We Need the Bailout
Quite simply, the whole financial system is headed for a meltdown. While many will gleefully cheer the fall of those whose greed brought them to the precipice, we must keep in mind that ordinary people will ultimately suffer here. Nobody can obtain credit. Investment plummets. Unemployment skyrockets. Remember the Great Depression: 25 percent unemployment and massive poverty, with few social safety nets. Yes, it’s that serious. We need to hold our noses and take action now, making sure we deal with the more structural issues (making sure this does not happen again) at a later stage.
Having looked at some of the proposals, I side with Paul Krugman and Brad De Long: since the core problem is less a liquidity issue than a lack of capital, and since the private sector is unwilling to pump in funds, the first best solution would simply be nationalization, putting large insolvent banks with insufficient capital into conservatorship. This has the benefit of wiping out shareholders and giving the taxpayer a stake in the upside. At the moment, though, we need to stay focused on what is realistic, and large-scale nationalization is simply not realistic. A version of this plan proved highly successful during the major early-1990s banking crisis in Sweden, and the taxpayer did not end up losing money. Some form of public re-capitalization might ultimately be needed.
So what of the Paulson-Bernanke plan of creating a taxpayer-funded vehicle to remove toxic mortgage assets from banks’ balance sheets? Again, not ideal, as it benefits shareholders. But although nationalization would probably be a better deal for taxpayers, it is not certain that taxpayers would lose, and quite possible that they would gain. Bernanke’s reasoning on this front has been attacked, but it has some merit. Because of the widespread fear and loathing of these assets right now, nobody will touch them with a ten-foot pole. Everybody is trying to dump them, which of course makes the price collapse– this creates further losses and compounds the solvency problem. This “firesale” price is well below their true value. These assets still have value. Put it another way: most people are not defaulting on their mortgages, and the widespread sell-off assumes they are. The problem is one of information: nobody knows where the bodies are buried. If, therefore, they are purchased at a price that is above the firesale price and yet below their true “hold-to-maturity” price, then banks will be willing to participate and taxpayers will actually make money.
Sounds too good to be true? The problem is that nobody reallys knows how to value these extremely complicated assets, making it highly uncertain that the government will indeed get a good deal. Which is why it is important that taxpayers be protected from loss, in the form of equity warrants (though, in the compromise agreement, this protection is not as strong as it could be).
It is also important to look at the budgetary implications, as noted by Larry Summers. It’s frustrating that people focus only on spending 700 billion dollars of taxpayer’s money, failing to note that they are getting assets (which still have value) in return. Indeed, as noted above, the taxpayer could still come out of this on top. Another point noted by Summers is that the usual argument of large government deficits sucking up funds that would otherwise be used for investment (“Rubinomics”) doesn’t really apply here, as the government is just issuing debt to purchase asset-backed securities. In other words, Jim Lehrer notwithstanding, there is little reason to think that fiscal priorities such as health care reform should be scaled back to pay for this bailout, especially since cutting the deficit in the midst of a recession makes things worse. Of course, bad spending and tax proposals that cause the deficit to balloon should be scaled back anyway…
So, all in all, the plan is imperfect, but we need it. And we need it now, as the meltdown might well be imminent. What makes it all so frustrating is that some politicians– Republicans in particular–seem willing to destroy an economy to further their electoral ambitions.
…it would literally be making the same exact mistake. gov’t intervention in the markets (central banks) create the booms and busts. catch up on some austrian economics and ron paul.
Have you no understanding of fiat currency? Gov. regulated fake money is always destined to fail:
http://www.kwaves.com/fiat.htm
I understand that this bust will be painful, but booms and busts are not good things for a market.
I too was uninformed in past. The last year has been spent educating myself on economics, and without realizing it, I was previously a Keynesian (fascism light), where now I am an Austrian (true free market). We’ve had enough of this Keynesian mess, it is time the power swings back to the people, and not the fatcat aristrocrats in Wall Street.
I’m sorry to say this, but for once in my life, I agree with libertarians–and I think this bailout is not going to save the economy. This is a pretty good commentary:
http://www.cnn.com/2008/POLITICS/09/29/miron.bailout/index.html
Hats off to the congressmen who opposed this bailout, like Congresswoman Marcy Kaptur:
http://kr.youtube.com/watch?v=oAADyc6t4nY&eurl=http://libertyvsleviathan.wordpress.com/
Watching this from a purely selfish hunker-down vantage point, all I can say is thank God we cashed out of the stock market when I retired 12/31/06. Now we have only insured CDs and bonds, Socialized Secirity and Socialized Medicine’ a/k/a Medicare+Rx drug insurance, a paid-off house, 2 paid-off cars and a few hundred on the credit card. We are not the envy of the neighborhood, no 52″ plasma whizbang up on the wall, Subzero frige or behemouth SUV in the garage. I’d feel better with a safe deposit box full of gold bars but never thought about it before and now they’re too expensive. So I just watch this unfold from the sidelines and hope for the best whatever that might be. In the meantime, I’m not losing any sleep.
