoning the concept of anti-trust in letting companies become "too big to fail." None of these mistakes will be corrected by letting the people in dire circumstances go under because they aren't rich. Hoover was wrong, the Republicans were wrong in 1930 and wrong now, Bush/McCain were wrong, and the author of this article is wrong, wrong, wrong.

    The idea that government is the problem, not the solution, brought us three decades of failed leadership, and now a major recession. That idea has been resoundingly rejected by the voters, and deserves to die an unlamented death.

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