Progressive Conditions for a Bailout
The events of the last week showed the urgency of dealing with the financial crisis. There is a real risk that the banking system will freeze up, preventing ordinary business transactions, like meeting payrolls. This would quickly lead to an economic disaster with mass layoffs and plunging output.
The Fed and Treasury are right to take steps to avert this disaster. While there is an urgency to put a bailout program in place, there are several important issues that Congress should address in the context of bailout.
While there is not time to prepare all the details of the financial restructuring that will follow after the bailout, there can be an agreement on the outlines that this restructuring should take. This list of suggestions is presented in that context:
Principles to Guide the Bailout
1) Financial institutions should be forced to endure the bulk of the losses with taxpayer funds only used where absolutely necessary to sustain the orderly operation of the financial system.
2) The bailout must be designed to minimize the opportunity for gaming.
3) The bailout should be designed to minimize moral hazard.
4) In the case of delinquent mortgages that come into the government's possession, there should be an effort to work out an arrangement that allows the homeowner to remain in her house as owner. If this proves impossible, then former homeowners should be allowed to remain in their homes as renters paying the market rent. This should be done even if it leads to losses to the government.
5) There should be serious efforts to severely restrict executive compensation at any companies that directly benefit from the bailout.
Principles for Restructuring the Financial System
1) Combating asset bubbles must be one of the Fed's key responsibilities.
2) The government should impose a modest financial transactions tax, comparable to the one in the United Kingdom. This can both restrain excessive trading and raise more than $100 billion a year in revenue.
3) Regulatory agencies should require that potentially tradable assets (e.g. credit default swaps) actually be traded on exchanges.
4) There should be strict limits on leverage for all regulated financial institutions.
5) Fannie and Freddie should remain fully public institutions, returning them to a status comparable to Fannie's prior to its privatization in 1968.
6) The Fed should be restructured so that all the key decision makers (e.g. the open market committee) are appointed by democratically elected officials. Its responsibility is to manage the economy in the interest of the general public, not the financial sector.
Given the urgency for passing a bill, Congress should look to enshrine principles in a bailout bill that will allow subsequent legislation to circumvent ordinary procedural issues (e.g. the filibuster in the Senate).
Principles to Guide the Bailout
1) Every effort should be made to ensure that the financial institutions bear absolutely as much of the cost of these bailouts as possible, thereby minimizing the cost to the taxpayer. This is important not just to protect taxpayers. The managers who got their institutions and the country into this housing and financial crisis exercised extremely bad judgment. They should be forced to face the consequences of their actions. Similarly, the shareholders who benefited on the upside of the housing bubble should be forced to experience the downside that resulted from risky investment strategies.
Without details of the plan, it is difficult to say how best to accomplish this task, but one obvious way is to have an equity stake be the price of admission to the auction system. For example, any company could be forced to sell itself to the government in proportion to the assets it puts up at auction. For example, if the government buys $10 billion of its junk-rated mortgage backed securities, then it gets an equity stake in the company of $2 billion. This would also get around the issue of having foreign financial institutions get into the mix. If UBS or other foreign banks want to sell themselves to the U.S. government, they can be given that option.
2) A big part of our financial problems stems from the corruption of the appraisal/rating processes. This occurred both at the level of home appraisals in the mortgage industry and at the level of the bond rating agencies who gave investment grade ratings to mortgage backed securities and derivative instruments that did not deserve this status.
This creates an obvious problem for any reverse auction system of the sort being described by the Treasury. One way that a bank can offload much of its assets at these auctions is to misrepresent the quality of the asset. In other words, if there is a reverse auction for near-investment grade MBS, and a bank offers to sell a large amount of complete junk, that it claims to be near investment grade, then it is likely to be a big winner at the auction.
A way to limit such gaming would be to structure the contracts so that both the companies and their managing executives are personally liable for the subsequent performance of any assets they unload. If the assets perform substantially worse than other assets in the same grade, then they can be sued to make up the difference.
For example, if Citigroup sells $10 billion worth of assets in a particular investment grade, and the loans in this sale end up having a default rate that is 20 percent higher than other loans in the same investment grade, then the government can sue Citigroup and the executives who signed off on the sale to collect the difference, plus some penalty.
