Tuesday, September 30, 2008

Responsible--and Irresponsible--Voices

Where is responsible leadership in the current financial crisis?

1. Treasury Secretary Hank Paulsen has not demonstrated it thus far. Well-schooled in the financial markets, and with a previous record of success in buying distressed securities and selling them later at a profit, he proposed a solution narrowly tailored to the immediate needs of Wall Street. There was no attempt to address the wider systemic failures that led the country into this mess: under the Paulsen proposal, Fannie Mae and Freddie Mac would have continued their privileged GSE status. (They were each a "Government-Sponsored-Enterprise"---meaning a private corporation that pays no state or federal taxes, and has a bottomless line of credit with the U.S. Treasury.) In a year or two under his plan, they would have been back playing havoc with the mortgage securities markets as soon as all their bonds and guarantees had been paid off.

2. President George Bush, our first M.B.A. president, has also failed to demonstrate leadership thus far. He failed to see that the Paulsen plan would get nowhere as long as it was described, or seen, as a "bailout". His fifteen-minute speech to the nation maintained a non-partisan tone that was appropriate for the moment, but failed to explain just why the Paulsen plan was the best solution to the problem (it wasn't). He has been AWOL with regard to helping his own party rally behind a coherent position on what needs to be done.

3. Speaker of the House Nancy Pelosi exhibited nothing but cynical partisan politics---she failed to put her own prestige behind the compromise rescue plan, and as a result 95 of her own party could not come up with the 13 votes needed to enact it. Every Democratic member of Congress felt free to "let the others vote for it, so I won't have to face the heat at home." She deserves a vote of "No confidence" from her own party.

4. And where was Sen. Barack Obama during the entire crisis? He stood carefully on the sidelines, not wanting to get his skirts wet. This is the consummate opportunist, who will bide his time until he sees a moment that he can use to his advantage, while in the meantime he keeps a finger to the wind so he can tell what he should say or propose next (once he figures out, or thinks he has figured out, which way the wind is actually blowing).

In the midst of all this irresponsible leadership, there are a few responsible voices.

• Suspend “Mark to Market” Accounting: Suspend the mark-to-market regulatory rules for long-term assets. These rules require financial firms to mark assets at current market levels, even where no market exists and any immediate transactions would result in fire-sale prices. Instead of allowing firms to mark these assets to their true economic value, these rules contribute to a downward spiral as firms have to evaluate their assets not on the basis of their long-term investment but rather on a short-term panic.
• Reform Section 404 of Sarbanes-Oxley: Make voluntary the duplicative reporting requirements under Section 404 of the Sarbanes-Oxley Act, allowing companies to comply with standards that better fit their size while still insuring that they protect their investors. The average compliance cost for a business under Section 404 is $3.8 million, with smaller businesses paying over twice as much in percentage of revenue as large businesses. Relieving this burden will reverse a policy that is chasing capital offshore and encourage more companies to go public in the United States.
• Repeal federal mandates for risky loans: Repeal the Carter-era Community Reinvestment Act, which requires banks to make loans available to borrowers who would otherwise be deemed as too high a credit risk, and who often cannot afford to repay the loans. Under this law that contributed to our current crisis, if banks don’t make enough risky loans, community organizers can take financial institutions hostage during regulatory proceedings when banks try to merge, acquire or otherwise alter their status.
And Congresswoman Michele Bachmann of Minnesota is another:
Today marks an historic moment for America as a solid bipartisan majority of Congress rejected the fatally flawed Paulson Plan. Standing shoulder to shoulder with taxpayers, we declared that we can do better.
As I’ve stated previously, this plan was rushed, unworkable, and short-sighted. A majority of House Republicans have parted ways with President Bush on this plan and we demand that alternative proposals be put on the table. There is universal agreement that this plan was bad, but its supporters claimed it was the only option. There were alternatives available, but Speaker Pelosi and the Administration chose to ignore them and used every parliamentary trick in the book to stifle debate. Now, they will have to listen to the voices of American taxpayers who refuse to open their checkbooks to Wall Street to write a $700 billion check with no strings attached.

I support a plan that would have Wall Street bail itself out, not hardworking taxpayers, by requiring institutions to insure troublesome assets that are causing today’s credit crunch. It would suspend mark-to-market accounting, which forces companies to take losses on artificially devalued assets on an artificial timetable, to give investors more confidence.

The plan I support would break up Fannie Mae and Freddie Mac -- government sponsored enterprises that are at the heart of this crisis -- so that the encumbered taxpayer no longer backs them -- implicitly or explicitly -- and so that they do not artificially grow larger than the market will allow. We cannot pass legislation that sets America up for a Groundhog Day reprise of this mess and that means changing the problem at its core - the GSEs.

Furthermore, the plan I support suspends capital-punishing tax rates to bring more capital into the U.S. markets rather than our foreign competitors. And, the plan ensures the Federal Reserve’s attention is focused on long-term price stability rather than short term economic growth. Finally, it requires the US Treasury to write rules keeping executives who made the risky decisions from personally profiting from them with excessive compensation or golden parachutes all at the expense of taxpayers. We can't have a market that only condones risky behavior. The balance between risk and reward is an important part of the free market.

