THE DREAM IN ACTION

This weekend I had a friend who works at JP Morgan explain his take on the bailout and why he thinks its a good idea. I thought his explanation was the best I’d heard so I’ll try and replicate his description here.

The major financial institutions in the US have bad assets on their balance sheets. These bad assets were absorbing many of the good assets on their balance sheets and thus negating any potential profits. These institutions would have been fine (wouldn’t have gotten caught) and could have survived if people and the markets weren’t involved, but thankfully they are! As the markets realized the affect of these bad assets on the financial institutions they lost all confidence, got scared and wanted their money back. As the markets began to panic, due to lack of confidence, the cash was yanked (bank run) from the banks and thus many of them failed.

Then the US Government decided that it needed to act to prevent a complete collapse. Enter $700B from the government in the form a bailout. Basically, what will happen is that the government will take the bad assets off of the balance sheets of the financial institutions and consolidate them on one balance sheet, the governments. As these bad assets are consolidated and quarantined the confidence in the banks will “hopefully” return and people will lend money to banks again, then hopefully back to business as usual.

So the bailout should not be looked at as a handout. It is more of a transfer of assets (loans that “should be” paid off) from banks to government. Luckily, it looks as though the bailout plan as proposed today will stagger the investments in these bad assets. This will hopefully work similar to a venture investment in the sense that they are tip-toeing into the water and not diving in. If they do this they will slowly vs. abruptly expose themselves to the risk that will come along with these bad assets.

At this point most people I’ve talked to would say that the bailout is needed and inevitable but the process by which it occurs is critical to its success. It is also generally accepted that the bailout alone will not be enough. It will take a significant effort from congress to look at the regulations that go into how money is lent in the future. Mark Cuban wrote on his blog that, “It should immediately become illegal for anyone or any company to advertise the sale of individual assets sold to non qualified investors.” That should give you an idea of how severe the regulatory changes need to be in order to protect us from future credit crisis.