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Congress Acts: A Little Better Than Nothing

October 3, 2008

The $750 trillion bailout plan that the Senate approved, and which the House is expected to endorse reluctantly, could give us all a little more breathing room in the current economic crisis, but it won’t resolve anything. It’s much the same plan the House voted down a few days ago, with a bushel of tax breaks calculated to draw more votes but unrelated to the turmoil in the capital markets. It should stave off a short-term panic, but it won’t stabilize the credit or housing markets. Such a little impact seems hardly an effective use of $750 billion.

It’s hard to know how many members of Congress understand the forces seizing the financial system or how this plan would actually affect it, especially since the Treasury’s original three-page plan outline has become a highly complicated, 750-page piece of legislation. Most lawmakers know they have to act quickly to at least begin to address a crisis that’s become a critical focus for the voters most of them will face in five weeks. The truth is, economists don’t agree on the best course, with a broad range of theories and proposals — and telling agreement on not much more than the likelihood that the government’s plan won’t do the job. It’s not even likely to get all of us through the general election on November 4 without further upheaval.

To be fair, most members of Congress are caught between two opposing and very discomforting forces: Pass a bailout plan that will anger many of their constituents, or reject it and be held responsible for the next wave of economic shocks. It’s a fact that the markets will slide sharply and quickly if they believe that the government cannot pass any response — but also that this plan will only modestly soften or delay those consequences.

Why are we all left with these two sorry alternatives? I’m afraid we’re all prey to what economists call path dependence, when an outcome is heavily influenced by how a development began. A classic example is the ubiquitous success of Microsoft Windows. It’s arguably not the most efficient, powerful or effective operating system, and a rational market would normally have moved to other systems over time. But personal computing started with DOS, people and institutions became invested in its particular approach to the technology, and it continues to prevail. In this case, the Treasury hadn’t developed a plan even as the crisis unfolded, responding in an ad hoc way to the collapses of Bear Stearns, Merrill Lynch, Freddie Mac and Fannie Mae; bailing out some and not others based on their judgment of the moment about whether a rescue was needed to avoid system-wide panic.

By last week, after letting Lehman Brothers fall and facing a real prospect of multiple major failures and bank runs, the Treasury pulled together a three-page outline which it called a plan. And once that plan was distributed, it became the focus and organizing principle for the congressional debate, and path dependence took hold. The plan is inadequate — it doesn’t recapitalize financial institutions nor address the underlying deterioration in the housing market — but without a substantial period to bone up and consult experts, most members of Congress don’t have the ability to step back, ask basic questions of the plan, and approach the crisis in a different way.

Ironically, this suggests the same ‘best case scenario’ thinking that the Treasury and Federal Reserve have brought to this problem for two years, and which the Bush Administration has used for even longer in Iraq.

For now, this is the only plan we have. It should have some benefits. For $750 billion, or several million dollars per-American, we will place a floor under the losses of financial institutions for their speculations in the market for housing-based securities and derivatives. Our own best-case scenario is that this floor will be enough to attract outside equity investors for these institutions, recapitalizing the system over the next six months or so. But the bill includes only weak and marginal steps to help stem the foreclosures and falling housing values driving this crisis; and if the floor is not enough the attract outside equity investors, we will be right back where we started fairly quickly.

We could face the next phase of this systemic crisis soon, and as the problems spread across Europe and into Asia, intensified by a deepening recession, it could well be a dominant problem well into 2009 and the first great test for the next president of the United States.



It’s a Bad Bailout

September 24, 2008

Congress is now embroiled in an important and passionate debate about the Bush Administration’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 country’s wealthiest financial institutions.

The administration’s first mistake — that’s more polite than calling it simple distortion — 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 don’t trust their ability to repay even the next day. It’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 administration’s second gambit is closer to reality, though it, too, does not necessitate the administration’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. That’s correct –– 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.

It’s too late this time, but the administration’s bailout would be either nonsensical or very inequitable. If the government intends to buy the toxic instruments at their market price, it won’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 government’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 America’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 won’t much like that, since it would give government leverage over their activities. There’s an alternative: Don’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 what’s called a debt-equity swap.

