22 September 2008

$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.


Andrew Oh-Willeke said...

The September 20, 2008 draft proposal is not encouraging. It reads:



Section 1. Short Title.

This Act may be cited as ____________________.

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

(1) appointing such employees as may be required to carry out the authorities in this Act and defining their duties;

(2) entering into contracts, including contracts for services authorized by section 3109 of title 5, United States Code, without regard to any other provision of law regarding public contracts;

(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;

(4) establishing vehicles that are authorized, subject to supervision by the Secretary, to purchase mortgage-related assets and issue obligations; and

(5) issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities of this Act.

Sec. 3. Considerations.

In exercising the authorities granted in this Act, the Secretary shall take into consideration means for--

(1) providing stability or preventing disruption to the financial markets or banking system; and

(2) protecting the taxpayer.

Sec. 4. Reports to Congress.

Within three months of the first exercise of the authority granted in section 2(a), and semiannually thereafter, the Secretary shall report to the Committees on the Budget, Financial Services, and Ways and Means of the House of Representatives and the Committees on the Budget, Finance, and Banking, Housing, and Urban Affairs of the Senate with respect to the authorities exercised under this Act and the considerations required by section 3.

Sec. 5. Rights; Management; Sale of Mortgage-Related Assets.

(a) Exercise of Rights.--The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act.

(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.

(c) Sale of Mortgage-Related Assets.--The Secretary may, at any time, upon terms and conditions and at prices determined by the Secretary, sell, or enter into securities loans, repurchase transactions or other financial transactions in regard to, any mortgage-related asset purchased under this Act.

(d) Application of Sunset to Mortgage-Related Assets.--The authority of the Secretary to hold any mortgage-related asset purchased under this Act before the termination date in section 9, or to purchase or fund the purchase of a mortgage-related asset under a commitment entered into before the termination date in section 9, is not subject to the provisions of section 9.

Sec. 6. Maximum Amount of Authorized Purchases.

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

Sec. 7. Funding.

For the purpose of the authorities granted in this Act, and for the costs of administering those authorities, the Secretary may use the proceeds of the sale of any securities issued under chapter 31 of title 31, United States Code, and the purposes for which securities may be issued under chapter 31 of title 31, United States Code, are extended to include actions authorized by this Act, including the payment of administrative expenses. Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure.

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Sec. 9. Termination of Authority.

The authorities under this Act, with the exception of authorities granted in sections 2(b)(5), 5 and 7, shall terminate two years from the date of enactment of this Act.

Sec. 10. Increase in Statutory Limit on the Public Debt.

Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.

Sec. 11. Credit Reform.

The costs of purchases of mortgage-related assets made under section 2(a) of this Act shall be determined as provided under the Federal Credit Reform Act of 1990, as applicable.

Sec. 12. Definitions.

For purposes of this section, the following definitions shall apply:

(1) Mortgage-Related Assets.--The term “mortgage-related assets” means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

(2) Secretary.--The term “Secretary” means the Secretary of the Treasury.

(3) United States.--The term “United States” means the States, territories, and possessions of the United States and the District of Columbia.

Anonymous said...

I have faxed letters urging opposition to the plan as originally presented to Senators Allard, Salazar, Obama, and Reid and to Reps. DeGette, Frank, and Pelosi.

I urge readers of your blog to do the same. Visit Calculated Risk blog for an overview and updates on this issue. The comments are always worth reading.

Bush has played his "scare them stupid" game once to often. (His approval numbers are tanking.)

I'm not sure any bailout will work, but then I'm just a J6PK. Even so, we've stocked up on food and cash (for whatever that's worth).