This provision can be written so that normal variance would not trigger any action (e.g. if the default rates are 5 percent higher). This will provide a substantial disincentive for the most obvious form of gaming.
3) The bailouts so far have allowed the institutions that took irresponsible risks to fail (e.g. Bear Stearns and Lehman Brothers), while protecting their creditors. This has the effect of punishing the executives and shareholders of these institutions, but allowing those who foolishly lent money (often for high returns) to escape unscathed.
Any future bailouts should also ensure that those who took excessive risks suffer the consequences, but they should also attempt to ensure that creditors exercise better judgment in their loans in the future. One way to do this would be to initially allow the creditors of failed institutions to recoup their funds immediately, but to reserve the right to reclaim some of this money for loans that carried especially high rates of return.
For example, if a creditor had lent Bear Stearns money at a 15 percent interest rate the month before its collapse, there is no reason that the government should fully honor this debt. The lender obviously understood that this was a high-risk loan at the time it was made. Any loan to a failed institution should be subject to such a review, which could result in a demand for a partial repayment to the government. This would only apply to large loans, since there would be little point in scrutinizing a loan for $20,000.
4) The government will inevitably come into the possession of a vast amount of mortgages in various stages of delinquency. The priority in these cases should be to allow people to remain in their homes, not maximizing the return on the mortgages.
This should mean first a good faith effort to negotiate a write-down that makes it possible for homeowners to remain in their house as owners. If this proves impossible, then the next recourse should be to give homeowners the option to remain as renters paying the market rent for the house. Only if the homeowner can neither arrange a new mortgage nor pay the market should the government move ahead with foreclosure procedures. This is a subsidy to homeowners, but it is a relatively small subsidy to people who were often the victims not only of abusive marketing practices by the mortgage industry, but an explicit government policy to push moderate income families into homeownership.
It is also important that renters in foreclosed properties have their rights protected. This should mean, at the least, that any existing leases be honored and also that a reasonable time period be given before a new owner is allowed to carry through with the eviction of tenants.
5) The government can set whatever conditions it wants on participating in the reverse auctions. One of the conditions it should set is that executive compensation be severely constrained at any financial firm that participates. For example, it can set an absolute limit of $2 million in total compensation for any executive at any firm that takes parts in the reverse auction.
Since participation in the auction is completely voluntary, this would make the cap voluntary. Furthermore, there need be little fear about losing good talent, because well-managed firms would not have to participate in the reverse auction.
Restraining compensation on Wall Street will be incredibly important in reversing the pattern of inequality that has developed over the last three decades. The exorbitant compensation packages on Wall Street distorted pay structures throughout the economy.
Executives at non-financial companies looked at the pay on Wall Street and used this as a basis for demanding outrageous pay packages for themselves as well. Presidents of universities often get over $1 million a year, and even top executives at private charities can often earn near $1 million a year. These salaries seem low when compared to their counterparts in the corporate world, but they are outrageous when compared to the pay checks of typical workers. If we can bring about voluntary pay restrain on Wall Street with this bailout, it will be a very big step toward reversing the pattern of inequality that has developed over the last three decades.
Principles for Restructuring the Financial System
1) The Fed must see the combating of asset bubbles as one of its main responsibilities, along with maintaining high employment and low inflation. We are in this crisis because Alan Greenspan chose to ignore first the growth of a $10 trillion dollar stock bubble and then an $8 trillion dollar housing bubble.
The Fed has a wide variety of tools that it can use to rein in bubbles, starting with talk. The Federal Reserve Chair regularly testifies before Congress and frequently speaks in other public forums. The chair can use these occasions to lay out evidence that a bubble exists in a financial asset and to explicitly describe the potential risks to the actors involved.
For example, in 1998 and 1999 Alan Greenspan could have carefully explained that price to earning ratios in the stock market were inconsistent with any plausible projection of corporate profit growth. He could have explained the risks that pension funds and other investors faced from being heavily invested in an over-valued asset.
Similarly, if Greenspan had pointed out in 2002-2006 that house prices had hugely diverged from a 100-year long trend, rising by more than 70 percent in real terms after staying flat for 100 years, then it is likely that many people would have paid attention. He could have also pointed out that many of the holders of mortgage backed securities and derivative instruments were taking very serious risks, since these assets would suffer large losses with a reversal in the housing market.