The advantage of all threes approaches is that they don’t require direct transfers from taxpayers of modest means to shareholders and executives with much greater means – 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, we’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 that’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.



Crisis on Wall Street

September 18, 2008

This week’s financial developments have unfolded in the ways that keep people up at night and spark panic in even seasoned investors. And it’s not over yet — we’re perhaps midway through the financial crisis (which actually could get much worse), and headed fast into a serious and disturbing recession.

It’s as if the economy entered a time warp and we found our way into a 19th century boom and bust cycle — and the bust phase is never pleasant. It started, as everyone can now understand, when the bubble in the housing market opened up a new flank in subprime borrowers, Wall Street hotshots packaged those subprime mortgages into securities, bought by the tens of billions with tens of billions in borrowed money; and then even hotter shots created trillions in “credit default swaps” that guaranteed those securities against default. Once the housing market swooned, the rest was dominos, from mortgages to mortgage-backed securities to credit default swaps to the institutions that provided all the borrowed money for both.

You know the rest as the financial system began to crack under the monumental weight of defaulting securities — the denizens of free-market capitalism in the Bush administration bailed out Bear Stearns, then took over Fannie Mae and Freddie Mac, and then threw $85 billion in loans at AIG, with all of its assets as the collateral. Lehman Brothers and Merrill Lynch are gone, and in another month, so a number of other major financial institutions will join them.

The time to tackle these problems was during the boom, not during the bust, in extremis. That’s especially true with a boom where the risks are as graphic and obvious as they were this time. Instead, the potential costs were consistently denied, set aside, or ignored, and the biggest responsibility lies with those who should have made the long-term health of their companies and our economy their top priority. The titans of Wall Street and senior officials at the Federal Reserve, the Treasury and the White House economic council all understood the nature and extent of the risks. They are the “Michael Brownies” of the current financial crisis. (And lest we forget — as if anyone could — most of the Wall Street titans are walking away with tens of millions of dollars, because their compensation agreements reward them for high profits based on speculative risks and impose no penalty when it all collapses.)

This is a bust that was inevitable. With the enormous expansion in the global capital pool and the stream of hundreds of billions of dollars a year of that capital into the United States, financial institutions found increasingly risky ways to earn fees and other income from all that capital. Our government sat by as largely unregulated funds and investment banks create new securities and then sold them to investors leveraged up to 95 or 97 percent — including new funds they created themselves to buy the securities they issued themselves. Where was the Fed, the Treasury and the White House — or John McCain — when these instruments proliferated into the trillions with little collateral behind them. Ironically, many of these new instruments were intended to diversify risk, such as the credit default swaps. With those, the owner of assets like mortgages, auto loans or credit card debt exchanges a piece of the income stream from those assets for a guarantee that he’d be covered if the debtors defaulted. It works only if the incidence of default is very low — and those issuing the guarantees can make good when defaults happen. Indeed, a good of the colossal failure of the Federal Reserve, the Treasury and the administration involves their negligence in insuring that such defaults would remain rare and that those providing the guarantees when did happen could make good on them. Even as the defaults began to rise and the guarantees began to fail, they remain aloof, and their oversight and regulation virtually non-existent. The market became an inverted pyramid that inevitably would topple.

We’re in the middle of a slow-motion, cascading systemic crisis, and it’s not over yet. In fact, it probably won’t end until the housing market stabilizes and begins to recover. Meanwhile, it will continue to slowly grind down the economy for everyone. As the institutions that remain absorb more losses, they will have to sell more assets to restore their balance sheets, driving down asset prices, and limit their new lending to businesses. To get some sense of the dimensions, consider that the global market in credit default swaps is an estimated $60 trillion — that’s equal to the estimated value of all assets in the U.S. economy. If five percent of those swaps go bad, that’s $3 trillion, or six times the size of the Savings & Loan crisis and a nearly one-quarter the size of U.S. GDP. That’s another measure of the dimension of the criminal negligence committed by the Federal Reserve, the Treasury, the managements of Lehman Bros., Bear Stearns, AIG, Fannie Mae and Freddie Mac — and while we’re at it, thousands of smaller hedge funds.

