Bailout, Free-market, and Capitalism

From Motley Fool:

We believe that if the Paulson Plan is done correctly, American taxpayers will profit not only from the return of lending capacity to our banks, but also from these troubled investments. However, the plan should embrace the tenets of free-market capitalism. The government should demand equity stakes in the banks.

The discussion of the bailout plan seems to be less smooth as the market knew yesterday. Nobel Laureates in Economics and Economics professor signed in a letter to urge the congress to look into the details before passing the bill. Jim Rogers, of course, continues with his criticism of the Fed and US Treasury, claiming that the bailout is "Welfare for the Rich". The discussion is also political as it is going to cause taxpayers money, and especially with John McCain getting involved after suspending his presidential campaign. Well, I believe John McCain really knows nothing about Economics, and the US would be better off if they don’t choose John McCain.

Besides that no details were available and the discussion becomes political, another question worthwhile of considering would be the free-market and capitalism. As we see from the Motley Fool letter says that "the plan should embrace the tenets of free-market capitalism. The government should demand equity stakes in the banks." On the other side of the Atlantic, the France president Nicolas Sarkozy called for a "rebuild the whole world financial and monetary system from scratch", which sounds quite extreme. Let us look at not only bailout, but also the crisis itself. Are they exposing the weaknesses of Capitalism? Is Capitalism not working?

Supposedly, in a capitalist economic system, savings are being invested and create wealth. In the past, savings would be placed into a bank, which is a financial intermediary, and bank will invest by lending out money to corporate or individual and earn the spread between the interest the bank is paid and the interest the bank paid to depositor. With stock and debt markets, our savings have larger variety of places we can invest it, but at the heart of this process is that, we provide capital for corporate which can create most wealth first.

The amount of savings varies across countries. The invention of mortgage-backed securities was a good thing in a sense that people with much savings can invest into somewhere which does not have much saving, but at the same time demand much savings to fund their investment. However, I believe that many of the innovations in mortgage securities have gone too far for most people to understand, even for smart people. Tranching for example, try to distribute the prepayment risks across difference tranches, so that investor which hate the uncertainty of maturity of mortgage would still have chance to buy one. Insurance companies are one example of these. When the structure of the product becomes more and more complex, investors will have less and less knowledge about it. Buying them before knowing them thoroughly is perhaps a cause of this crisis. And this "illness" of investors are not limited to individual investors, but also institutional investors, who are supposedly smarter.

The development of derivatives was also a dangerous thing. It is easy to blame it now, but I did think that there is problem with these derivatives. Now we all know how AIG went bust as it sold credit insurance. Credit Default Swap (CDS) is a derivatives instrument traded over-the-counter. The credit insurer who sells CDS will receive a premium from the counterparty, for example, 300 basis point of the notional. If the notional is 100 million, the premium is 3 million paid annually, for example. If the underlying notional bond does not default, the insurer will keep on receiving 3 million. However, if it does default, the insurer will have to pay 100 million to the one who has bought the CDS. It may be a nice business if the insurer are selling CDS insuring 1,000 different bonds, the face value of each is 100 million, and the premium is 300 basis point. It will be a good deal if over time only 1 of the 1,000 default each year. But now, as we are in a credit crisis, 10% of them going default will probably kill the insurer. The one who bought the insurance is in trouble too as their counterparty may go default. But why everyone did not ever think of the risk of the insurer being not able to pay?

So our system supposedly was to put money into somewhere which needs money and create wealth. But at the height of the boom time, were investors turning into gambler?

So now the crisis is unfolding. Who needs help? Of course, it does not make sense if those who bet on the market and end up losing money are worth being helped: investors (or gamblers) should be responsible for their own actions. Is the 700 billion bailout plan violating this by helping Wall Street firms to get through? Is it ok to use the taxpayer’s money to help the Wall Street? It actually sounds not quite right, as Wall Street firms made their wrong bet. In some sense, it is wrong to bail them out. But then, it is very hard to assess the impact of letting them die on the economy. While Jim Rogers always think that letting it die to clean the system up is the best way, I believe that if this was allowed, we would see a very deep recession which takes years to recover. Will the States and the world afford that? I wonder.

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About Zarathustra

Zarathustra: Founder and Managing Editor of Also sprach Analyst. Once an analyst, now an investor and entrepreneur. Based in Hong Kong, but Londoner at heart.