Bailouts with cojones

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Democratic leadership: selling us down the river, as usual. 

Doing something “right away” is actually far less risky than doing “the right thing.” Oppose the manipulation of fear by the establishment’s professional scaremongers.

(I) Bailout Defeat Offers Opportunity

by Meteor Blades

Dateline: Mon Sep 29, 2008 | [print_link]

Whether you supported the bailout gladly, supported it holding your nose, opposed it but worried about the results if it failed or were unhesitatingly eager to see it fail, that ship has sailed. Or rather sunk. Three choices remain: do nothing, jury-rig something to get us through to January or come up with something better. Contrary to conventional wisdom, many of us who opposed the Paulson bailout, and the Democratically tweaked bailout we saw defeated in the House today, don’t reside in the do-nothing camp.

Moreover, it’s easy to understand the bind the Democratic leaders were in. Most of them hated the Paulson plan but felt constrained in how much they could adjust and add to it and still get enough votes to pass it. They sought to reach a compromise in the bipartisan fashion that Republicans always say they want but rarely act on since GOPspeak for “bipartisan” roughly translates as “kowtow to us and shut your frakkin’ piehole.” And they had the added obstacle of John McCain fluttering around, mostly silent, while trying to figure out which side to come down on in order to take credit for whatever eventually would happen. As it turned out, McCain came down on both sides, proving once again what a two-faced, impulse-fueled jackass he is.

Ultimately, the compromise failed. Doesn’t matter whether you think that’s good or bad. It’s dead.

Former Labor Secretary Robert Reich thinks what we’ll get as a consequence is a much-reduced plan and soon:

Prediction: A scaled-down bill will be enacted by the end of the week. It will provide the Treasury with a first installment of $150 billion. Treasury can use it to back Wall Street’s bad debts with lend no-interest loans of up to two years, until the housing market rebounds. Or to invest in Wall Street houses directly, in exchange for stocks and stock warrants. There will be strict oversight. Congressional leaders will promise further installments, but with conditions calling for limits on salaries and relief to distressed homeowners.

Maybe so. That’s the safest route.

But the defeat offers the Democrats a chance to rethink this whole shebang, to look at some of the ideas from people who got ignored the first time around. This is something I urged last week to no avail.

One of those so far unlistened to is economist Brad DeLong. Although he reluctantly supported the bailout version we saw go down today, as did Paul Krugman, he’s all along thought the 1992 Swedish plan makes more sense, as does Krugman.

Here’s what he had to say on the subject today:

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

• grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship

• requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent paying off in full or not paying off in full the liabilities of the firm at its discretion, unless

• the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress

• grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury

• requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

Someone else who should get some face time among the Democrats is economist Nouriel Roubini.

On Sunday, he explained that any systemic banking crisis requires recapitalization to avoid a massive contraction in credit. “But, purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to recapitalize the banking system.” He points out that a recent study by the International Monetary Fund of 42 banking crises found that in only seven instances did the governments in question buy the toxic assets.

In the Scandinavian banking crises (Sweden, Norway, Finland) that are a model of how a banking crisis should be resolved there was not government purchase of bad assets; most of the recapitalization occurred through various injections of public capital in the banking system. …

Thus the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer – the common and preferred shareholders and even unsecured creditors of the banks.

He calls the now-defeated bailout “socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this Treasury scam that does little to resolve the debt burden of millions of distressed home owners.”

Roubini has proposed HOME (Home Owners’ Mortgage Enterprise): A 10 Step Plan to Resolve the Financial Crisis. There are other ideas, too, like those of  James K. GalbraithDean Baker and Doug Henwood, who said months before we were brought to this impasse:

The public should get something in return: that means different kinds of financial institutions emerging from this crisis: community, nonprofit organizations – cooperative institutions that would provide basic financial services at low fees to lower and middle-income people, and stay out of speculative markets. This would create a much less speculative and profit-driven financial sector.