It is difficult to believe that if Greenspan had made these sorts of explicit warnings, it would not have an impact on the bubbles in the stock and housing markets. Economists and financial analysts can certainly have differing views on the state of the economy, but it would be incredibly irresponsible to simply ignore clearly stated warnings from the Fed.
In addition to the impact of explicit warnings, the Fed also has substantial regulatory authority that it can use to rein in bubbles. The main tool in the case of the stock market is the margin requirement for borrowing to buy stock. Raising the margin requirement by itself would have little impact (relatively little stock is bought with margin borrowing), however raising the margin requirement would be a clear warning that the Fed views the stock market to be over-valued.
The Fed has more extensive regulatory powers with regard to the housing market. Its failure to use these powers allowed for the proliferation of questionable mortgage practices.
The Fed can raise interest rates to rein in financial bubbles. This is an extremely blunt instrument that also has the effect of slowing the economy and throwing people out of work. For this reason, the Fed should be very hesitant to use higher interest rates as a weapon against asset bubbles. However, in the case of the housing bubble, if the Fed's other tools were insufficient for containing the bubble, it would have been appropriate to raise interest rates to prick the bubble, even at the cost of slowing the economy.
2) Congress should impose a modest financial transactions tax with the explicit purpose of reducing excessive trading and downsizing the financial sector. The financial sector has exploded in size over the last three decades. It accounted for more than 30 percent of corporate profits in 2004. Back in the 1950s and 1960s, the country's period of most rapid growth, the financial sector accounted for less than 10 percent of corporate profit.
The financial sector performs an incredibly important function in allocating savings to those who want to invest in businesses, buy homes, or borrow money for other purposes. But shuffling money is not an end in itself. The explosion of the financial sector over the last three decades has led to a proliferation of complex financial instruments, many of which are not even understood by the companies who sell them, as we have painfully discovered.
The best way to bring the sector into line is with a modest financial transactions tax. Such taxes have long existed in other countries. For example, the United Kingdom charges a tax of 0.25 percent on the purchase or sale of share of stock. This is not a big deal to someone who holds their shares for ten years, but it could be a considerable cost for the folks who buy stocks in the morning that they sell in the afternoon.
Scaled taxes on the transfer of other financial instruments (e.g. a 0.02 percent tax on a trade of an options, future, or credit default swaps.) could go a long way in reducing speculation and the volume of trading in financial markets. Such a tax could also raise an enormous amount of money--easily more than $100 billion a year. This would go a long way toward funding new programs or reducing the budget deficit.
And, this tax would be hugely progressive. Middle-income shareholders might take a small hit; but it would be comparable to raising the capital gains tax rate back to 20 percent, where it was before it was cut to 15 percent in 2003. The real hit would be on the big speculators.
3) Tradable instruments, like credit default swaps, should be standardized and traded on regular exchanges. One of the factors that made the financial system so vulnerable was the proliferation of credit default swaps and other instruments that were not publicly traded. This makes regulation very difficult, since regulators don't have good current information on the volume of these assets. In addition it leaves companies with a large amount of discretion in their accounting for these assets, since they don't have an exchange determined price.
4) There need to be much tighter restrictions on the extent to which financial institutions can leverage themselves. Profit maximization will encourage firms to become as leveraged as possible. In principle, the market should provide discipline, charging high interest to heavily leveraged firms. However, if lenders either exercise poor judgment or assume a government bailout will protect them (as has been the case in this instance), then the market will not by itself prevent excessive leverage.
Any institution subject to regulation should face tight restrictions on leverage. There should be absolute commitment that lenders to any institution not subject to financial regulation will not be bailed out.
5) Fannie Mae and Freddie Mac should remain as public corporations, operating in a manner similar to the way Fannie Mae operated prior to its privatization in 1968. These institutions play an important role in making low-cost mortgage money available nationwide by sustaining a secondary mortgage market. While they operated poorly in the housing boom, making risky loans and becoming overly leveraged, they still acted more responsibly than private issuers of mortgage backed securities, just about all of whom are now out of business.
There will continue to be a role for Fannie and Freddie to provide the anchor of the secondary market, ensuring the operation of a smooth functioning market. Now that they have been taken over by the government, there is no obvious reason to return them to their mixed public/private status.
