The cost of recovery

Last week will go down as one of the big ones in financial market history. The failure of Lehman, the purchase of Merrill, the government takeover of AIG, the $200-billion "run" on money-market funds after three "broke the buck" told authorities that a systematic approach to solving the crisis was needed - and the week ended with such a plan.

Congressional leaders have promised to quickly allocate $700 billion to purchase bad assets from troubled banks and the Treasury has earmarked another $400 billion to guarantee money-market funds. In short, the US has shifted into bail-out mode.

It's important to note that the "cost" of the programme is not the $700 billion but the loss taken on that value. Our rough estimates, based on initial sub-prime loss estimates of $1 trillion and the fact that more than half of this has been written off already, put the cost to the taxpayer at between $90 billion and $180 billion.

Another estimate can be gleaned from the 30-per-cent haircut taken by the Resolution Trust Corp (on its $550 billion of assets bought/sold) in the early 90s, of which 80 per cent was paid for by taxpayers. The same proportions today (on $700 billion of assets) imply losses to the taxpayer of $168 billion and another $42 billion of losses paid for by existing shareholders.

Is that a lot of money? It's a lot to ask the taxpayer to fork over when he didn't cause the problem. As unfair as this is, it is a lower-cost solution than doing nothing.

Why? The economy is growing at about a 2-per-cent rate. It should be growing at about 3 per cent. That difference - 1 percentage point - is worth $145 billion on a $14.5-trillion economy. In 2007 and 2008, growth will have averaged 2 per cent instead of 3 per cent, costing taxpayers $290 billion. If not fixing the banks were to bring zero growth for a year (many predict worse, that is, negative growth/recession) the cost to the country would be an additional $435 billion.

So what's worse? Paying $100 billion-$200 billion to bail out the banks? Or paying another $435 billion in lost output (on top of the $290 billion already paid)? That debate can have already been made moot. The programme is likely to be passed this week.

Still, politicians will complain loudly (and correctly) that bail-outs are unfair and efforts will be made to make them less obvious. One way is for the Fed to keep short-end rates low, allowing banks to profit/rebuild capital by lending at the long end.

"Riding the yield curve" was useful in the 1990s and it will probably be employed to some extent in this crisis, too.