Posted on 09/23/2008 2:55:47 PM PDT by mojito
What’s a principled conservative to think of the Bush administration’s proposed $700 billion authority to allow the U.S. Treasury buy illiquid securities? On the one hand it would appear to be a necessary step to solve a systemic crisis in the U.S. banking system. On the other, it promises to be an enormous expansion of government power and commitment of taxpayer dollars.
To arrive at a principled view on this intervention, we must answer three critical questions: Is it necessary? Will it work? And even then, is it morally justifiable?
Unfortunately, we are thwarted at the outset. There’s simply no objective way to know whether the banking system is as close to disaster as top officials at the Treasury and Federal Reserve claim. They themselves don’t really know. This is a “banking crisis,” they say. But then again, other politicians claim there is a “health care crisis,” an “immigration crisis,” an “energy crisis,” and so on.
There’s no doubt that there is serious turmoil in the banking system and financial markets. But that doesn’t mean the proposed extraordinary intervention by the government in private markets is justified, considering that throughout history we have periodically gone through convulsions worse than today’s and survived them without such interventions.
According to the Federal Deposit Insurance Corporation there have been 15 bank failures in the U.S. between 2007 and today. We had thousands over a few years in the late 1980s and early 1990s. Since the stock market hit an all-time high last October, the S&P 500 has fallen 23 percent. It fell more than twice that — 49 percent — during the last bear market, between March 2000 to October 2002.
Even if you grant that this really is a “crisis,” and that it justifies an extraordinary intervention, there can be no doubt that the $700 billion authority being sought for the purchase of distressed mortgage-related securities is far too great an amount. Of the $1.26 trillion in non-prime mortgages — that is, “sub-prime” and “Alt-A” mortgages — $743 billion is already either owned or guaranteed by Fannie Mae and Freddie Mac, companies that were shored up by a government rescue earlier this month. That leaves $521 billion, which means the Treasury’s $700 billion would be more than enough to buy them all. And that’s even if the Treasury paid full value. In fact, the Treasury will get a steep discount, considering that many of the mortgages in question are in delinquency or default. Does the Treasury really have to buy every single non-prime mortgage — even the healthy ones — twice over?
And if the Treasury’s authority were scaled down to something more in proportion to the size of the asset market it claims to address — say $350 billion — must that authority be granted all those dollars at once? Couldn’t we start with $100 billion and see how it goes, and go back later for more if necessary?
In order to restore confidence in these shaky markets, there’s no doubt the administration would claim that its commitment must be both large and irrevocable. But considering the enormous powers being vested in the discretion of a single unelected official — the Treasury secretary — markets may also find solace in the idea that there will be an accountable process for learning from mistakes and making appropriate corrections.
Which brings us to the next question: Will it work?
Nobody knows. On the face of it, it is plausible that the banking system could be reinvigorated by having unwanted assets taken off its books. With those assets gone, and replaced by government cash, banks could stop worrying about the bad decisions of the past and get back to the business of financing investment and consumption in the American economy.
Yet there is ample room for doubt. The officials advocating this — Henry Paulson and Ben Bernanke — are the same ones who, in similar haste, engineered interventions this year in the collapses of Bear Stearns, Fannie Mae, Freddie Mac, and American International Group. With each intervention the banking crisis has gotten progressively more severe. Experts differ on this, but it is my professional judgment that these interventions actually made matters worse, because of the unintended consequences that were nearly impossible to forecast at the moment of decision. We simply cannot know what unintended consequences might be unleashed in the process of a massive acquisition of mortgage assets by the federal government.
And it is a false comfort to compare the proposed $700 billion purchase authority to the Resolution Trust Corporation, the government program of the early 1990s that was created in the aftermath of the savings-and-loan crisis. The RTC was quite successful in managing the assets of insolvent banks and thrifts, and the administration’s current proposal bears little resemblance to it.
The present proposal is primarily about the government acquisition of unwanted assets from solvent banks. The RTC acquired its assets automatically when thousands of banks and thrifts became insolvent and fell under receivership by the FDIC and the Federal Savings and Loan Insurance Corporation. There were no troubling ethical questions about which assets would be acquired, from whom, in what priority order, and, most critically, at what price. All the RTC had to worry about was eventually selling the assets it already had.
And assuming that it is necessary, and assuming that it is likely to work, is this epoch-making intervention in private markets morally justifiable? Die-hard conservatives — especially deficit-hawks and free-market libertarians — would say no. But some mitigating circumstances should be considered.
It seems at first blush that spending $700 billion to buy mortgage-related securities would be a budget buster. But remember, this is not government “spending.” It is government “investment.” The Treasury would issue bonds, pay a low interest rate on those bonds, and use the proceeds to buy mortgage-related bonds that pay a high interest rate and can probably be sold at a profit in the future.
It also seems at first blush that the government ought to not bail out banks that made terrible investments they now regret. But remember, many of these bad investments were the result of government meddling. Would we be experiencing a sharp housing downturn, and a wave of mortgage defaults, if the Federal Reserve had not created a housing bubble and a mortgage bubble in the first place by artificially lowering interest rates to 1 percent in 2003 and 2004? And how much was the housing bubble inflated by the highly leveraged mortgage buying spree of government-sponsored and government-influenced Fannie Mae and Freddie Mac? Shouldn’t the government shoulder some responsibility for its own mistakes?
As the week goes on, and as more details become known about the form the intervention legislation will take, it could be that the principled conservative who supports the administration’s plan today will find that he must ultimately oppose it. It’s hard to object to calls by Democrats for more oversight and accountability. But the Democrats are threatening to poison the legislation as they attempt to grab equity stakes from, and control executive compensation at, the companies that would sell securities to the Treasury under the program. And they are larding the program with pork to further subsidize the already heavily subsidized housing industry, turning some of what should be government investment into government spending.