We usually want the private sector to take the lead in most areas because we expect private entrepreneurs to be more innovative and willing to take risks. However, we really don't want these institutions to be innovative and risk-taking; we want them to carry through the mundane task of buying up and bundling mortgages and selling them in the secondary market. Private financial firms will still have the opportunity to experiment with new instruments insofar as opportunities develop.
Privatization would also lead to much higher pay for the top executives at these firms. The annual compensation for top executives at both Fannie and Freddie ran into the tens of millions, effectively imposing a tax on mortgages.
In short, privatization of Fannie and Freddie simply adds risk and costs. It provides no obvious additional value.
6) The structure of the Fed should be changed so that all the officials with a direct say in monetary policy are appointed by the president and approved by Congress. The Fed is supposed to act in the public interest, not in the service of the financial industry. It is disturbing that the public is being represented in this debate over the restructuring of the financial industry almost entirely by top figures from the financial industry. This would be comparable to having national policy on the auto industry determined by former top officials with the United Auto Workers. It is difficult to believe that the views of Treasury Secretary Paulson and other government officials from the financial industry are not influenced by their long association with the industry.
This problem should not be worsened by giving the banking industry a direct voice in the conduct of monetary policy, by allowing it to appoint Federal Reserve district bank presidents who take part in open market committee discussions. There should be a strict separation between the conduct of open market policy, which should be done exclusively by people appointed by the president and approved by Congress and the responsibilities of the district bank presidents. The banking industry deserves no special voice in the conduct of monetary policy.
Whew. That's quite a list, most of which can be distilled down to reform of the rating agencies, deprivatization of F&F, return of the uptick rule, and using the Treasury as an auction house for illiquid securities.
But let me make a suggestion. I'll bet the average poster here has absolutely no idea what is going on, and why they should be concerned about it. Perhaps your proscriptions would be better received at a finance blog, while the people here could do with a primer on the situation.
How did the foreclosure rate moving from .5% to say 2% precipitate all this? How are mortgages put together and sold to other people and why? what happens when those bundles are rated improperly? Why is trust so important between institutions, and the lack thereof, freeze the flow of money?
After all that, why does this affect the rest of the country's businesses and their paychecks? All this is pretty dry stuff and the national attention is sure to wander soon. it's a perfect time to educate some people.
September 20, 2008 1:18 PM | Reply | Permalink
I'll put it in an even smaller nutshell - extremely high leverage combined with extremely cheap credit, a pernicious combination if there ever was one.
September 20, 2008 2:41 PM | Reply | Permalink
All the public has to know is that the right wing capitalists, the "deregulation, free market" sharks caused this debacle and they're supposedly going to fix it.
So the next time a Ronald Reagan comes along and tells you "government is in the way" or "we gotta get government off our back", or "Government is the problem", kick him in the balls.
Or if a sleaze bag named Phil Gramm comes by and starts telling you about Dickie Flatt and getting out of the wagon and helping everyone else pull, lynch the SOB!
The ex head of The Club for Growth, Stephen Moore, was on C-SPAN today and proclaimed he was a strong supporter of free market capitalism.
heh heh heh
September 20, 2008 3:24 PM | Reply | Permalink
I agree with your sentiment, but it may not be a Ronald Reagan and to "kick him the balls" may not get the best results:
"Government is not always the answer. In fact, government is often the problem." - Sarah Palin (from her stump speech)
September 20, 2008 11:35 PM | Reply | Permalink
House,
Stupitus Americanus votes for the "get Government out of the Way" gang and they get them. Then the unbridled capitalists screw over the public and Stupitus Americanus screams; "Why doesn't the Government do something?"
September 21, 2008 8:49 AM | Reply | Permalink
Raygun infamously quipped, "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"
Really? Where, exactly, did Wall Street run for help again?
Hmm.
So do we get to kick that one to the curb now, along with Reagan's balls (and Palin's excuse for a brain)?
Palin's "quote" is also a ripoff from Raygun, who said in his first inaugural address, "Government isn't the solution to our problems -- Government IS the problem."
Really?
Again, that seemed to work only as long as the rich were getting obscenely rich.
Now they want the government to give them a solution.
And with Bush-Paulson, they're getting a solution that caters to them.
Nothing new under the sun.
