Just Say No to the Bailout Plan
Sep 27th, 2008 by Dave
- The problem is not clearly defined. If we don’t clearly define what we’re fixing, how do we agree what we’re fixing and if we’ve made any difference when we’ve stopped fixing it? What would happen if we didn’t dump in $700 billion of taxpayer money to bail Wall Street firms out of their bad investments? That’s right - nobody really knows what would happen. Paulson talks about intangibles such as restoring confidence in the credit markets, but you can’t buy that, you have to earn it. In fact if you want to destroy confidence in the markets, rushing through an ill-conceived bailout plan seems like a pretty good way to do it.
- Plan doesn’t address the heart of the problem The ostensible problem is that the credit markets are freezing up, due in large part to spiking foreclosure rates in the sub prime mortgage sector. The plan is aimed at the wrong end of the mortgage financing food chain. If you want to throw money at the problem, it would be a lot more effective to fund those lending institutions that have had the good sense to avoid the bad lending and risk management practices that got the Wall Street banks in trouble. Otherwise what you are doing is the equivalent of pouring more water into a leaky bucket - we’d just be setting ourselves up for another round of loans going bad.
- Sets a bad precedent for the future Managements, creditors, employees, even investors of other companies in precarious condition will look to the government for a bailout in the future. “Too large to fail” is a vague criteria. “Just this time” is not credible. Already the scope of the bailout has spread far beyond the initial stated objectives. This creates a “moral hazard” which encourages lenders and borrowers to continue bad behavior. Why don’t we just have the government buy up all the bad mortgages in the country and work them out? That would be just idiotic. (Update - Oops! One of the presidential candidates just suggested that idea.)
- Investing in junk mortgages; Selling insurance without capital The major Wall Street firms bankrupted themselves by loading up their portfolios with junk sub-prime mortgages and insuring each other against default. They called the insurance “credit default swaps” instead of credit default insurance because swaps are unregulated and insurance is. They sidestepped the regulatory requirements to get around the pesky capital reserve requirements of the insurance industry. But there’s a reason that you are required to have a capital reserve if you sell insurance - because it is supposed to provide a cushion in the event of higher than expected payouts. The plan shouldn’t be trying to fix the mess they’ve got themselves into; it should be aimed at keeping loans going to the rest of the economy.
- Insane Leverage The banks not only didn’t have capital reserves - they took on insane amount of leverage to juice their profits. Your average commercial bank is required to have a ratio of assets to capital somewhere in the 11:1 range. Back when Long Term Capital Management went bust, they had a ratio of 28:1 which everyone thought was insane. Bear Stearns went belly up with a 33:1 ratio! Back in March, the Wall Street Journal reported very high leverage ratios at the other newsmakers - Morgan Stanley, also 33:1; Lehman, 31:1; Merrill, 28:1, and Goldman Sachs was 26:1. Obviously the lessons of LTCM have been lost. If a small investor takes on huge leverage and goes bust, that’s unfortunate, but that’s his problem. When financial institutions that are too large to fail take on much more leverage than they should and put themselves at risk of failure, it comes back to us, the taxpayer, to make things right. Investment banks have operated under different rules than commercial banks, but considering recent history, this cannot continue. The recent restructuring of the two remaining large investment banks to holding companies is a step in the right direction. For the investment banks that are small enough for us to let them fail, let them continue to take risks.
- Serious conflicts of interests among the main participants pushing the plan According to the NY Times, the collapse of AIG would have left a “$20 billion hole” in Goldman Sachs. Paulson owes his 1/2 billion $+ net worth to Goldman and was the formerly chairman of the company. Other advisors pushing the plan, have deep ties to the companies that would stand to have the most to gain from the bailout. Item #5 in this article lists other conflicts which should give any supporter of the plan pause.
- Wisdom of Crowds Calls and emails to Congress are running 20:1 or higher against the bailout. Is it possible the experts have it wrong and the rest of us have it right? It happens all the time; read James Surowiecki’s great book on how that happens.
- Impenetrable Complexity Financial wizards sliced up pools of ordinary mortgages into complex derivatives and kept the most volatile and exceedingly difficult to value slices for their own portfolios. Mathematical models value the securities, based on projected foreclosure rates in the pools. When foreclosure rates spike, the value of the securities plunge. Highly leveraged capital structures add more risk to the equation. Then credit default swaps spread risk between institutions. The complexity overwhelms the ability of the institutions to manage risk. If the professionals are having a hard time valuing their own derivative securities, how do we expect the rest of us, much less the bureaucrats administering the plan? Mortgage lending isn’t rocket science. OK, let me rephrase - shouldn’t be rocket science. Yes securitization has brought additional funds and liquidity to the market, but if there’s no way to reasonably value the resulting WMD derivatives, and they have the capacity to wreak havoc on our financial system, we’re better off without them.