I want to go on record as being opposed to a second Great Depression. Nevertheless, there are a couple of things about this explanation that I don’t quite understand. I don’t see, for example, how this can be primarily a problem of information. Say you have ten loans, and you know two of them are not going to be repaid but you don’t know which two. The fact that you have this uncertainty doesn’t mean you can’t have a market for those loans. It just means that buyers and sellers will discount the price of each of the loans to take account of this uncertainty. Likewise, if you aren’t sure how many of the loans won’t be repaid, but know that it’s unlikely to be more than, say, 4, then you can discount the price of all the loans to take account of that uncertainty, and so on. For the Paulson plan to make sense in these terms, one would have to assume that the market right now was being wildly and irrationally pessimistic in calculating the risk associated with these loans, and that Paulson knows better what there real value is. That’s possible, but I wouldn’t bet on it (neither, I think, would Paulson – at least not with his own money).
Further, to the extent that the problem here really is uncertainty, the short term effect of the Paulson plan seems to be to trade one sort of uncertainty for another. If a certain type of loan is being traded at, say, 20 cents on the dollar, and the government steps in and says it will buy that asset for significantly more than 20 cents in a couple of months, but doesn’t say how much more, then I would think that this would make people more reluctant to sell the loans than they would otherwise. Why sell for 20 cents on the dollar, after all, if the government is willing to pay more?
I took a closer look at your argument, re-read it a couple times actually. You make some really great points, especially in your second paragraph. Until just this morning, my stance on the bailout was a 100% No Way. I just did some extra reading on the topic on various blogs, news-sites, etc., and I’m starting to re-think this bailout idea. I agree with you, in your fourth paragraph, that the “equity warrants” to protect taxpayers are not strong enough in the proposed plan which was just rejected. I have many problems with this plan, but the idea of a bailout and its absolute necessity, theoretically-speaking, is making much more sense to me. Thanks for your insightful points in this post.
So why do you suppose 95 dems voted against it? I think I know why the republicans voted against it, but why didn’t the vote go along party lines like it does with seeming every other democrat-backed legislation that comes up for a vote.
We’d HAVE the bailout if Nancy Pelosi had keep her rabies vaccinations current!!
I agree that the government has to do something, but I don’t think the bailout as it is currently conceived is necessary. First, this is fundamentally a two fold crisis–confidence and liquidity. The government, through the Fed could instead make low interest loans to solvent banks so that they could purchase insolvent banks or their bad paper at deep discounts. The solvent banks are the ones which were well-run and avoided the risky investments in dubious new instruments without sufficient liability coverage. There are plenty of solvent banks out there and their purchase of the insolvent ones would get the greedy idiots out of the banking industry.
I do not see any reason that the government should directly purchase bad paper on 5% of the US housing market and then be responsible for selling these properties. The government is barely competent to do what it does now. I dont not believe it competent to manage the resale of every 20th house in America. Let it re-concentrate on just running the V.A. for a change.
My point is that if the government stands to make a profit on these properties, then let the market go after those profit margins. The proper role of the government in this case is not to insert itself in the marketplace but to assist the marketplace with its two real problems which are temporary: Liquidity and confidence. It can achieve both by supporting buyouts within the market by providing low interest loans.
What’s up with the moderation?
Check out this, it’s hilarious, at least some good comes of this horrid mess. http://www.geraldnaus.com/?p=10987
Did you notice how neither McCain nor Obama said much about the financial catastrophe ? Both parties eat from the same troth, they aren’t likely to incriminate themselves.
THis is a banner day. A Post that I agree with Morning Minion One Hundred Perecent on!!!!
I am tired of the political BS on both sides. Finally the news tonight seemed to show signs of real panic. This is just incredible we are playing with this.
“So why do you suppose 95 dems voted against it? I think I know why the republicans voted against it, but why didn’t the vote go along party lines like it does with seeming every other democrat-backed legislation that comes up for a vote.”