In the end, each principled conservative will have to use his or her own judgment to weigh the imponderables here and come to a conclusion, yeah or nay. As of this writing, I’m inclined to support the administration’s proposal, although I wish it could be made smaller, at least at the outset.
One thing I know for sure: While the administration and Congress wrangle over the details, markets will continue to flail. It’s going to be a rocky week. Let’s hope it has a happy ending.
But if you give me a big bag of money....
Like going all in while trying to fill an inside straight.
> I find this discussion a persuasive accounting of the pros and cons to the bailout. <
Yes, but Luskin concludes with a weasel-like statement to the effect that everybody must simply make up his own mind.
I prefer the analysis of Thomas Sowell, who realizes that delay will only increase the odds of a financial meltdown:
http://www.freerepublic.com/focus/f-news/2088742/posts
mortgage backed securities held by US banks
mortgage backed securities held by Chinese foreign banks
securities backed by student loans
securities backed by credit card debt.
It may be just an oversight, but he's not yet been asked whether he'd be buying securities backed by torn-up Lotto tickets.
I suspect much of the money would be used to try to prop up a house of cards built on credit default swaps. The basic idea of a credit default swap is that Bob gives Joe $20,000 in exchange for a promise that if the value of a certain asset falls below $1,000,000 Joe will make up the difference. Note that there's no requirement that Joe actually hold that asset, nor even that Bob hold it (or anyone for that matter). Further, there's no accounting of how many such bets Joe has underwritten, or what assets exist to back them up.
To adapt a simple analogy from Freeper on another thread, suppose I offer you a wager that a coin flip will come up heads; if I win, you give me $10,000,000; if you win, I give you $10,000,000,000,000. For whom is that a fair deal?
Obviously that example is a bit extreme, but consider this one: assume I have $6,000,000 in assets. You give me $100,000, and if next Friday's Mega Ball in the Illinois lottery is a "7" (one in 46 chance) I'll give you $5,000,000. Looks like a good deal for you, since it seems I have the funds to back it up. Suppose I make the same deal to 1,000 people, though. If I win (the ball isn't a "7") I pocket $100,000,000. If I lose, well, then I lose; my customers may get their $100,000 back plus about $6,000 for "winning".
The banks should then be grateful. They'll know what they'll be getting, which won't be a total loss, and they can then write down accordingly.
Then the Treasury will be able to discard the bad, and repackage those assets (the underlying mortgages and real estate) and sell them for a small profit, say 7 cents on the dollar. Which would still be a good bargain to attract private purchasers.
That money can then be refunded to the American taxpayer, with a small profit for the cost of the loan.
Thanks for your responses! I am amazed at the wealth of knowledge here....and as a result, when I go out to deal with liberals, I find I’m a lot better off than they are in the facts department!
Supercat, are the hypotheticals you created examples of derivatives? If so, you defined for me what many articles and talking heads did not!
Well I hope so. Maybe then I can get paid for my torn up Alabama-LSU-East Carolina parlay card from last week.
In theory, companies offering credit default swaps are supposed to cover independent risks. An "honest" arrangement of that type would be for me to offer $4,000,000 payment instead of $5,000,000 to "winners" of my Mega Ball bet, and to have 1/46 of the assets cover a Mega Ball of "1", 1/46 cover a Mega Ball of "2", etc. In that scenario, the buyers whose ball comes up get $4,000,000, while I'll net $13,000 per investor. Note that if I take 1,000 bets my theoretical total risk exposure is $4,000,000,000 but in practice if the bets are evenly distributed my real risk exposure would be very small (since 46 doesn't divide into 1,000 I might have to pay 22 winners instead of 21.7).
Unfortunately, there's no way of telling whether the CDS bets a company has sold are safely independent. In some regards, the CDS house is better off if they are independent (since its systemic risk is zero); in other ways, it's better if they're all dependent (to maximize the likelihood of having no payouts). Note that in the former scenario, the CDS must pay out below the applicable odds ratio; in the latter scenario it can claim to pay out anything.
If the bond defaults, not if it drops below $1,000,000. Kind of a huge difference there.
I suppose the term "value" was a bit too vague, since the value of a fixed income stream can vary with interest rates even if the income stream itself is constant; a CDS would not be expected to cover that type of fluctuation. Perhaps I should have said "...if an asset that is supposed to generate a specified amount of revenue fails to do so, Joe will make up the difference."
On the other hand, perhaps I should have added "...or half the difference, or 150% of the difference, or whatever is agreed upon." Unlike real insurance, a credit default swap does not require that the "insured" have a meaningful property interest in the asset. Totally bizarre. Imagine if someone could buy an insurance policy that would pay $5,000,000 if some particular stranger's $50,000 shack burned down. Would that not encourage massive fraud?
I'm still flummoxed by why anyone would think credit default swaps have any legitimate value. IMHO, in the raw form, they're nothing but a vehicle for fraud.
Say I bet that IBM will default on its debt. How can I benefit from fraud? How can I cause IBM to default? How can the CDS seller prevent IBM from defaulting, if they were on that path?
How does fraud enter into the CDS equation?
The fact that one can obtain multiple credit default swaps on an asset which together exceed its value creates an easy opportunity for fraud, equivalent to buying $5,000,000 on a $50,000 house and torching it. Doing things so directly might get some unwelcome attention, however. It may be safer to bribe someone else whose $50,000 house you've insured. Even if it's obvious to everyone that the house was torched, unless someone can show a connection between you and the owner, you're in the clear.
I don't believe you.
equivalent to buying $5,000,000 on a $50,000 house and torching it.
Great, how can I buy a CDS on IBM and "torch the house"?
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