Why the Fed Bailed Out the Banks instead of ‘Regular Folk’

A friend of mine asked me one question that a lot of people seem to have about the last recession: why did the Fed bail out the major banks whose financial recklessness had set the recession in motion, instead of bailing out the man and woman on the street who needed the help more?
There are a lot of ways to answer that question so I’ll try my best to keep it simple (a proper explanation would require volumes).

Reason #1: The stakes were higher on the banking side.

 To me, the biggest reason the government bailed out the banks instead of the ‘people’ is the immediacy of the banking system’s pressure. Without a cash infusion, banks would have collapsed which would have taken down assets and deposits across the economy, far beyond just real estate. By the time Lehman Brother’s collapsed (because the Fed wanted them to sink or swim on their own, sans bailout) it unleashed such a tsunami of losses and asset write downs across many banks that were counter parties to Lehman’s derivatives and loans that it would have made no sense to let another one follow its path. Look at AIG’s near collapse for another example. If those banks collapsed, Main Street companies like GE, Ford, General Mills would quickly find themselves unable to pay suppliers, employees, or run operations leading to even greater catastrophe, mass layoffs and even deeper mortgage defaults etc. The recession it would unleash would make the Great Depression look like a practice test. By not bailing out the people, what we did have is massive defaults of people who had mortgages they shouldn’t have had anyway. Remember, this was subprime mortgages. Which leads us to:

Reason #2: The Fed bailouts are Loans not Gifts

The banks were sitting on huge productive assets that could provide cash flow to get them back on their feet. Not all the banks ‘bailed out’ actually needed it, the Fed just gave a blanket bail out to prevent giving people a clue to which banks were under and thus, inadvertently setting off bank runs . Even Lehman at the time of its collapse had more assets than liabilities, the problem was that it was highly levered (circa 32x its shareholder equity) and the value of its collateral, it’s real estate and mortgage portfolio was deteriorating faster than it could keep up with (just as leverage juices your returns when times are good, When it turns against you the devastation is just as rapid). So by giving the banks a massive cash infusion, it gave them breathing room to survive their liquidity crunch knowing fully well that they would then pay back through their other assets. 

If the government had handed huge loans directly to the citizens affected precisely by their inability to service existing debt obligations then how would they have ever paid back? And if you say they could’ve got the money as free grants, it would’ve required $1 trillion at the very least. $1 trillion in a pay back loan is not the same as $1 trillion ‘free money’. Treasuries and economies have been wrecked by less. 

Reason #3: The Use Case Effectiveness

Let’s say by some magic, Uncle Sam could even afford to hand out that much free money, then what? Would the people use it to pay off the mortgages (majority of which at the time were way higher than the value of the underlying homes) which would still amount to a massive transfer of wealth from government to the banks (who would book massive profits) completely free of charge? That would just mean they found a massively more expensive and completely free way to still bail out the banks (don’t forget that a mortgaged house is owned by the bank in the real sense). The other option would of course be to just walk away from the homes and keep the money in which case, the government just rewarded some citizens handsomely  for financial recklessness and speculative buying which I don’t imagine will go down well with those who were busting their behind to make their own payments.

There are plenty other reasons, some of which have to do with the nature of reserve banking itself (the Fed Reserve system means that the Fed lends money to banks (not people)precisely when they can’t find any other source in the expectation of eventual pay back. That’s their entire raison d’etre. Plus, they would expect whatever money they hand to banks to experience the multiplier effect as it is handed out as loans ($10bn Fed money can turn into $100bn in new loans in the economy). Handing money directly to the people has no such multiplier effect. 

While I recognize the unfairness (morally speaking) of bailing out the banks after their recklessness, there were few better alternatives. The Fed and govt should’ve kept a tighter leash on the system to begin with instead of creating incentives for the recklessness like they did (during Clinton’s admin with their mortgage guarantees to spur home ownership) so they have complicity in the issue too. Now, after the whole fiasco, the regulatory environment has improved massively. If only they had done that from the start. 


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