Bemused ,
I would say that the reason the Democrats voted against it are many. THe first key is not to see this as some Conservative Blue Dog democrat revolt. Many Democrats voted against it because the good reforms Republicans wanted in it were in the bill
Yeah Pelosi was a idiot today. I am not sure her over the top partisan speech on a bill caused all those votes to go the other way but the dems were playing politics at the exact moment they should have not
On the flip side I have no idea what the Republicans were thinking. DO they actually think they will get a better bill? I think not and we shall be lucky if we don’t have a bill that is further to the left and pass on a Party vote. Make no doubt that Bush will sign it because he has no choice.
Both parties blame one another, like little kids. Meanwhile the Dow’s down almost 800 points. If only one could vote for a third party. Conveniently, the two parties have rendered that all but impossible. Yay. In the 18th century, a revolution was started for lesser reasons than this *$#! The level of greed and corruption is beyond belief.
You won’t be getting assets for that money, but just debt, and letting your bankers (under the dire leadership of the Federal Reserve) get away scott free. The fact is that the financial system must be returned from the hands of the bankers back to the people. Sure there will be pain and dislocation in this, but if this rescue goes ahead then at the next crash it will only get worse and then the US will be a subsidiary of China Inc.
So why do you suppose 95 dems voted against it? I think I know why the republicans voted against it, but why didn’t the vote go along party lines like it does with seeming every other democrat-backed legislation that comes up for a vote.
Bemused,
To call the bailout “democrat-backed legislation” is to ignore reality. The plan that was cobbled together within days was based on Treasury Secretary Paulson’s three-page proposed draft. Paulson is a Republican. So is George Bush, who urged passage of the Paulson plan. The work done on the legislation was genuinely bipartisan, at least on the part of the Democratic and Republican leadership. It’s probably the most genuine compromise to occur in Washington in a long time.
One of the major reasons why it failed is that the mail and phone calls to congressional representatives were running 100 to 1 against the bailout, and we have elections coming up. Clearly many politicians where more worried about their own chances for reelection than they were about economic disaster for the United States.
Again, we dont need a bailout. We just need liquidity. It’s a liquidity crisis.
The fact is that the financial system must be returned from the hands of the bankers back to the people.
What in the world does this mean?
Have you no understanding of fiat currency? Gov. regulated fake money is always destined to fail:
Indeed. Money backed by gold became “legal tender” backed by a politician’s promise in 1972. Money is supposed to be a storage medium for the value of your goods and services. I spend two hours fixing a guy’s computer and he gives me $100, I turn around and give $40 to a gardener for 2 hours of his work.
Every dollar that the government legally counterfeits (prints) dilutes the value of my dollars and siphons off my spending power. By giving more of this monopoly money to people who haven’t earned it, makes the value of my goods and services less, requiring more monopoly money to buy what I want.
Government has caused this problem, and I don’t want the same stooges who got us into this by pandering to their constituencies with the value of our goods and services to try and figure out how to get us out of it. You’ll have to excuse me if my level of trust is not at an all time high.
You want to infuse liquid capital into the system, suspend the capital gains tax for the next two years. You’ll see an infusion of billions, my money being among it. I’d even buy some of those distressed securities to put into my retirement portfolio (if they were valued fairly).
Brad De Long’s plan is ludicrous. The Fed takes over any bank that is not “well-capitalized”? Please, define “well-capitalized” which would basically apply to no bank at all. Do we really want the Fed to run Citigroup?!? Or Goldman Sachs?
Fr. J: don’t know about moderation, maybe a word triggered it. It’s not so much a liquidity crisis at this point. The Fed has been heavily injecting liquidity at different maturities, and even came up with a novel balance sheet transaction to swap mortgage-backed assets for treasuries. It worked for a while, but after Lehman collapsed, all bets are off. Right now, the writedowns that are approaching firesale prices are turning this into a solvency crisis.
On Blackadders’s point: I think you under-emphasize the confidence effects. Remember you have mortage-backed securities, sliced, diced, packaged, and re-packaged as CDOs that were supposed to have been safe as houses (sorry for that!). The rating system turned out to be off the wall. And nobody knows where the bodies are buried. Yes, this is irrational, but nobody really believes markets are rational, do they? :)
Greg: it is an issue of regulation. See Basel II capial adequacy requirements. Undercapitalized can mean something quitew specific, whether you use a simply leverage ratio or a more complicated risk-weighted measure.
What’s the difference between the financial industry and a highroller in Las Vegas ? The latter is more cautious. Well, and there is an actual roulette table, not its derivative.