And while we're kicking people, their ideas and their body parts, to the curb, Obama should add Robert Rubin to his to-the-curb list.
September 22, 2008 4:13 PM | Reply | Permalink
I'm not an expert, but enjoyed what I understood of the long, detailed list. If people want a primer, they should set aside an hour to listen to "The Giant Pool of Money" on This American Life.
September 20, 2008 5:56 PM | Reply | Permalink
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December 16, 2010 5:25 AM | Reply | Permalink
This is a smart blog. I mean it. You have so much knowledge about this issue, and so much passion. You also know how to make people rally behind it, obviously from the responses. Youve got a design here thats not too flashy, but makes a statement as big as what youre saying. Great job, indeed.children health
January 10, 2011 7:47 AM | Reply | Permalink
I do agree with all the ideas you have presented in your post. They’re very convincing and will definitely work. Still, the posts are very short for starters. Could you please extend them a bit from next time? Thanks for the post.by healthy families and child health plus
February 14, 2011 8:39 PM | Reply | Permalink
public servant needs to have a seminar on how there duty works.
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January 27, 2011 1:58 AM | Reply | Permalink
I suspect, given the track record of this Regime, the changes ultimately requested, will to use a saying currently in vogue “put lipstick on a pig!”
Two changes in the law and corporate governance could have prevented the current financial crisis and should be added to your wish list. First, reverse the 19th Century Supreme Court ruling to treat Corporations as citizens and remove the corporate veil from Officers. This change would fundamentally change the mindset of Directors and Officers to act more responsibly and within the law. Make Corporations responsible to their customers first and profits and shareholders second; from tactical leadership to strategic leadership as in other parts of the Corporate world.
Given the ethical and intellectual shallowness of the 110th Congress, don’t expect these bailouts well thought out or in the best interests of the citizenry!
September 20, 2008 1:32 PM | Reply | Permalink
Dean, the NYTimes has the text of the draft proposal online.
None of your wishlist is included. And it is not the Fed in charge, but the Sec. of Treasury, for 2 years.
Otherwise I have + a million questions.
September 20, 2008 1:49 PM | Reply | Permalink
Or to put the question at little less tactfully --
Now, that the draft of the proposed Bailout Plan is available (about time; it was probably composed weeks or months ago. Remember the Patriot Act!), do its provisions meet with your approval, Dean?
September 20, 2008 2:02 PM | Reply | Permalink
I'm sorry, but although your wish list is well-considered, you already know that your Magic Pony Plan is not being considered. They will do whatever they already think is a good idea, and the Dems are jumping right along. Their Magic Ponies re middle-class foreclosure relief will be scrubbed from the agenda, methinks. Apparently it's impolitic to suggest that there is confusion among the "experts" as to the true causes and esp. re useful remedies. Craven, every one of them.
What I'm not understanding is why anyone with two neurons left to rub against each other BELIEVES George "Known Serial Liar" Bush when he says that 'doing nothing will be worse'?
What's going to happen is that he and his pals are buying / insuring golden parachutes for the other members of the ruling class implicated in this fiasco, and ordinary Americans will be footing the bill for throwing good money after bad, along with the other $3T we and our descendents are already on the hook for.
September 20, 2008 2:07 PM | Reply | Permalink
There is a far more fundamental issue at stake and that is the nature of the monetary system.
Money is a medium of exchange and store of value. These work at cross purposes because as a medium of exchange, money functions as a public utility, while as a store of value, it is a form of private property. It is as private property that most people think of it, due to its historical origin as an accounting of assets, yet the reality is that modern monetary systems are fundamentally a medium of exchange and only as a function of that are they a store of value, as they have no real backing other than faith in the issuing institution and must be invested for the system to function and maintain value.
The monetary system, with its broad connectivity, is similar to a road system. You own your car, house, business, etc., but not the roads connecting them. That the money in your pocket is interchangeable with what is in others pockets is what makes it a function of exchange. Money is not private property, since you cannot print what you want, as the government retains copyrights, but effectively leases it out to the private banking system. Its value is based entirely on public faith in the institution issuing it, so the taxpayer is ultimately responsible for guaranteeing its value. The result being private gains and public responsibility.
