It will take a lot of time to complete this post.

Don't read it till it is completed....it will be edited a 100 times....

Once it is complete , i ll open the thread.

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Lets start with the very beginning.

It is essential to understand the problem before we can find a solution.

Everyone knows that a bubble has burst in the world economy.

2000 had seen the IT bubble burst.

*** So what was this bubble about?

Many people would say it was a real-estate bubble or bad-debt bubble.

The truth is that it was something much bigger much more sinister than that.

It was an assets bubble.

This bubble was very different from most of the other bubbles that the world economy has seen in its recent history.

It was a bubble where money was losing value and assets were gaining value.

Think of any asset that you can - debt instruments, real estate, crude oil, gold, stocks, food etc. Most assets had seen significant price appreciation before the bubble burst.

Why were the prices of these assets going up?

because money was losing its value.

When money loses its value, prices go up.

This is what we call inflation.

The world had trapped itself in a financial system where it made no sense to hold cash. No one wanted to hold cash and people started buying all sorts of assets.

but why did it happen?

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*** So why did we have as "assets bubble"?

It is common knowledge that excessive money supply causes inflation.

When there is a lot of money in the financial systems, price of goods/assets go up.

For years, central banks around the world had kept their monetary policies loose. Interest rate were kept low and government deficits were allowed to grow beyond reasonable limits. (This is true especially for US and a few EU economies).

but excessive money supply was not the only cause of this bubble.

There were two more reasons:

excessive leverage - In the last few years, dozens of different financial instruments had been come into prominence which allowed companies to create assets much bigger that their actual capital.

A good example of this would be mortgage-backed securities.

Multiple mortgage loans were bundled up as one single instrument and were sold-off to investors. This freed capital for banks and allowed them to give more loans. Thus, banks ended up with assets and liabilities much bigger than their own capital.

excessive risk - Excessive money supply and excessive leverage resulted in excess of money in hands of the lenders. When these lenders couldn't find reliable borrowers, they started lending to anyone who wanted a loan.

Thus, emerged the sub-prime crisis. (It must be noted that the sub-prime problem is not limited to real-estate. It even exists in credit cards, personal loans, corporate loans etc. It is just a matter of time before these get exposed too).

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*** What will happen if the institutions are not bailed out?

1. Domino Effect:

A failure of one big financial institution can lead to failures of my more.

Lets assume AIG was allowed to failed.

AIG had a asset base of over $1 trillion.

If AIG filed for bankruptcy, then all its assets would be put for sale.

This sale would have to completed within a fixed time frame.

As explained in earlier post, this would mean AIG would recover only a fraction of value of its assets.

In case of Lehman Brothers, its lenders estimate that they will recover 40%-60% of their debt.

AIG's asset base is bigger, but at the same time it is better in quality than that of Lehman Brothers.

My estimate is that AIG's assets would fetch around half of their current market price if sold in a hurry.

This means lenders of AIG lose half of their money.

Now many other banks are creditors to AIG. These means these banks will have to write-off huge amount of their assets.

This in turn could mean that many banks would suddenly find themselves short of capital and also may forced to file bankruptcy.

More bankruptcies = more writing-off of losses = even more bankruptcies.

A domino-effect would start and one by one banks will start to fail.

Most people think that they won't be affected if bigger institutions fail.

This is absolutely incorrect.

As more and more banks will fail, people will lose their deposits with the banks.

In US, deposits only up to $100000 are insured by FDIC.

Now, FDIC itself has very little capital left.

If a domino-effect starts in the US banking industry, FDIC would have no money left. Unless US government injects billions of dollars into FDIC, most depositors would lose a part of their deposits with banks.

2. MTM Losses will Jump:

Many assets of banks are recorded at market prices.

If institutions like AIG start dumping financial assets in open markets, the prices will crash.

There may be many banks who don't have direct exposure to AIG, but carry similar assets like AIG. All such banks also will have to mark down their assets according to market prices.

This will mean they will need more capital to run their daily business.

If such banks aren't able to raise adequate capital, they too may start selling their assets.

3. Money Markets will be Killed:

US money markets (where banks and corporates lend and borrow) have already come to a near-standstill.

If bigger banks start to fail, everyone and I everyone will stop lending money in the money market.

Lending would become a high-risk business.

In such a scenario, business that need constant cash flow will be badly damaged and many may even be forced to close down.

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The above mentioned consequences are not a product of imagination.

US has already faced them during the "Great Depression".

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*** What these Bailouts Prevent a Recession?

These bailouts are definitely not going to prevent a recession.

The motive behind this bailouts is to buy time.

If the bubble is given time to unwind, the consequences will be less destructive.

