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.