Why it’s better to bail out borrowers than banks

By Felix Salmon
April 11, 2009

Justin Fox does us all the favor of asking — again — why we’re bailing out banks rather than borrowers. If I had to give a simple answer, I’d say that it was because the failure of Lehman brothers has shown us that we simply can’t afford not to bail out the banks. If banks’ creditors in general, and their senior unsecured bondholders in particular, are forced to take massive haircuts on their holdings, we could suffer another sickening downward lurch in the fragile credit markets, with nasty knock-on effects for the economy.

But I’m not entirely convinced that the simple answer is necessarily the correct one. I just got a very smart question via email from Liaquat Ahamed, author of the excellent Lords of Finance :

Lehman had a balance sheet of around $800 billion, $30 billion of equity, $120 Billion of unsecured debt and $650 billion of secured debt (repo etc). The secured debt was fine, the unsecured debt got paid out at 20 cents on the dollar and the equity went to zero. Total loss was $100-120 billion.

As I understand it no counterparties in the US lost any significant amounts of money. Counterparties had been worried about Lehman for a while and had collected margin on unrelaized gains on outstanding trades. In the UK there were some losses from the practice of rehypothecation by the prime broker but even here the losses were only in the tens of billions.

The main impact of the Lehman failure was psychological. The Reserve fund broke the buck the next day from losses on Lehman commercial paper but even then the run on money market funds was contained. Everything the Fed then did that week was designed to contain the psychological damage from the Lehman collapse.

I sort of buy the John Taylor idea that it was the failure of Congress to approve Tarp on the first go around that really spooked everyone and raised the specter that the US would not bail out its banking system.

I’d add to this the fact that when Washington Mutual went bust with massive losses for unsecured bondholders, the systemic implications were relatively small: while it’s received opinion that the Lehman bankruptcy was devastating, very few people (other than John Hempton) think that of the WaMu implosion.

Politically, it’s extremely difficult to pass a bill giving hundreds of billions of dollars to people who borrowed money and now find themselves incapable of repaying it. But then again, it’s politically just as difficult to give that money to the banks who lent it, too. And as Steve Waldman notes, the alternative to not bailing people out is basically to force “prudent” investors and savers to take losses instead:

Don’t go all Rick Santelli on me about the injustice of paying for your asshole neighbor’s granite countertop. We are bailing out a banking system that served as a vast criminal conspiracy built around plausible deniability and limited liability. We are bailing out “savers”, who not only demand to be made whole by the government on risky loans they chose to make to banks for profit, but are smugly self-righteous about it, like it’s their “right” because after all they were the “prudent ones”. Of the three groups we might bail out, these crybabies and criminals are no more deserving than some nearly-broke bastard who believed his financial adviser, his banker, his mortgage broker, and the Wall Street Journal op-ed page when they told him that a cash-out refi was as good as money earned, and that granite countertops were a luxury that would pay for themselves. Don’t get me wrong — I’d rather we could bail out no one, just do a rip-off-the-band-aid kind of reset and let everybody take their lumps. But households and firms in debt are by far the most sympathetic villain in this horror show we wake up to every day.

So maybe we should be spending less time on the banks and more time on the borrowers. Yes, bail out the banks — but don’t do it directly; do it indirectly, instead, via the borrowers. Maybe the banks will take slightly more losses that way. Fine. That just means the banks creditors will be more bailed in than they have been to date, and the current market price of the debts will be justified. And at least it will be ordinary Americans getting the government bailout, rather than multi-billion-dollar corporations who utterly failed at their primary job of managing risk.


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“And at least it will be ordinary Americans getting the government bailout, rather than multi-billion-dollar corporations who utterly failed at their primary job of managing risk.”

I couldn’t agree more!

Posted by TheWizard | Report as abusive

If you do the math and divide all of the dollars we have used in the bailout given directly to the banks, divide that amount by the total number of taxpayers in The US, that would be close to $10,000 per taxpayer. It would have been much better to have given those funds directly to the taxpayers and have them deposit the funds into the banks, which would result in solvency for the banks while substantially increasing the buying power and substantially stimulating the economy as those taxpayers would buy things with the $10,000 and pay off bills and foreclosures would probably come close to a halt. I wrote to my Senators and Congressman with those ideas and received a basic letter not touching on such a solution as mine, just thanking me for my opinions about the bailout.

In my opinion, the bailout is a criminal use of taxpayer’s dollars and does not seem to be helping in any measureable way. Furthermore, predictions are that it will drive up inflation.