It would be interesting to see what effect that would have in competition with the big  banks. These new institutions could conceivably offer basic financial services at lower cost than the big guys do. People are paying fees through the nose for basic financial services now. If there were some competition coming from public or cooperative institutions, that would be an interesting use of market competition to promote the public welfare.

Henwood, of course, is talking the long term. But there is no reason an alternative plan for solvency can’t at least lay one or two blocks of a foundation for future reforms.

Opposing the bailout has gotten a few people labeled as clueless hysterics maintaining a childish understanding of how tough the situation could get, how tough it already is for so many. Let the adults be in charge, they say, the people who really know what is going on. However, none of the above-mentioned people – all of them with credentials as good as the experts the Democrats have already paid attention to – are hysterical know-nothings. Their alternatives are worth as much time in hearings, surely, as a Treasury Secretary seeking dictatorial powers.

None of those alternatives may succeed in getting the necessary votes. But one of the problems with what the Democratic leadership does on so many occasions is compromise first (which often means capitulate), then vote. It’s not the losses that are irksome, it’s the unwillingness to put up a solid proposal, then fight for it. As if the voters will be upset with them for being uncooperative.

If they would put a fight, a real fight, and then lose, they would have a perfect argument when they went to the voters. They could say: “Look, first we tried to get the best possible deal. The Republicans shot it down. So then we compromised, and they shot that down. So finally we gave in because something had to be done. But you see who the problem is here, right?”

(II)

Dateline: The Nation  September 26, 2008

A Better Bailout

By Joseph E. Stiglitz

The champagne bottle corks were popping as Treasury Secretary Henry Paulson announced his trillion-dollar bailout for the banks, buying up their toxic mortgages. To a skeptic, Paulson’s proposal looks like another of those shell games that Wall Street has honed to a fine art. Wall Street has always made money by slicing, dicing and recombining risk. This “cure” is another one of these rearrangements: somehow, by stripping out the bad assets from the banks and paying fair market value for them, the value of the banks will soar.

There is, however, an alternative explanation for Wall Street’s celebration: the banks realized that they were about to get a free ride at taxpayers’ expense. No private firm was willing to buy these toxic mortgages at what the seller thought was a reasonable price; they finally had found a sucker who would take them off their hands — called the American taxpayer.

The administration attempts to assure us that they will protect the American people by insisting on buying the mortgages at the lowest price at auction. Evidently, Paulson didn’t learn the lessons of the information asymmetry that played such a large role in getting us into this mess. The banks will pass on their lousiest mortgages. Paulson may try to assure us that we will hire the best and brightest of Wall Street to make sure that this doesn’t happen. (Wall Street firms are already licking their lips at the prospect of a new source of revenues: fees from the US Treasury.) But even Wall Street’s best and brightest do not exactly have a credible record in asset valuation; if they had done better, we wouldn’t be where we are. And that assumes that they are really working for the American people, not their long-term employers in financial market! s. Even if they do use some fancy mathematical model to value different mortgages, those in Wall Street have long made money by gaming against these models. We will then wind up not with the absolutely lousiest mortgages, but with those in which Treasury’s models most underpriced risk. Either way, we the taxpayers lose, and Wall Street gains.

And for what? In the S&L bailout, taxpayers were already on the hook, with their deposit guarantee. Part of the question then was how to minimize taxpayers’ exposure. But not so this time. The objective of the bailout should not be to protect the banks’ shareholders, or even their creditors, who facilitated this bad lending. The objective should be to maintain the flow of credit, especially to mortgages. But wasn’t that what the Fannie Mae/Freddie Mac bailout was supposed to assure us?

There are four fundamental problems with our financial system, and the Paulson proposal addresses only one. The first is that the financial institutions have all these toxic products — which they created — and since no one trusts anyone about their value, no one is willing to lend to anyone else. The Paulson approach solves this by passing the risk to us, the taxpayer — and for no return. The second problem is that there is a big and increasing hole in bank balance sheets — banks lent money to people beyond their ability to repay — and no financial alchemy will fix that. If, as Paulson claims, banks get paid fairly for their lousy mortgages and the complex products in which they are embedded, the hole in their balance sheet will remain. What is needed is a transparent equity injection, not the non-transparent ruse that the administration is proposing.

