Is there a crisis?
For many in the banking industry, yes. For the economy as a whole, no.
Why is the administration shouting crisis?
There was a problem in the banking industry and they wanted legislative authority to address it. If they had asked for it in the normal way, the Congress would have viewed it as a normal, i.e. special interest bill favoring the constituents of the (right wing) Republicans. Then every centrist and (left wing) Democrat would have demanded his share of the pie as a price for going along. The administration hoped that by shouting crisis, they could get immediate action and forestall all that log-rolling.
What would have happened if they had succeeded?
They would have written a vague (3 page) bill that allowed great administrative latitude. The result would have been better than the (110 page) bill they had to come up with on a second try but neither version would have been better than not proposing any bill at all.
Having proposed action, any market adjustment that would have occurred in response to the "crisis" has been delayed while the players in the game wait for government money to play with.
What will happen if Congress can't agree on a bill?
If they give up and say "No Bill," the strong banks will gobble up the weak and the "crisis" will be over. If they hang on and keep debating for weeks, eventually the industry will give up and take care of the issue without help but it will take a long time to give up on the prospect of $700 billion.
What will happen if Congress does pass a bill?
The proponents hope that by promising to "do something" the panic will subside; they may be right. But it will take a long time for a bureaucracy to get set up and even longer to get started handing out money. It won't be long before Congressional oversight results in complaints of foot dragging, hasty decisions, bad personnel decisions (that has already started, even before the bill has passed), favoritism, and ultimately, graft and corruption. By then, all the administration actors will have left the scene so they can complain, along with everyone else, that the next administration has botched what was a well-designed plan. Meanwhile, these adverse results will be with us for years to come.
Tuesday, September 30, 2008
Sunday, September 28, 2008
Main Street vs. Wall Street—the Wrong Debate
Much of the current debate about the financial "crisis" describes the issue as Wall Street vs. Main Street. This reflects a fundamental misunderstanding of our economy. It is true that a government buy-out of the failed mortgages will probably require a substantial increase in taxes, at least for a while. And a buy-out might certainly be a bad idea, as another blog on this site argues. But underlying the debate is a fundamental misunderstanding, by many of our legislators and the media, of the role of Wall Street in our economy.
The capital markets channel funds from Main Street to create and support the businesses that hire all the workers, from unskilled to highly skilled, who produce our GDP—the vast array of goods and services that we all consume, food, clothing, homes, cars, repair sites, churches, schools, and so on.
The media often follows the mention of Wall Street with reference to the high salaries and golden parachutes that some large firms pay to attract CEOs—as if that's a defining characteristic of Wall Street. But that's an entirely separate issue. Those payments are an infinitesimal part of the total value of the failed mortgages that we're worrying about, and have no place in a discussion of major government policy regarding what to do about them.
The debate is not about Wall Street vs. Main Street. It's about the best way to serve the interests of our citizens.
The capital markets channel funds from Main Street to create and support the businesses that hire all the workers, from unskilled to highly skilled, who produce our GDP—the vast array of goods and services that we all consume, food, clothing, homes, cars, repair sites, churches, schools, and so on.
The media often follows the mention of Wall Street with reference to the high salaries and golden parachutes that some large firms pay to attract CEOs—as if that's a defining characteristic of Wall Street. But that's an entirely separate issue. Those payments are an infinitesimal part of the total value of the failed mortgages that we're worrying about, and have no place in a discussion of major government policy regarding what to do about them.
The debate is not about Wall Street vs. Main Street. It's about the best way to serve the interests of our citizens.
Saturday, September 27, 2008
The Government Buy-out Congress is Contemplating
There is probably not a single trained economist who ever encountered the term “market freeze-up” in his graduate studies. Yet, when asked for details of what to expect from the proposed buy-out of “toxic securities” (another neologism) held by banks, freeze-up is the threat mentioned repeatedly by Dr. Bernanke and Secretary Paulson.
What is it really about? The outlines of the current “crisis” are reasonably well-known. Banks and mortgage brokers made a lot of mortgage loans without the traditional buyer equity contribution. They made such “sub-prime” loans on the expectation that with home prices rising, the necessary equity would magically appear in a short time. The mortgages and securities (bundles of mortgages) were easily sellable and were counted as liquid assets by the banks that owned them. So when the home prices stopped rising and actually began to fall, lots of borrowers went into default and lenders found that their loans were, after all, not adequately secured. Many banks, lending institutions and individuals ended up with securities based on those mortgages that have not only lost value but are, at present, virtually unmarketable; what had been liquid assets have become illiquid. That is what the “freeze” seems to be all about.
Politicians and the media are currently in a frenzy to attach blame, but the question now is what, if anything, should be done to throw a lifeline to banks drowning in the bad debt they created? The administration has seized the initiative by proposing a buy-out, leaving unspecified what or how it is to be bought. Moreover, they have demanded immediate action as if the apocalypse is upon us and a delay of days would produce catastrophe. Many in the Congress and Executive branch have bought the Administration's point that the government should indeed take action, and are now arguing over the details. Like sheep following a bellwether, they seem to be saying, “I don’t know anything about how markets work, but these are smart guys and they must know what they are talking about, so I’ll accept their judgment.”