It’s unfortunate that our government has been duped by the larger banks and insurance companies so easily. When it seemed you could have eventually faith or hope whatever they were promising in the system this time, much is lost. It appears they collude.

Finally, if they can predict that the economy will get better in the fourth quarter of this year, why couldn’t they have foreseen the problems we are in now a year to two ago? They don’t know what they are doing really, except that they know that they can steal directly from the US Taxpayer with the direct aid of the government.

Posted by WT | Report as abusive

John Stewart was advocating this tactic on The Daily Show a few months back.

It made sense then. still does.

Posted by bryan X | Report as abusive

The real question, now, I think, is how the devil enough pressure may be brought to bear on the financial/governmental interests to force the bad assets to be written down in painful but forthright fashion.

At this point the policies presently pursued will compound and extend the crisis.

Personally, I’m prepared to sell torches, pitchforks, and, if necessary guillotines.

Any takers?

Posted by atomikweasel | Report as abusive

Helicopter Ben probably agrees as well. The problem is that the fed had to act. Of course, the could have opened the fed window to homeowners but I don’t think congress would have approved. The only fast solution was to bailout the banks. That’s it. All this talk of “should have done so an so” is forgeting the polital reality which is why we have not seen helicopters dropping greenbacks from the sky.

Posted by Jonathan | Report as abusive

The short answer is “moral hazard”. Around the world people who had the foresight to purchase variable rate mortgages are reaping significant benefits. Subsiding the others would reward feckless behaviour amongst a group of people who, collectively, are able to do far more damage to the global economy than investment bankers.

Posted by Ian Kemmish | Report as abusive

For every dollar the banks have received in taxpayer money in these bailouts, consumer debt to those banks should be written off and cancelled out, dollar for dollar. It is not fair to compensate the banks and let the banks still continue to attempt collection of debt from the consumer. That’s the bank being paid twice! It’s free money to people who are already rich! The banks have been paid for what the consumers’ could not cover. Our tax dollars have paid them so their CEOs and vice presidents and big stockholders can continue luxiuous lavish lifestyles while other people are losing their homes and starving in the street.

From the start it’s been all about enriching the banks. Even the latest Public Private Partnerships proposed by the government to clear out toxic assets is just another scheme to put more money in the hands of the bankers. Under this program ‘private’ bidders on the assets only have to put down 5-10% of the asset bid. This amount will be matched by the government and the balance will be covered by a non-recoverable government loan. That means that if the loan goes bad the bidder will only be on the hook for the original 5-10% of the bid. Wells Fargo has already made it known that it wants to participate as both auctioner and bidder. Talk about a scam! It allows the bank to be made whole on their bad loans except for the 5-10% of the bid and what ever the difference is between the bid price and the book value. Of course the bank would have plenty of incentive to bid the prices up in order to minimize any losses. All this will do is keep the air in the real estate bubble (at least temporarily) instead of letting the market find its balance. Since the government is going to foot the bill anyway, why not just let the government buy the loans directly and then let them work out loan modifications that would allow the original borrower to stay in the home? The original problem with the loan modification programs offered by the lenders was that they refused to modify them in any meaningful way. In many cases, the ‘new’ payment ended up being equal to or HIGHER than the original payment. Had the government set up serious guidelines and been willing to back the modified loans with guarantees (a la Indymac) a lot of these troubled loans could have been taken off the books. Instead we hear about how loan modification doesn’t work. Well no kidding! When the new payment is equal to or higher than the original payment that the borrower couldn’t afford, or course it doesn’t work.

Posted by A. Richardson | Report as abusive

Thank God someone in the media is finally saying this!

At the end of the day, however, nothing will change unless homeowners demand a seat at the table. Right now there are two, and only two chairs there: Government and Wall Street. Who speaks on our behalf? No one.

The irony, of course, is that there will be no recovery unless homeowners (aka taxpayers, aka voters, aka citizens) are given enough breathing room to stop panicking about losing their houses and start spending a little money again. We are literally drowning in debt and the government is holding us down with one hand (raising our taxes at the fed, state and local levels) while the banks hold us down with the other (refusing to write down any of our debt, even as they demand the right to do with theirs!).

The breaking point is near. Homeowners have voices. We need to start using them.

mc cain said the same and was called an obstructionist. not sure he had an actual plan (and i didn’t vote for him or his main opposition) but that made sense to me

if goldman was smart enough to hedge against an aig collapse they were smart enough to figure out they would be bailed out. bad idea to do it. bad idea to allow them to return tarp $ and stop paying interest to treasury

Posted by oops | Report as abusive