The third problem is that our economy has been supercharged by a housing bubble which has now burst. The best experts believe that prices still have a way to fall before the return to normal, and that means there will be more foreclosures. No amount of talking up the market is going to change that. The hidden agenda here may be taking large amounts of real estate off the market — and letting it deteriorate at taxpayers’ expense.

The fourth problem is a lack of trust, a credibility gap. Regrettably, the way the entire financial crisis has been handled has only made that gap larger.

Paulson and others in Wall Street are claiming that the bailout is necessary and that we are in deep trouble. Not long ago, they were telling us that we had turned a corner. The administration even turned down an effective stimulus package last February — one that would have included increased unemployment benefits and aid to states and localities — and they still say we don’t need another stimulus. To be frank, the administration has a credibility and trust gap as big as that of Wall Street. If the crisis was as severe as they claim, why didn’t they propose a more credible plan? With lack of oversight and transparency the cause of the current problem, how could they make a proposal so short in both? If a quick consensus is required, why not include provisions to stop the source of bleeding, to aid the millions of Americans that are losing their homes? Why not spend as much on them as on Wall Street? Do they still believe in trickle-down economics, when for the past eight years money has been trickling up to the wizards of Wall Street? Why not enact bankruptcy reform, to help Americans write down the value of the mortgage on their overvalued home? No one benefits from these costly foreclosures.

The administration is once again holding a gun at our head, saying, “My way or the highway.” We have been bamboozled before by this tactic. We should not let it happen to us again. There are alternatives. Warren Buffet showed the way, in providing equity to Goldman Sachs. The Scandinavian countries showed the way, almost two decades ago. By issuing preferred shares with warrants (options), one reduces the public’s downside risk and insures that they participate in some of the upside potential. This approach is not only proven, it provides both incentives and wherewithal to resume lending. It furthermore avoids the hopeless task of trying to value millions of complex mortgages and even more complex products in which they are embedded, and it deals with the “lemons” problem — the government getting stuck with the worst or most overpriced assets.

Finally, we need to impose a special financial sector tax to pay for the bailouts conducted so far. We also need to create a reserve fund so that poor taxpayers won’t have to be called upon again to finance Wall Street’s foolishness.

If we design the right bailout, it won’t lead to an increase in our long-term debt — we might even make a profit. But if we implement the wrong strategy, there is a serious risk that our national debt — already overburdened from a failed war and eight years of fiscal profligacy — will soar, and future living standards will be compromised. The president seemed to think that his new shell game will arrest the decline in house prices, and we won’t be faced holding a lot of bad mortgages. I hope he’s right, but I wouldn’t count on it: it’s not what most housing experts say. The president’s economic credentials are hardly stellar. Our national debt has already climbed from $5.7 trillion to over $9 trillion in eight years, and the deficits for 2008 and 2009 — not including the bailouts — are expected to reach new heights. There is no such thing as a free war — and no such thing as a free bailout. The bill will be paid, in one way or another.

Perhaps by the time this article is published, the administration and Congress will have reached an agreement. No politician wants to be accused of being responsible for the next Great Depression by blocking key legislation. By all accounts, the compromise will be far better than the bill originally proposed by Paulson but still far short of what I have outlined should be done. No one expects them to address the underlying causes of the problem: the spirit of excessive deregulation that the Bush Administration so promoted. Almost surely, there will be plenty of work to be done by the next president and the next Congress. It would be better if we got it right the first time, but that is expecting too much of this president and his administration.

About Joseph E. Stiglitz

Joseph E. Stiglitz is University Professor at Columbia University. He received the Nobel Prize in Economics in 2001 for research on the economics of information. Most recently, he is the co-author, with Linda Bilmes, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict.

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