Now we’re headed for recession. The economy has taken three massive hits — first housing, then energy, and now finance — and the inevitable result will be real cutbacks in both consumer spending and investment, and with them, growth and employment. The government is spending trillions of dollars to prop up failing institutions, but it has probably reached the limit of its capacity for bail outs, or will soon. That’s why, for the first time, the market is pricing the possibility of a U.S. government default.

For now, the best steps we could take would be measures to stop foreclosures and stabilize the housing market. Instead of just lending AIG, which speculated in mortgage-backed securities and the credit default swaps on them, $85 billion, we should make a comparable sum available as special loans to homeowners facing the possibility for personal default and foreclosure. Americans periodically go through phases where they believe that markets can do no harm. But markets fail as well, and this time, the lesson is an especially painful one. Hopefully we’ll learn, and begin at least to regulate financial transactions, wherever they occur, to ensure their basic transparency and a reasonable measure of probity.



Understanding the Mortgage Crisis

September 11, 2008

It’s a truism of this time, though one often doubted, that globalization is fundamentally good for healthy, successful economies. But unchecked and unscrutinized, globalization also can impose terrible costs, as we see clearly in this week’s U.S. government bail-out of Fannie Mae and Freddie Mac. Globalization set much of the stage for the meltdown, as our government’s systematic failure to regulate excesses in the financial system raised the curtain. Globalization produces enormous benefits — cheaper prices for electronics, garments, autos, and IT, to name but a few standard goods now produced through global networks. It also accelerates medical advances by increasing the demand for treatments. It promotes higher incomes and standards of living across much of developing world. And it also generates enormous new pools of saving and capital that have left the world awash in liquidity. All that capital creates inflationary pressures that found their way into asset markets, producing price bubbles in housing markets around the world. All that capital also seeks as high returns as possible, so that much of it found its way to our capital markets, where billions went into subprime mortgages and many tens of billions more into the leverage for financial institutions to buy the securities based on those mortgages and the derivatives based on those securities.

The sub-prime collapse was utterly predictable and could have been avoided entirely. Instead, the thoughtless, deregulatory prejudices of the Bush Administration allowed the excesses and distortions to grow until there was way no choice but to take over the two giants of the mortgage market, Fannie Mae and Freddie Mac. The Bush White House’s reckless approach to regulation is only part of the story. At any point, the Treasury or the Federal Reserve Bank could have stepped in or at least urged the Congress to do its duty. But we live in an era in which conservatives and some liberals live in exaggerated awe of unregulated markets. It’s been part of this cultural moment, and one aggressively supported by the economy’s most powerful and influential financial institutions.

Finally, the government’s takeover of Fannie Mae and Freddie Mac, which originate or buy 80 percent of mid-level mortgages in this country, became unavoidable. Their complete collapse would have stalled out the national mortgage market and sent housing prices falling further. In addition, foreign central banks hold tens of billions of dollars in Fannie Mae and Freddie Mac securities, creating a new and serious foreign policy dilemma for the Bush Administration. While the White House has remained steadfastly unmoved by the difficulties and interests of American homeowners, it could no longer stand by unconcerned about the difficulties and interests of our economy’s central financial institutions and those facing allied governments. Yet the takeover will do little about the declining value of securities held by them, unless taxpayers pick up the tab.

Make no mistake. This is the most serious financial problem U.S. markets have faced since the Great Depression. It requires responses comparable to those undertaken in the 1930s, namely to fashion new regulatory standards and rules to protect the economy from distortions and excesses in financial markets, made more serious and more likely by the globalization of capital. Our government should have no interest in protecting financial institutions from their own bad decisions. If they choose to invest 30 percent of their capital in risky markets, they can do so. But they cannot be permitted to do so with 90 percent leverage, because if and when those loans default, they create enormous losses for other institutions, producing a cascading effect that squeezes the normal flow of credit that our businesses and credit depend upon. We will need a new regulatory system to protect our economy from those cascading losses.

The Bush Administration is not up to this task, so if will have to come from the next president and his administration. They’ll need the support and backing of Wall Street as well as the American people, which will require difficult political work and unusual political leadership. That’s part of the challenge that President Obama — or perhaps president McCain — will face next January.