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Fed bailout of Wall Street: Reverse Redistribution of Wealth September 19, 2008

Posted by The Armchair Economist in Business, Commentary, Economics.
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Fiscal conservatives (and the rich) have always cried foul over progressive tax policies and socialist policies(or as they see it, the redistribution of wealth from the rich to the poor). Today, we are witnessing perhaps history’s greatest reverse redistribution of wealth.. from the lowly taxpayer/common man to those who gambled on risky bets (and lost).

While this bailout was necessary to stem the fear running in on the Street and risking catastrophic damage to the US/world economy (think: companies going bankrupt, people losing jobs, less tax revenue, less social services.. depression perhaps), there is no debate that this is basically a free ‘put’ option to gamblers who were caught holding the bag.

Investing is a zero sum game, that means that for every dollar that was lost in the market, someone gained a dollar. When you invest, you are essentially making an educated gamble… this bailout offers a free ‘bottom’ to the losses that investors can incur (typically you can buy insurance to protect yourself from risky bets.. ie through derivative investments and hedges.. but the trouble comes when sellers of this insurance become too concentrated in a few companies and they are unable to cover in the event they need to pay out, as was the case with AIG and their credit derviative swaps)

Contrary, to popular belief, the term ‘bailout’ doesn’t mean that the investors who ‘lost’ are going to be protected from all of their losses.. they still are going to lose out, but they essentially aren’t going to lose as much as they could. For example, the fed negotiated a very tough deal with AIG… investors took a huge hit in their stake (an 80% dilution of their investment if my understanding of the deal is correct), but its not as bad as the alternative, which was if AIG went bankrupt and their investment is essentially worth zero.

While I hoped that the Fed would let the market work its magic and learn from their mistakes, I suspect that their actions will merely provide a band aid to a system that rewards leveraged and risky bets. We might not see another instance like this for 10 years or 40 years, but as companies grow bigger the systemic risk of their investments and actions get larger. In fact, I wonder when people will start adding a new factor into their investment models: the value of a possible fed bailout (imagine: a free put option proportional to the value of the investment).

Perhaps we’ll reach a day where personal accountability will actually mean something.. but I’m not holding my breath.

Edit: For a more detailed framework of the subprime lending crisis, read my old post.

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