Congress is now embroiled in an important and passionate debate about the Bush Administrationâ€™s rescue-bailout plan. Get past the anxiety, and it seems clear that the plan will not resolve the underlying problems driving the crisis, the deterioration of the housing market. And in another instance of the Bush economic doctrine, it would transfer untold billions of dollars from ordinary American taxpayers to the shareholders and executives of some of the countryâ€™s wealthiest financial institutions.
The administrationâ€™s first mistake â€” thatâ€™s more polite than calling it simple distortion â€” is the premise that the bailout is needed to provide liquidity for a financial system short on it. This claim is then elevated to a matter of national urgency bordering on potential catastrophe by the assertions from Treasury Secretary Paulson, echoed by Federal Reserve chairman Bernanke, that this liquidity shortage will soon prevent businesses from securing normal bank loans and lines of credit for their investments and operating expenses. The explanation is that no one is willing to lend to banks, even on an overnight basis, because they donâ€™t trust their ability to repay even the next day. Itâ€™s a fact that intra-bank overnight lending has fallen, and so has very short term loans to banks from other financial institutions. But there are no reports of sound businesses unable to secure loans and credits to meet their payroll or carry out planned investments. Moreover, the Federal Reserve has opened its discount window to all financial institutions, offering as much funds as banks want at very low, below-market rates. If a liquidity crunch should emerge, we already have the traditional mechanism to address it.
The administrationâ€™s second gambit is closer to reality, though it, too, does not necessitate the administrationâ€™s solution. They argue, correctly, that many financial institutions are on the brink of insolvency, because their huge losses from their highly-leveraged mortgage-backed securities and the derivatives based on them have overwhelmed their capital base. Thatâ€™s correct â€“â€“ and presumably after this round Congress will be sufficiently chastened to apply reasonable capital requirements to all financial funds and institutions that issue or purchase securities and their derivatives.
Itâ€™s too late this time, but the administrationâ€™s bailout would be either nonsensical or very inequitable. If the government intends to buy the toxic instruments at their market price, it wonâ€™t much help the institutions, since they will just have to take their losses. The alternative is the government buys the securities and derivatives at above-market prices, which would constitute the largest, regressive direct transfer in our history. And as an economic matter, how would this above-market price be set? And once it is, the governmentâ€™s intervention in the financial markets to buy hundreds of billions of dollars of assets at above market prices would constitute the most dangerous moral hazard imaginable.
If the financial market problem is a genuine and pressing need to recapitalize Americaâ€™s financial institutions, then those who provide the capital should receive the normal equity share. If the money comes from taxpayers, the government should claim preferred equity position in the institutions receiving the capital infusion. Those institutions wonâ€™t much like that, since it would give government leverage over their activities. Thereâ€™s an alternative: Donâ€™t ask taxpayers to recapitalize institutions that have squandered their capital through reckless mismanagement. They can find it somewhere else, as Goldman Sachs has done with Warren Buffett. Or, Congress could effectively require that the lenders to these institutions take equity shares, in whatâ€™s called a debt-equity swap.
The advantage of all threes approaches is that they donâ€™t require direct transfers from taxpayers of modest means to shareholders and executives with much greater means â€“ or if they do, the taxpayers get something real in return, as they would in any market transaction.
That will leave the larger problems still unresolved. First, weâ€™ll still need to address the underlying cause by slowing or ending the waves of foreclosures dragging down the housing market by creating either a direct loan facility for homeowners facing foreclosure or terms for them to renegotiate their current mortgages. Once thatâ€™s done, Congress will have to turn to the equally serious business of establishing transparency, capital and other regulatory requirements for all financial institutions, so we never find ourselves on this path again.