The problem with capitalism is that it has created a large surplus of capital. This encouraged ever more lax lending standards as a way to absorb savings and sustain further growth of the money supply. The effort to privatize Social Security is a good example of the disconnect between rhetoric and reality, since there is no place to invest this amount of additional personal savings and would only be a boon to the brokers given the responsibility for handling it. We invest in our old age by investing in our parents old age, so that our children might continue the practice. It is a clear example of investing in the larger community as a viable form of savings. Wealth is a convective cycle of rising assets and precipitating benefits. Stopping this process only creates large storm clouds of marginally productive wealth hanging over a parched economy, much like we have now.
Currency did originate as a store of wealth, because it started as a accounting of specific assets, but political power also started as a projection of individual influence and evolved into monarchism before the inherent instability and corruption drove society to devise methods for making political power a public trust. It has come time to make economic power a public trust as well. Money lubricates the economy, rather than fuels it. Ideas, labor and resources are the real economic fuel.
If money were thought of as a public utility, it would have definite psychological effects. People might be less inclined to define their security in terms of the size of their bank account and start leaving natural wealth undisturbed and investing more effort in their communities and environment, rather than draining value out to put in a bank.
An effective financial system should have a currency loaned directly by the government, with the additional currency to pay these loans put into circulation by government payment for infrastructure. This would incorporate the banking system as a function of government at all levels. Small banking systems to serve at the county and town level, medium sized ones at the state and local level and larger national institutions. These would feed their profits directly back into the levels of the community which produced them and the various communities would be in competition to provide the best environment for people and business with these funds.
There are many aspects of the public sector which function quite well, from legislatures, courts, police, education, military, roads, etc. if they are managed effectively. It is not coincidence that private enterprise only insists on privatizing those aspects of community services which they can derive a direct and substantial profit from. Nobody thinks lots of regulatory detail will improve the situation, since the details are massaged best by those with an interest in them, so rather then trying to re-regulate the entire economy and society, just start with nationalizing a banking system that will have to be bailed out anyway. Government might be slower than the private sector, but that might be more healthy, since its perspective is longer term.
As it is now, government debt is the basis of our economy, which serves to transfer wealth from taxpayers to bondholders. Do we really want our government foreclosed on?
September 20, 2008 2:12 PM | Reply | Permalink
Speaking of communities being able to control their environments, as it is now the cards are stacked against it happening.
We Californians voted to require cars sold here to reduce greenhouse gas emissions 30 percent by model year 2016. Nine global automakers sued us to block what we had voted for. A majority of the shareholders of at least 7 of those automakers weren't American citizens.
(If only people rather than companies could sue and to sue required citizenship this kind of practice couldn't happen.)
I throughly agree with your basic premise at the same time as I realize that to carry out will be a monumental task.
September 20, 2008 4:41 PM | Reply | Permalink
I've made this point many times. Corporations, at least multi-nationals, aren't citizens and aren't entitled to the rights of citizens. Nor are they entitled to lobby our congress.
I happen to think this is over the top obvious.
And as for the financial sector that has made this mess? I would love to see the mix of the entities represented in their portfolios. Wanna bet it isn't a global conglomeration that has little to do with anything that even remotely looks like U.S. nationalism?
September 21, 2008 9:40 AM | Reply | Permalink
Dean Baker. Your list of suggestions is magisterial. As we might expect. Unless you object I'd like to copy and email to Frank and Dodd but I won't do so without your approval.
September 20, 2008 2:37 PM | Reply | Permalink
Dean's proposals: Good
"Bail Out Plan": Very bad. Really bad.
I'm sure it would take many people some time to digest Dean's proposals. Is it really "dry?" I don't think so. Given the complexity of the problem and the number of people whose lives will be directly affected by any solution, this is a pretty straightforward and actionable proposal.
This crisis was not at all unexpected. The "regulators" have largely been cheerleaders or silent or vague. Often the various agencies have not even enforced the laws on the books, let alone regulate anything.
Now those directly responsible are using a crisis they created as a reason to grant them even more power without any real accountability. Making a report to Congress every six months just schedules a dog and pony show. Read Section 8 and ask yourself what it means:
"Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
Maybe what Dean needs to do is to specify a stop gap measure to get us through the point where there is a new administration and Congress. Given the track record of this administration, I'm very skeptical about giving them this kind of power. Is there any reason to trust this administration to do anything other than what they have done in the recent past, including creating this situation?
