Rock, Paper, Scissors for the Bail Out

About a month ago, I started talking with some friends and family about the sub-prime mortgage scramble, and the inevitable business deal that would have to take place between the Fed and the financial sector. That somebody, in some meeting, would need a hefty incentive to volunteer to insert his finger in the hole in the dike that Bear Stearns drilled. Economist Dean Baker does an excellent job of explaining how the whole scenario runs:

The Welfare King of the 21st Century
By Dean Baker, co-director of the Center for Economic and Policy Research

" ...While the subsidy involved in the below market lending is easy to see, the commitment to support the investment banks is probably the bigger subsidy to the Wall Street crew. The basic story here is that the investment banks made commitments, mostly in the form of credit default swaps, that they lack the resources to honor. These credit default swaps are essentially a form of insurance. The investment banks promise to make payments to bondholders in the event that there is a default on the bonds they hold.

The banks were prepared to deal with an occasion default, but they don't have the resources to deal with the sort of large-scale collapse that we are now witnessing as a result of the bursting of the housing bubble. Mr. Bernanke has effectively told the banks' creditors not to worry, because the Fed will make good on these credit default swaps, even if Bear Stearns, Lehman Brothers, or Goldman Sachs can't.

This is a very nice deal for the investment banks, because they got the fees for selling the credit default swaps, not the Fed. And they were very big fees, making the banks and the bank's executives extremely wealthy. In effect, the investment banks sold insurance that they actually were not in a position to provide. Instead the Fed is providing the insurance, but the investment banks get to keep the money they got from selling the insurance: nice work, if you can get it..."