I have seen this misconception portrayed in almost every media article that I have read concerning the proposed government intervention in the capital markets. The overriding error in logic is that the proposed 700 Billion dollars is simply flushed down the toilet. Wrong! The federal government would be buyings assets that currently are not liquid, but do have some value. Much of these assets are collateralized debt obligations, or sometimes referred to as securitized loans. A substantial portion of these loans are “non-performing”, meaning that that there are payments in arrears or perhaps the foreclosure proceeding have already begun. This does NOT mean these instruments are worth nothing! For instance, even if they government had to foreclose on every loan, the government would still be able to sell the collateral (the house) for some amount of money. Furthermore, since the borrowing costs to the federal government are extremely low (treasury yields are almost at 0.0% percent right now), this means the government can take a long time to unwind these securities. Many reputable economists and financiers believe the government will be able to purchase the distressed asset for less than cost (including carrying costs). This is commonly referred to as a profit. For instance, Warren Buffet believes that the few securities that are trading in this highly illiquid market are seeing potential rates of returns in the 15-20% range. Meaning, the federal government may ultimately be able to turn a profit on investment of around 140 Billion dollars. Failure to act on the other hand could lead to a collapse of the finance markets.
I should state that there are highly intelligent people who disagree with me. For instance Robert E. Lucas Jr and James Heckman both Nobel Laureate economists along with ~200 economists signed a petition with objection to the original State Department proposal. I have excerpted the objections from the position below:
As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:
1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.
2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.
3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.
For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.
I hope my two cents have helped you be more informed as to the trials and tribulation of the current economic mess. If you would like to know how we got into this mess in the first place you might want to check out this funny cartoon.