$700 Billion Is Too Much, Too Fast

The thrust of the Bush Administration plan for the financial sector is to buy lots of financal investments that are at grave risk of going bad, $700 billion worth, give or take. We've already authorized something like $200 billion for FannieMae and FreddieMac, which were government sponsored but privately owned companies that dominated the secondary market in mortgages, $70 billion in foreign insurer AIG, and something like $30 billion in investment bank Bear Sterns, although only in support of a buyout from J.P. Morgan Chase.

Bailout Alternatives

Other institutional crisis situations have been handled for more conventional and traditional approaches.

About a dozen failed FDIC banks, most notably IndyMac, have been handled through the existing FDIC receivership progress.

Investment bank Lehman Brothers filed for bankruptcy under Chapter 11, which contrary to the folks saying that government bailouts are necessary, is swiftly parceling out the company by auction to private sector investors in a manner that is preserving thousands of jobs, without putting public funds at risk, and may even leave most bondholders

Bank of America bought investment bank Merrill Lynch in an entirely non-governmentally funded transaction.

Goldman Sachs and Morgan Stanley, the remaining big investment banks, have agreed to become traditional commercial banks, primarily at the cost of becoming far less leveraged.

The private sector has already also put together a $70 billion emergency lending fund.

Essentially, the market has shut down the investment banking industry as preciptiously as it previously shut down the subprime mortgage industry.

This isn't a first in the history of the modern economy. The U.S. steel industry, textile industry, and television industry were all wiped out by foreign competition and the U.S. automobile industry looks eager to follow suit.

Better Options

The cycle of overleverage producing excessive risk taking from players who have head I win, tails you lose incentives is a very old one in the American economy. Investment banks are only the latest players. Waves of insurance and banking bankruptcies have characterized panics since well back into the 19th century.

There are essentially two solutions that work. One is to insist as a regulatory matter on reduced debt to equity ratios. This, far more than the insurance product itself, is why FDIC regulated banks have weathered the latest financial crisis so much better than mortgage finance companies and investment banks.

The other is to organize companies on a cooperative or as financial companies prefer to say, "mutual" basis. When your shareholders and your investor/customers are the same, there isn't an incentive to become excessively leveraged. This is why credit unions and mutual insurance companies are not all over the headlines.

Shareholder owned insurance companies are regulated by state governments, most of which have reserve requirements. But, some of the more esoteric players in the market, like AIG which participated in sophisticated small markets like credit enhancement for otherwise weak investments, state regulation is not always enough for thin markets.

Credit rating agencies have also failed to adequately factor in the risks associated with excessive leverage.

Bottom Line

Simply put, the Bush Administration has not made the case to the general public that buying assets, as opposed to increasing regulation and allowing the Chapter 11 bankruptcy process to work, are so inadequate as means of responding to the current financial crisis that we need to socialize the losses of major investment firms at public expense.

When the price for mortgage backed securities gets low enough to reflect the risk, investors will buy them, and that price will be nowhere close to zero. Yes, the stock market will fall. A bubble has punctured, not for the first time. Indeed, this administration started out with the tech bust and let it run its course. But, the bust is mostly a function of unreasonable paper gains.

Rather than spending $700 billion proping up bad business decisions on Wall Street, we should be focusing on a bailout that is almost certain to follow, the huge inadequately declared risk that the Pension Benefit Guarantee Corporation will have when corporations drop their defined benefit pension plans in bankruptcy, a risk the federal goverment insures, but has inadequately guarded against from a regulatory perspective.

By increasing pension regulation, PBGC premiums, and increasing PBGC reserves now, we can minimize that risk while letting risks that government never undertook play out in the market, which isn't nearly as bad at dealing with financial institution collapse as suggested. And, if there are weaknesses in the bankruptcy system (e.g. because it fails to give priority to trade creditors and short term payment system debt needed to maintain market integrity) than we need to fix those problems.