Thoughts on the financial situation

Brad DeLong just put a post up on his blog suggesting that the proposed $700 billion bailout might function as a large carry trade, in which the US Treasury would sell a number of risk-free(ish) Treasury bonds at relatively low interest rates to finance the purchase of risky assets from failing banks. Press coverage on this idea has mainly focused on the $700 billin number, which I find misleading. Reading only newspaper headlines, a person would likely assume that the situation was that the government is taking $700 billion dollars and giving it to troubled institutions to finance their day to day operations, lest they all go out of business and create a "credit crunch" where no bank will lend money because of the extreme unpredictability of the loan market. That's different from reality.

What's really happening (or is being proposed), is that the government sell off bonds (interest-bearing instruments backed by the equity of the US Government) with yields of 3-4% to invest in "toxic" assets that, due to their volatile nature, will likely yield somewhere in the area of 10% (after the massive discount of worthless securities and loans) . $700 billion is just the total amount of money that Congress is considering making available to the Treasury Secretary to make the initial asset purchase with. In the end, the government will almost certainly recoup some of that money--but there is also the possibility that, in the long run, this may be a net money maker for the government in the absolute rosiest scenarios. What is more likely to happen is a minimization of catastrophe--"losing the minimum" in poker speak--and the long-term gains of a more efficient system*. We're trading safe, low-return securities for high-risk, high-reward assets. Since most people seem to take the $700 billion as a sunk cost, hopefully we will be seeing some very pleasant surprises once all the bloodshed is done.

Or, to blockquote Brad Delong blockquoting Bloomberg:

Do the arithmetic. Suppose the government buys $700 billion worth of assets after a 50 percent haircut, holds them for four years and then sells them for 40 percent of par. That would be a capital loss of $140 billion. Meanwhile, the carry trade has earned perhaps $50 billion a year, or $200 billion over the four years -- an overall profit of $60 billion -- and lower budget deficits. Remember, there are no taxes affecting this deal.... [T]he risk to taxpayers is much less than you might think based on the congressional debate over the plan offered by Treasury Secretary Henry Paulson...

Like a number of others have noted, what we're facing here is completely unprecedented; before this is all over, you may see the government taking substantial, even controlling, interests in a number of Wall Street banks. I doubt it, though. Despite some in Congress grumbling that the government may not be asking for enough equity in the companies it's bailing out, I don't think Republicans will allow any systemic absorption of Wall Street by Congress. We'll see.

Side note:

In this video, shot about a year ago, Jim Cramer is screaming for Federal Reserve Chairman Ben Bernanke to "open the discount window" to banks--essentially to loan entities like Bear Stearns and Lehman Brothers liquid capital to refinance their operations. A lot of people have been tempted to proclaim Cramer a prophet--including me and Cramer himself--at this point it's spilt milk. Had we gone through with Cramer's idea of low-interest recapitalization, the "credit crunch" that we're experiencing--if we're even experiencing it; Tyler Cowen has yet to find much evidence for it--would have been staved off temporarily, though the housing bubble would still have burst. He's still a cool guy, but my "oh shit he's brilliant" moment has passed.

*This is my dangerous idea: Though nobody knows at this point how bad the market contraction will be, from the damage we've seen so far this may be a relatively painless(!!) process of correcting some systemic problems in our financial system. This weird socialist-capitalist hybridization of the US has yet to sort itself out, but in the end it may prove more market-efficient than many commentators currently forecast.

Thoughts? I truly don't know my ass from my elbow in economic anything, but this is my first reaction.