When a bailout isn’t

Big Lizards has a good explanation of what is going on in the financial sector debacle in Democrats Try to Hijack the So-Called “Bailout”.

This is the crux of the crisis: Back in the cretaceous period, when a bank or S&L issued a mortgage, it held that mortgage until the borrower paid it off. But in the contemporary era, what starts out as a mortgage is typically bundled with other mortgages into a “mortgage-backed securitie” (MBS) — essentially bonds that can be traded on the open market. Bizarrely, in the process, bad debt automagically becomes good investment.

How are MBSs created? Let me quote from an excellent sumary in a newsletter by John Maudlin (free registration required):

What happened is that the mortgage loans got sliced and diced into investment securities and separated from their underlying value base. That meant their actual value was difficult or impossible to determine. When some parts of a sliced and diced investment goes sour, the rating of the investment drops and current laws and regulations may require the investment be sold. The problem is that no one wants to buy because they don’t know what they are buying and what it’s really worth.

It was that uncertainty that caused the mortgage market to collapse. It’s like trying to buy a car when all you can see is a grainy photo in a newspaper: You can’t test-drive it, inspect it, or even kick the tires. You don’t even know whether it contains an engine… how can you possibly make any kind of offer whatsoever?

That is where the government comes in. The idea is to purchase the investments that must be sold at a significant discount.

That’s why the Paulson-Bernanke plan is neither a bailout — the so-called beneficiaries in fact must pay dearly for their folly — nor massively expensive, since it resells most of the securities it bought, and at a profit.

The idea is that the government has the capital ready to hand to purchase these fuzzy investments now and the time and manpower necessary to sort them out and determine actual values. If the discount was properly determined, it should ameliorate or eliminate any net cost to the government.

The rest of the blog post is about how the Democrats in Congress are playing political games by using the need to assist the financial sector as a lever to push some of their political goals. No one disputes the need for assistance but some think it an opportunity to force others to comply with their desires.

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