And if mortgage based derivatives weren’t complex enough, there are credit default swaps in the mix which were supposed to mitigate risk but instead magnified the impact of deteriorating mortgage portfolios on the system. We’ve had bad times before and foreclosure rates have spiked; and the banks seem to have loaded up their portfolios with the most speculative parts of the securities. The point is, there’s plenty of cash out there for good investments. If the securities are such a good deal, smart investors are going to step in and take advantage; we don’t need the Treasury to do it. And if the securities aren’t such a good deal, we’re just sending good money after bad; the equivalent of putting more water in a leaky bucket. The money isn’t going to institutions with sound lending / investing practices - it is going to institutions with bad practices - and perpetuating those practices. - Lack of Foresight Smart money saw this coming and has been shorting the bad companies for months. Treasury Secretary Paulson, Fed Chairman Bernanke, the Administration and Congress appear to have been blindsided by it; with Paulson declaring less than 72 hours prior to the announcement that the economy was “fundamentally sound”. Do you want smart money making decisions or do you want Paulson in charge, at our expense? The point is, while there will be blood now if the plan doesn’t go through, in the long term we’re all better off if we let the market work this out and tap into the wisdom of the crowds (including the shorts) rather than the wisdom of one man who has consistently proven to be wrong.
- Interfering with normal corrective action of the market. One of the first steps they take, to “restore order” is to outlaw the shorts, aka smart money. Shorts aren’t the problem; they aren’t creating reality; they are reacting to reality. By cutting shorts out of the picture, we are depriving ourselves of a valuable source of information about the market. Anyone questioning this idea would be well served to read the book Sold Short about the essential role of shorts in a free and fair market to ferret out fraud, hype and incompetence.
- Creeping Assumption of Liability When a conventional bank merges with an investment bank, you end up with FDIC insured deposits backing these so called “toxic assets”.
- Not the end, just the beginning $700 billion isn’t the end of the financial crisis, it is just the beginning. Do you remember the rush into Iraq, going after non-existent WMD, on the threat of imminent catastrophe if we didn’t act? And do you remember how this administration told us that the war would probably “pay for itself with Iraqi oil revenues”? Sound familiar? Now they’re selling the bailout plan by saying that taxpayers may ultimately make money on deal by buying up the distressed mortgages at a discount and then selling them at a profit when the market recovers. That is certainly a logical argument, but is an argument for letting private investors, much better equipped to value and manage the portfolio (and risk their own capital) than the Treasury. Remember how many years ago, how our president stood on the deck of an aircraft carrier and declared “Victory in Iraq”? Paulson is going to have his “Victory in Iraq” moment, and then inevitably the day will come, perhaps weeks, perhaps months later, he will be back to Congress asking for more money to stave off another unforeseen catastrophe.
- Unintended Consequences Look back at the history of government intervention in markets and you see unintended consequences of those actions, often as bad or worse than the original problem. For example, leading up to the LTCM failure, then Treasury Secretary Rubin led a bailout of Mexico which fueled subsequent speculation in Asia. Hey the US government is going to bail us out if we get into trouble so why not go for it! Then Russia defaulted and no one stepped in to bail them out and that started a chain of events in financial markets around the world that led to LTCM’s demise. This sub-prime market meltdown is part of a chain of events stretching back to 1999 when Congress, with the best of intentions, pushed FNMA to extend loans to people previously unable to qualify, in order to expand the ranks of homeowners. Little did we know at the time we’d be footing the bill for those homeowners who were ultimately unable or unwilling to pay their mortgages. And it was Congress that passed a bill to gut the Glass-Steagall Act in 1999
- Natural correction to an overdeveloped financial sector What’s happening now is a normal correction to an overdeveloped financial sector (see the link on Ken Rogoff’s quote below). The financial services sector made up 1/3 of corporate profits in 2006, according to official US statistics. The sector grew in response to the excessive liquidity of the Greenspan years, where by keeping rates low we juiced the economy and cushioned ourselves through some downturns but you don’t get something for nothing and the cratering of the housing market, just like the bursting of the stock market bubble in 1999, were both aftereffects / hangover from the loose monetary policy of the Greenspan years. Low rates provide big profits to the financial services industry, especially the spread between FDIC insured rates paid to depositors and the high rates being charged to sub prime borrowers. Profits are generally a good thing, but the way markets work (ask any Econ 101 student) is that profits increase supply (more firms come into the industry) and inevitably more firms come in than are supported by the demand and there is the inevitable consolidation. If government intervenes to stop this consolidation we will just weaken the credit markets, not strengthen them, by keeping companies alive with bad lending and risk management practices. To really understand what’s going to happen in the future we have to take a hard look at the choices we made in the past.
Plenty of others think this bailout plan is a bad idea:
Nouriel Roubini:
David Cay Johnston, former NY Times Reporter, in an open letter to journalists:
Allan Meltzer, a former economic adviser to President Reagan:
Jim DeMint, Sen. (R-S.C.):
Michael Lewis:
Carl Icahn:
Barry L. Ritholtz:
The newest spin on the massively expensive plan is “Hey, its a jumbo money maker!”
The spin reminds me of the classic retail stock jockey. The guy has buried his clients in a series of bad trades, bad judgment, poor risk management — all motivated by his self-interested, commission-generating trades. The only way out of the money losing mess, pitches the broker, is a big, Hail Mary trade.
Sound familiar?
Kenneth Rogoff:
If this is the right diagnosis of the “financial crisis,” then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.