About five decades ago, General Motors’ CEO Charles Wilson infamously uttered what’s become the anti-Rand rallying point: “What’s Good For GM is Good for America”. The legions of Youtube bailout refusniks might rightfully wonder if our monetary policy is being driven by such self-serving drivel. After all, any national bailout of the entire banking system is never going to be popular.
So Hank Paulson went to congress donning a metaphorical bulletproof vest knowing there’s plenty to dislike in his prescription. And let’s be honest here: there’s plenty to dislike on both sides of the political circus. Democrats kept wailing about welfare for guys in $5,000 suits while Republicans barked about a shameful slide into socialism. These folks are well aware that an election is only 5 weeks away, so I’m willing to bet they’ll all bemoan some nefarious arm twisting by the President as they cast a “yea” for the bailout. He’s been a political leper for a while now anyway, so they might as well slap him with the politically expedient scapegoat to save their own hides, right?
The whole notion of a bailout has to give any self-respecting capitalist heartburn. I absolutely hate the idea. However, we can’t sit idly by either – some kind of bailout is necessary.
How We Got Here
The empty talking heads predictably blame “predatory lenders” courting “subprime borrowers”, but what’s really driving the crisis is profligate use of credit derivatives. Here’s how this game works: banks previously made loans backed by a home asset and held them. In the brave new world of financial innovation, issuing banks hedged against risk through “insurance” or selling those loans to investment banks (or both). Many mortgage backed loans were “cleansed of risk” through credit default swaps where an insurer (*cough* AIG *cough*) agreed to pay the face value of a the debt in case of a homeowner default. Other home loans were bundled into “collateralized debt obligations” (CDOs), broken up into shares, and sold on Wall Street. Because that insurance policy or a CDO has a value, it’s sitting on someone’s balance sheet as an asset.
Basically MBAs take a real asset (the home), and create lots of paper assets deriving their value from that real asset – in effect we’ve created “wealth” out of thin air. Keep in mind those financial instruments are sitting on someone’s balance sheet at some calculated value, so the value of the home plus the financial asset on banks’ balance sheets exceeds (far exceeds) the value of the home itself. To put some actual numbers on this, the total value of mortgages in the U.S is roughly $14 trillion. The total “notational value” (or funny money value) of the an mortgages on the books? 168 trillion, or 12x in credit derivatives.
Now a highly leveraged position isn’t bad as long as the underlying assets keep growing. However..
The Ownership Society and the Big Gamble
President Bush walked into office championing something he called the “ownership society“. In essence, the idea involved promoting home ownership for everyone as a path to increased individual wealth. Noble but naive, he and the congress relaxed regulations and drove policies which lowered credit costs to make lending to the riskiest of home buyers financially feasible for banks. The result was a cheap-money fueled real estate boom which made many of us wealthy (at least on paper). I think you can see where this is headed: as attractive introductory rates gave way to higher market rates, risky borrowers defaulted bringing down the entire house of cards built on top of those mortgages.
Add together the cocktail of highly leveraged financial instruments and risky home loans they’re backed by, and you get the fiasco we’re now in.
We also from both liberals:
And free market types:
I Want Your Money
Hank Paulson’s prescription is best summed up by the economist’s lead story this week:
Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction a huge buyer like the federal government would end up paying more than today’s prices, temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect the high chance of a default….
Government support to the banking system can break the cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention may help taxpayers, because they are also employees and consumers. Although $700 billion is a lot—about 6% of GDP—some of it will be earned back…
In plain English, many of these financial instruments will be bought cheap by taxpayers, held for a while until the market hangover has run its course, then sold back to Wall Street. Investment bankers buying them on the cheap can ostensibly resell them at a profit, doubling down on commissions made from reselling the same securities the first time around.
It seems like lunacy to throw our weight behind a bailout, but the alternatives are few and far between. One alternative is doing nothing, which we tried in 1929; That didn’t work out so well for most. Another alternative is direct government seizure and servicing of mortgages, which helps homeowners but does nothing to nurse a much needed credit market back to health. Two things are certain however. Firstly, passage of a bailout bill devoid of personal bankruptcy easement will be inerpreted as cronysm (and will meet with fierce rebuke during elections). I’d be surprised if bankruptcy isn’t easier to come by in the future. The other certainty is that if we want a continued healthy environment for startups and growth, we’ll need a liquid credit market in place. That means we’ll need to be proactive.
Besides, provided a 50% impairment and a liquidation doesn’t happen for pennies on the dollar, taxpayers might make a buck or two.
In a 1999 article that now looks absolutely insane, the New York Times reported on the easing of credit terms. Fannie Mae Chairman Franklin Raines, who’s quoted in the article, was all sunshine and roses as he threw away the financial future of millions of Americans. But at least one person. Peter Wallison, had a good idea of how this would all play out:
“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.”
”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”