Maybe we need a much better assessment of the risks of not acting at this time. Doing the wrong thing, aside from relieving some frustration, rarely makes things better.
September 20, 2008 2:47 PM | Reply | Permalink
Folks,
the bailout proposal that Paulson has put forward is a blank check. It would outrageous if Congress approved it in its current form. This is the domestic equivalent of the Iraq war authorization.
The threat of financial collapse is analogous to the weapons of mass destruction. The markets will wait. Congress can give a proposal with real conditions and then it will be Bush's call if he wants to be responsible for collapsing the U.S. economy.
September 20, 2008 2:52 PM | Reply | Permalink
The markets will wait.
You mean to say that if this bailout isn't enacted by this Friday, there won't be a worldwide financial meltdown on the following Monday?
Well, I never!
September 20, 2008 3:30 PM | Reply | Permalink
Ellen, the administration's proposal is hideous, in fact a total joke. But that's a new and different issue.
I still would like to ask you:
1) What do you think was causing the run on istitutional money funds?
2) What do you think would have happened if that run continued unabated, or if it resumes again?
September 20, 2008 7:10 PM | Reply | Permalink
Answers:
1) Certain corporate CFOs who opened their Finance 101 textbooks and learned, shockingly, that the reason they were earning more income on their MM funds than everyone else was because they'd assumed more risk than everyone else. Surprise!
2) Nothing other than a few -- well, maybe more than a few -- red faces.
It is the case that except in the most general terms most investors don't know (can't find out) what investments these MM funds hold. Thus, a run on them after Lehman's bankruptcy (Lehman being a large CP borrower) was predictable. As usual Paulson and Bernanke were late to the show* but at least they arrived (insurance and Fed funds), finally.
* If I were a tinfoil hat wearer, I'd swear the two of them arrived late on purpose. "Oh, we're the boys that promote the panics and don't we look clever and droll."
September 20, 2008 8:47 PM | Reply | Permalink
I'm not talking about you and me right now, Ellen. People like you and me, no, we can't find out what our money market funds own.
But the run last week was by institutional investors, and they have an entirely different kind of access. They are also the ones who pulled out 170 billion in just a few days.
Not you and me and aunt Sally.
September 21, 2008 2:33 PM | Reply | Permalink
Does anyone have faith that Congress will turn against the Unbridled Capitalists?
September 20, 2008 3:33 PM | Reply | Permalink
Hell no, they'll just go back to renaming post offices - one quarter of the legislation passed by this Congress was renaming post offices - Morgan, Stanley, Lehman, Merril, Lynch, Bears, Sternes - I made those up.
September 20, 2008 5:20 PM | Reply | Permalink
Yes it is. Exactly. And I am not liking the way the Dems are lining up to go along, just as they went along the first time.
September 20, 2008 7:07 PM | Reply | Permalink
Yeah. And just as with Iraq the MSM is along for the joy ride. MSM = Corporate America. They're just tickled that congress is about to hand them $700B.
And you can be assured the real cost will be way higher. Maybe a multiple of five or ten when they figure out what value to assign to all the worthless derivatives.
We'll all be able to paper our living rooms with hundred dollar bills.
September 21, 2008 9:51 AM | Reply | Permalink
"...privatization of Fannie and Freddie simply adds risk and costs. It provides no obvious additional value." Talk about hitting the nail on the head! But can't it be said that, ",,,privatization of ***any government service*** simply adds risk and costs. It provides no obvious additional value...?"
September 20, 2008 3:03 PM | Reply | Permalink
Here's an additional proposal: Tenants living in foreclosed properties have a use interest in that property (whether month-to-month or on a fixed-term lease). Tenants who choose to leave foreclosed properties should be made whole by payment of (multiple of the rent, size, some appropriate mechanism), but have the right of first refusal on the foreclosed property. Tenants could apply their use interest payment to the down payment on the property.
September 20, 2008 3:55 PM | Reply | Permalink
It occurs to me that Maliki has shown far more backbone in standing up to this administration than congress has.
Bunch of sheep.
It seems the Constitution is crumbling as fast as the economy.
September 20, 2008 5:11 PM | Reply | Permalink
From the draft proposal:
At least they are honest about their priorities.