Only a few, however, are questioning whether any government action is called for at all. First of all, the buy-out is not without problems. A close reading of the statements by Bernanke and Paulson indicates that they don’t feel as confident as their followers. They use terms like “if this works,” and “we hope.” Not “here is what we will do and this is what will happen.” In fact, what they will do is defined in only the barest outline: they propose to buy what they think are unsellable securities from banks, and maybe other institutions, at prices that have not yet been determined and sell them at some uncertain future date when their value can be determined. An op-ed by Andy Kessler in Thursday’s Wall Street Journal even claimed that if the Paulson plan goes through, the government will end up making money.
The most important question, however, is why the government has to attempt the rescue at all, rather than private investors. One thing is clear: these securities are not unmarketable in principle. Some mortgages are in default, some properties are already foreclosed on, and some will likely go under in the future. But all of these mortgages, thrown on the market, would bring a price greater than zero. If buyers and sellers want to get more information about the value of these securities, estimates can be made in a relatively short time. That should go a long way toward reducing the uncertainty and unfreezing the market. J. P. Morgan Chase has just bought Washington Mutual at a fire-sale price based on just such estimates of future profitability.
The administration's proposal has already inhibited market solutions to the problem. Experience has shown that when the government promises to spend money on an activity that the private market would otherwise finance, private investors pull back and wait and see what will happen. If the Congress manages to reach agreement and pass legislation, that will be only the beginning of the process. Endless haggling will ensue about what to buy, what to pay, who should make the decisions, which Congressional districts should receive what benefits, and ultimately, who has been doing what illegal things to rip off the public. With $700 billion at stake, and possibly more before it is all over, the sharks will be circling for years to come.
If they really want to “solve the problem,” the Congress should prominently announce that it will not, under any circumstances, participate in this operation. In short order, securities would be sold, the losers would go under, and we could all go back to watching reruns on television.
What is it really about? The outlines of the current “crisis” are reasonably well-known. Banks and mortgage brokers made a lot of mortgage loans without the traditional buyer equity contribution. They made such “sub-prime” loans on the expectation that with home prices rising, the necessary equity would magically appear in a short time. The mortgages and securities (bundles of mortgages) were easily sellable and were counted as liquid assets by the banks that owned them. So when the home prices stopped rising and actually began to fall, lots of borrowers went into default and lenders found that their loans were, after all, not adequately secured. Many banks, lending institutions and individuals ended up with securities based on those mortgages that have not only lost value but are, at present, virtually unmarketable; what had been liquid assets have become illiquid. That is what the “freeze” seems to be all about.
Politicians and the media are currently in a frenzy to attach blame, but the question now is what, if anything, should be done to throw a lifeline to banks drowning in the bad debt they created? The administration has seized the initiative by proposing a buy-out, leaving unspecified what or how it is to be bought. Moreover, they have demanded immediate action as if the apocalypse is upon us and a delay of days would produce catastrophe. Many in the Congress and Executive branch have bought the Administration's point that the government should indeed take action, and are now arguing over the details. Like sheep following a bellwether, they seem to be saying, “I don’t know anything about how markets work, but these are smart guys and they must know what they are talking about, so I’ll accept their judgment.”
Only a few, however, are questioning whether any government action is called for at all. First of all, the buy-out is not without problems. A close reading of the statements by Bernanke and Paulson indicates that they don’t feel as confident as their followers. They use terms like “if this works,” and “we hope.” Not “here is what we will do and this is what will happen.” In fact, what they will do is defined in only the barest outline: they propose to buy what they think are unsellable securities from banks, and maybe other institutions, at prices that have not yet been determined and sell them at some uncertain future date when their value can be determined. An op-ed by Andy Kessler in Thursday’s Wall Street Journal even claimed that if the Paulson plan goes through, the government will end up making money.
The most important question, however, is why the government has to attempt the rescue at all, rather than private investors. One thing is clear: these securities are not unmarketable in principle. Some mortgages are in default, some properties are already foreclosed on, and some will likely go under in the future. But all of these mortgages, thrown on the market, would bring a price greater than zero. If buyers and sellers want to get more information about the value of these securities, estimates can be made in a relatively short time. That should go a long way toward reducing the uncertainty and unfreezing the market. J. P. Morgan Chase has just bought Washington Mutual at a fire-sale price based on just such estimates of future profitability.
The administration's proposal has already inhibited market solutions to the problem. Experience has shown that when the government promises to spend money on an activity that the private market would otherwise finance, private investors pull back and wait and see what will happen. If the Congress manages to reach agreement and pass legislation, that will be only the beginning of the process. Endless haggling will ensue about what to buy, what to pay, who should make the decisions, which Congressional districts should receive what benefits, and ultimately, who has been doing what illegal things to rip off the public. With $700 billion at stake, and possibly more before it is all over, the sharks will be circling for years to come.
If they really want to “solve the problem,” the Congress should prominently announce that it will not, under any circumstances, participate in this operation. In short order, securities would be sold, the losers would go under, and we could all go back to watching reruns on television.
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