Contrary to what most people believe, I will many banks will fail in spite of the $700 billion package.

From what I understand, the package will buy assets from banks that are willing to sell them at the cheapest discount (compared to the price at which the asset was created).

This means that the banks which sell assets to the government will still have huge losses. In many cases these losses will be big enough to push the banks in to bankruptcy.

As I stated earlier, the motive of these bailouts is to unwind the bubble slowly.

The government has given itself 2 years to purchase bad (or illiquid) assets. This period may be extended too.

This would mean not all assets will get dumped in the open markets at the same time.

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*** How long will the recession last?

See this thread:

US Recessions - An Observation

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*** Where should a US investor park his money?

The best bet would be the US treasury bills.

It is very unlikely that banks will come out of this turmoil unscathed.

It is very difficult to predict which banks will fail and which will survive.

If at some point of time, FDIC doesn't have enough money to compensate customers of failed banks and the government refuses to replenish FDIC's funds, customers may lose their bank deposits too.

Another good investment may be Gold.

In the long-term, gold doesn't appreciate much compared to equities or real estate, but in turbulent times gold can be a big saviour.

If US economy collapses, the dollar will be butchered too.

In such a scenario gold prices compared to the US$ will rise very very sharply.

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*** Why forced selling is bad?

When a company files for bankruptcy, it is forced to sell its assets within a given period of time.

For assets that aren't really big or have a liquid market, selling them off isn't a big issue.

However, when the assets are disproportionate to short-term demand for the assets, the price recovered is far less than fair value of the asset.

Let me give an example here.

Consider what happened to Orchid Chemical's stock in March 2008.

It all started with the collapse of Bear Stearns.

Bear Stearns had long positions in Orchid Chemicals.

When Bear Stearns's survival became doubtful, it started its holdings in global equity markets.

Orchid's stock started going down because of this selling.

When the price started to crash, other traders who also had long-positions started getting margin calls. Many were not able to meet these margin calls and brokers started selling their holdings too.

more selling = more price fall = more margin calls = more selling.

It became a vicious cycle and the stock halved within a few trading sessions.

Did Bear Stearns believe that the stock was a bad investment?

No.

Did other traders believe that the stock was a bad investment?

No.

The stock didn't fall because there was a fundamental problem with the company, but it fell because there was a problem with those holding the stock.

Thus, the stock recovered all its price in a week.

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If US financial institutions start filing bankruptcies and are forced to sell their assets in a short-period, they won't even get a fraction of the current prices.

(Mortgages are assets for the lenders and liabilities for the borrowers).

Lets take the example of Freddie Mac and Fannie Mae.

Both this institutions own mortgages worth trillions of dollars.

If trillions of dollars worth of mortgages were dumped in the open markets, how much would the two companies recover?

My guess is these companies won't even recover 20% of their assets' current prices.

Forget about mortgages.

Think about any other asset.

Lets say gold.

Gold is trading around $800/ounce.

If a seller dumps trillions of dollar worth of gold in the open markets, will he get an average price of $800?

No.

He won't even get $200 per ounce.

Why?

because each market has a limited supply-absorbing capacity in the short-term. Gold did not lose its value, but as there was a temporary increase in supply the price would correct sharply for a short-period and recover when the selling stops.

If this same gold is sold slowly over a year, it would fetch a much better price.

Same is true for all assets.

It is estimated that mortgage assets in US are worth $10 trillion.

If these financial institutions go bankrupt and start dumping these assets in the open markets, who will buy these assets?

Americans or their government don't seem to have much money now. It will be impossible for them to buy $10 trillion worth of mortgage assets.

So who will come and buy?

The people who have lot of cash. People like oil-rich Arabs. People like the Chinese, who have huge foreign exchange reserves.

The end result?

$10 trillion worth of American assets will go in hands of the Asians (and other investors) for $1 trillion.

Asians will be buying American debt worth $10 trillion for $1 trillion.

Even if every 1 in 2 mortgage borrowers defaults, the buyers of these mortgages would still recover $5 trillion from these mortgages.

A neat 5 times profit for the Asians.

Do the supporters of bankruptcies really want this to happen - cash-rich Asians coming and buying US assets at throwaway prices?

Who will lose from these bankruptcies?

The equity holders in these companies are already wiped out. The market value of these stocks is hardly a fraction of their 2007 peak prices.

If these big financial institutions were to go bankrupt, the biggest losers would be the debt holders of these financial firms - majority of these are still American.

Instead of letting these big financial firms to fail, if the US government buys some of the mortgages and slowly sells them, the amount recovered from the sale of these assets would be much higher.

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