My colleagues and I stand ready and willing to negotiate with any parties on a plan that will help stabilize our financial markets and relieve the liquidity crisis without exposing taxpayers to a $700 billion bailout debacle.
This woman gets it, and she is in her first term!

So I went to the websites of the two presidential candidates, and here is what I found. Sure enough, both of them had put up short videos explaining their ideas to solve the crisis. To my amazement, however, Barack Obama's solution was all about lowering taxes on the middle class!

Does he really believe that the current financial crisis was brought about because taxes on the middle class were too high? No, of course he doesn't, but Obama evidently thinks this is the message voters want to hear. And so once again his qualities of leadership are on display for those who are not too blinded by hero-worship to see.

As for John McCain, at least his suggestions actually addressed the problem (with the exception of his opposition to earmarks---but he is only being consistent there). And he gets credit for listening to those like Sen. DeMint and Michele Bachmann who actually have thought this through, and who have concrete ideas about what needs to be done.

The best overall brief summary I have found on the Web of the nature of the current crisis and why the Paulsen plan has it all backward is this one, by Jeffrey Miron, a lecturer in economics at Harvard:
This bailout was a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.
Exactly right. This makes the obvious point that the Paulsen plan does not teach any of the players in this mess that they have to act differently if the crisis is not to repeat itself. It simply appears on the scene, like a deus ex machina in 18th-century opera, and rescues the characters who have gotten themselves into a difficult situation.

Mr. Miron goes on to explain why the doom-sayers must not be allowed to drive legislators into a panic:
In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.
No thoughtful person can disagree with this analysis. The bottom line is this: bailing out Wall Street is a Wall-Street-contrived solution that will benefit mainly Wall Street. If Main Street muddles through, it will be no thanks to Wall Street, but this does not mean that if Wall Street faces bankruptcy, Main Street will necessarily be ruined as well:
So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.
This analysis has it right, and should form the backbone of any legislative solution that makes it through Congress.

Now, however, go back and look again at yesterday's vote. Since Nancy Pelosi did not ask even five of her own committee chairmen to vote for the measure, what does that say? It says that she wanted the vote to fail---or if it happened to pass, it would only be with the help of a large number of Republicans, while leading Democrats could distance themselves from it. And make no mistake---voters would have been very angry, with good reason, at all those who passed such a bailout of Wall Street.

So what did Nancy Pelosi gain by having the vote fail? Again, the answer is staring you right in the face: If the measure did not pass, the doom-sayers might be right, and a second Great Depression would begin. Whom would that help? Again, the Democrats, since the collapse would, whether properly or not, be laid at the door of President Bush and his party (for failing to support the bailout strongly enough).

Is that cynical enough for you? Like it or not, it's the kind of politics that is being played in Washington right now. I don't know about you, but I've had enough. As I write this, the Dow Jones Industrial Index is up nearly 300 points; maybe---just maybe---the talk of a collapse is just talk. Sure enough, a wave of bankruptcies will not be pleasant for many, but as Mr. Miron points out, it just means that the companies will have new owners---ones who are not so inclined to take risky strategies on the expectation that their political friends will bail them out in exchange for the millions of dollars contributed to their campaigns over the years.

The beauty of the Miron plan is that it is in large part self-executing. Leave things as they are, and bankruptcies are sure to follow. Then make sure to vote out any politician who so much as dares to suggest that Fannie Mae and Freddie Mac should be revived.

If we do just that much, we'll be well on our way out of this mess.


  1. Thank you for assembling this!!!

    I am concerned that there is a "moral hazard" among the ordinary "Main Street" people as well. Saying that "borrowers with poor credit characteristics got mortgages they were ill-equipped to handle," seems like a euphemism to me.

    At least in the states of California and Washington, people signed loan documents claiming to have higher incomes than they actually had.

    Isn't that a felony?

    I am thinking that it used to be, because 20 years ago I met a man who had been in prison for signing false loan documents.

    And didn't mortgage brokers collude by not questioning the inflated income claims? I am thinking that they colluded for personal gain. Is facilitating a felony a crime?

    I guess the problem is that the people who signed the documents with the fraudulent claims are so many and of such low status that it seems pointless and cruel to pursue this.

    But isn't there a "moral hazard" in ignoring this issue of signing false documents?

    What does it teach people when they see government expend money to help the ones who committed fraud keep their ill-gotten real estate gains?

  2. Perpetua, thank you for that comment. I don't know if it is a felony to falsify a loan application (meaning you can be sentenced to State prison for a year or more), but it certainly would be a misdemeanor. And yes, anyone who aided and abetted the commission of such a crime would be punishable as well.

    The problem of fraud is a two-way street. On the one hand are those who knowingly committed fraud---and we don't want to help them keep what they obtained by fraud. But on the other hand are those who were the genuine victim of fraud by loan sharks et al.---and do we really want the Government, if it takes over that mortgage, sticking it to the victim and foreclosing on his house?

  3. Thanks for this - I've been searching for some kind of commentary on the "bailout" and what it really meant and what it really should look like. Most things I've read are of the "doom and gloom" variety, or go over the top in terms of "it's your fault" vitriol.

    I have always appreciated your thoughts on the AC, and now I have another reason to spend time at the Curmudgeon's place! 8-)