I just posted a comment over on bonddad's latest diary. Thinking about it made me realize there was a lot more to say about this matter.
Government bailouts are, in financial terms, a free option game. For those who haven't played in the options market here is a little background.
An option is a right but not an obligation to buy or sell. The option on the right to sell is a "put"; an option on the right to buy is a "call". The study of options in real life - as opposed to financial markets - is the study of real options.
Real options are everywhere - the worst trader of real options in the world is the government.
More below the fold:
Why do I say that? Because options have a huge value in financial markets. Don't believe me - well, for example, yesterday you could have gotten over $3.50 per barrel now from someone for selling them the right to buy $110 per barrel oil from you in June, 2009. That is more than $15 per barrel over what the market is saying oil is worth next June. (If you want the basic concept of options and futures - "I'll glad pay you today for a hamburger next Tuesday" is a forward. "I'll pay you $0.25 today for a $1 burger next Tuesday" is an option). Not chump change.
So any time you are giving someone the ability to sell you their obligations in the future, you are giving them an option.
When Ben Bernanke says "we need to inject liquidity to protect lenders" he is saying two things: first, we will reduce the cost of capital to cover your loses; and second, we consider you too important to fail so we will bail you out somehow. In both cases, these act like a put to limit downside losses.
Now, as a trader, I look at these as leverage. Many traders base their strategies on what are called "certainty equivalents" - the likelihood of an outcome times the value of the outcome. If I think I have a 30% chance of making $5 million and a 70% chance of losing $2 million, my certainty equivalent is .3 times 5 minus .7 times 2 or $100 thousand. That is a very small margin for the potential risk.
But if I believe the government will bail me out for any risk over $1 million, my calculation now becomes .3 times 5 minus .7 times $1 or $800 thousand. My ability to "lean" on the government has just increased my expected profit by 8 times.
And if some is good under this scenario, more is better. What happens if I risk $15 million to gain $20. Now the number become:
.3 times 20 minus .7 time 1 (yup, the good old gov steps in again) for a potential profit of $5.3 million. Now change the M to TR and you are looking at the mortgage backed securities game.
And don't forget, that assumption of $9.8 million in risk (.7 times 14 - the risk over the bailout value) is an option on the government that was provided free by the government. The option on this could be a cost of - for example - over $5 million (estimating value based on the percentage likelihood). So the government has taken a large risk with no reward while giving the trader a shot at big reward with less risk and no cost for the risk reduction. Great trading strategy.
And the government bailout - as bonddad argues - continues to spiral the risk taking higher and higher. And the risk is really the taxpayers.
As so many poker players say, "Who cares, I am playing with house money." Unfortunately, in this scenario, the house money they are playing with is yours.