Why even bother voting ? These mofos are all in the pocket of corporations, interest groups etc. You’d think with a system this rigged they’d at least get just regular obscenely rich. But no, that wasn’t enough. Maybe the mob should run Wall Street. Or crack dealers. I imagine crackhouses are better run than finance. Every loan shark has more business sense than those people.
“Yes, this is irrational, but nobody really believes markets are rational, do they? :)”
No *#@! – it’s bipolar. It’s scary that’s foundational to the economy. Between Chicken Little and meth freak on a binge. A psychologist like my wife is a better source of advice than a stock broker. She studied insanity.
I agree with Father J. Why not put the money in the nads of the commercial banks, who I understand hold the deeds of trust yet on the houses. They can use the money to stay liquid, to foreclose and to make the loans that keep this country running. It would also keep the depositors safe if they make sure the fed has enough money to help these traditional banks.
Those who played the system took the risks and should have to take the results, not the rest of the country.
Fr. J: don’t know about moderation, maybe a word triggered it. It’s not so much a liquidity crisis at this point. The Fed has been heavily injecting liquidity at different maturities, and even came up with a novel balance sheet transaction to swap mortgage-backed assets for treasuries. It worked for a while, but after Lehman collapsed, all bets are off. Right now, the writedowns that are approaching firesale prices are turning this into a solvency crisis.
Yes, it has become a solvency crisis. True, and that is why we need cheap loans to solvent banks to buy out insolvent ones. This rewards those who deserve rewards and punishes those who deserve punishment. It is the only just way.
I’m not sure that allowing solvent banks to buy up insolvent banks would do much. The solvent banks would be saddled with the newly acquired debt plus the new loan from the government. How would that combination open up more lending? It may be better in the long-run but in the short term that’s a recipe for exacerbating the credit crunch, or at least not making a difference.
I think nationalization is better than the Paulson. Sure, the government may not be good at running a business but it’s still better than giving the money away. Besides, nationalization can take the form of non-voting preferred stock leaving the management intact.
The problem with nationalization is that it’s still bailing out the creditors. Why not charter a new bank or banks capitalized with $700 billion? It can be public, private, or whatever mix a political compromise would reach. Let the existing banks fend for themselves.
I think you under-emphasize the confidence effects. Remember you have mortage-backed securities, sliced, diced, packaged, and re-packaged as CDOs that were supposed to have been safe as houses (sorry for that!). The rating system turned out to be off the wall. And nobody knows where the bodies are buried. Yes, this is irrational, but nobody really believes markets are rational, do they?
Sure, sometimes markets behave irrationally. But so do governments. The question is why we should have more confidence in Paulson’s judgment of what the price of these assets should be than the market as a whole. Presumably if Paulson were still at Goldman, and was saying the same things he is now, few people would conclude that he had a better grasp “real value” of these assets than everyone else. Why should the fact that he’s moved from Goldman to the Treasury change that assessment?
Don’t worry everyone. McCain suspended his campaign to fix it, it will be taken care of by the end of the week. No worries.
Morning’s Minion,
I am surprised that you are calling for nationalization – especially after considering how poorly the crisis has been handled. Did the Fed and Treasury not reassure us a few months ago that Freddie and Fannie were “well-capitalized” and able to withstand the credit crunch? Did the Fed let Lehman fail which has had significant affects throughout the world’s economy? The last thing we need is the gov’t trying to run a bunch of banks..what a disaster that would be.
Certainly the Paulson plan is not perfect and leaves many questions open. For example, how will the loans, swaps, CDO’s, etc be priced? Will the Treasury pay enough to cover the loans or will banks require further write-downs upon sale of the loans? How will the banks be recapitalized? Just because the loans are sold doesn’t mean the banks are completely free to lend again – they are still extremely undercapitalized.
Blackadderiv,
I’d rather have Paulson than anyone else. And Bernanke has done nothing but prove that just because you are a high level academic doesn’t mean you understand the real world. He has been a deer in headlights since the credit crisis began.
I work in the financial industry and have worked with several of the top 10 banks. If there is no bailout, then it will help local banks who didn’t get caught up in the mess that the big banks got caught up in when the government gave them the opening to offer incredibly high-risk loans.
Whether the bailout happens or not, America is headed for some tough times. There was an S&L crisis in the 80s. We got through it. Even though this may hurt my future employment possibilities (I only work with the top banks), I think it would be best not to bail them out. I wonder who many people have their hands in the cookie jar on this one.