This is not an academic question. Every time he bails out a large financial institution he sends the message that the institution and all similar large financial institutions are insolvent. If they were not insolvent, there would be no need for the bailout.
As recently as December 2010, Tim presided over a bailout for Bank of America. This bailout took the form of Fannie Mae and Freddie Mac settling claims against BofA for pennies on the dollar.
Briefly, when a mortgage is sold to Fannie Mae and Freddie Mac, the seller makes a series of representations about the mortgage. If any of these representations are not true, Fannie Mae and Freddie Mac have the right to put the mortgage back to the seller and ask for their money back.
While the seller might contest these put backs, it is in the seller's best interest to write a check for the full amount. Why? Because Fannie Mae and Freddie Mac do not have to do business with the seller in the future.
But how can Fannie Mae and Freddie Mac stop doing business with the seller and still fulfill their mission? Nowhere does it say that the agencies must continue to do business with a financial institution where they cannot trust the quality of the mortgages that the financial institution originates (in fact, they are suppose to stop doing business with firms like this). As everyone knows, existing competitors in the mortgage market could easily replace BofA's origination capacity so there would be no disruption in access to funds by homebuyers. It is the capacity to shut off access without disrupting the mortgage market that gives Fannie Mae and Freddie Mac the leverage to insure that they are repaid the original purchase price.
Why are the deals between BofA and Fannie Mae and Freddie Mac a bailout? Because the US Treasury is covering all of Fannie Mae's and Freddie Mac's losses. If Fannie Me and Freddie Mac were private institutions without any claim on the taxpayer, it would be a different story.
The bailout had two parts.
- Fannie Mae and Freddie Mac received a fraction of the original purchase value of the mortgages. The difference between what Fannie Mae and Freddie Mac received and the this original purchase value is the size of the bailout. This bailout can be thought of as a direct equity injection into BofA.
- Fannie Mae and Freddie Mac did not stop doing business with BofA. This bailout can be thought of as an indirect equity injection as it flows through BofA's income statement.
Tim has long argued that he finds bailouts necessary but distasteful. If so, why does he keep doing them?
For example, is there any reason to believe that we have seen the last bailout of BofA? Today, BofA announced that it had $10 billion of exposure to representation and warranty claims by investors in mortgage backed securities. Is this figure remotely credible given that its Countrywide subsidiary was one of the largest originators and packagers of sub-prime mortgages? Or does management know that Tim will step in and bail them out if losses exceed this figure?
Furthermore, what about BofA's liabilities with regards to mortgage foreclosures? These liabilities arise for example if BofA sells a house that it foreclosed on, but it turns out that BofA did not have legal standing to foreclose.
How can Tim ever stop doing bailouts? He runs stress tests and claims that the largest financial institutions are solvent, but then turns around and bails them out. If they are solvent, why the ongoing need for a bailout?
Is Tim capable of stopping the government bailout machine? If not, is President Obama?
Is there ever a point in time, when Tim and President Obama might acknowledge that being on the bailout treadmill is not getting the US very far and that it is time for a different approach?