September 20, 2008 5:18 PM | Reply | Permalink
September 20, 2008 6:26 PM | Reply | Permalink
I like your list Dean, it's very thorough. Please send it to the key members of the Senate and House who are working on the new legislation. The only thing I would add is a big chunk of funds for a special prosecutor to indict the crooks in the finance community who have raked in the money illegally.
This whole bail-out mania is going too fast, we need to step back and get a second opinion. If our elected representatives are going to spend our money on a bail-out they better spend time putting in place new laws to rein in the cowboys of finance.
This won't wait until January and a new President and Congress.
We can't bleed $10 billion a month on Iraq and $1 trillion on bail outs. We have other priorities like health care for all our citizens.
The S&L mess in the 1980s was a result of the Reagan watch and the current mess is the result of Bush mismanagement. Electing Republicans is like letting the fox guard the hen house, they'll always serve their masters, Big Business.
September 20, 2008 6:54 PM | Reply | Permalink
This whole bail-out mania is going too fast, we need to step back and get a second opinion.
But, but --
There isn't time.
The Congress has scheduled its adjournment for this coming Friday. And don't we want our Dems out there on the campaign trail? What could be more important than that?
September 20, 2008 8:22 PM | Reply | Permalink
If Congress doesn't insist beforehand on imposing regulations on these bunch of scheming thieves before a bailout occurs all it will be is the US taxpayers subsidizing the financial market's love of moral hazard and we'll be going through all of this again in the future. Reform will never occur after the fact. If the American taxpayer is on the hook the markets now answer to us and we want concrete steps to be taken to make sure this won't happen again...and 'assurances' ain't gonna cut it.
No bailout without oversight and regulation. First it was the S&L bailout of the late 80's/early 90's and now this? Fool me once shame on you...fool me twice shame on me.
September 20, 2008 7:57 PM | Reply | Permalink
I think it's, "Fool me twice, uh, we won't get fooled again!"
-- ARG
September 20, 2008 9:06 PM | Reply | Permalink
I'd like to go further and say every homeowner whose mortgage is securitized into a government-owned derivative should be able to refinance at the 30 year Treasury Bond rate. The August auction was 4.5 percent.
Otherwise, the government borrowed cheaply to charge homeowners the same rate as before. It wouldn't be unfair to call this spread a tax.
September 20, 2008 8:28 PM | Reply | Permalink
It will be interesting to see the Republicans balk at extending unemployment benefits in this period of crisis.
The Republicans have waited all these years to overthrow FDR's plan.
In fact early in Bushes first term there were whispers of how FDR thwarted the Republican plans, of total control during the depression.
It would be icing on the cake for the Republicans to do away with remnants of FDR's plans to save the working class.
The Republicans would salivate at the opportunity of bringing manufacturing back to the US if only they could eliminate regulations and had a cheap workforce to boot.
Unemployment benefits interfere with forcing people to work for less. Food stamps interfere; any Government subsidies would allow the working class to refuse to work for slave wages, because the working class would have a refuge.
I wouldn't put it past the powers to be, to take advantage, or to have directed this crisis to accomplish this end.
If they don't get it now, they'll just pick over the carcasses.
DON'T FIGHT FOR A BAILOUT, FIGHT FOR A SAFETY NET!
September 20, 2008 8:42 PM | Reply | Permalink
This is about far more than mortgages and banks. Most major American institutions are insolvent. GM is insolvent. Goldman Sachs is insolvent. Cities are insolvent. States are insolvent. The dollar is insolvent.
If our response to this exercise of Shock Doctrine power is to demand a bailout mitigated by regulation, then we are bringing a knife to a gunfight.
Seize assets. Make arrests. Seize assets now. Pitchforks. You are not being bold enough-- seize assets, and seize them now. After we have a system, then we can think about regulating it. As it stands now, there is not even a system to apply law to-- your fantasy regulations are meaningless.
September 20, 2008 11:47 PM | Reply | Permalink
Having been an accountant in my past life, I understand some of the problems with this scenario - not all, as investment banking and real estate financiing are a specialized fields in themselves. However, my question is this - where were the accountants in all of this ? Shouldn't they have raised a red flag in all of this ? Did these investment banks receive an unqualified opinion in their yearly audits ? It seems to me that leveraging at a 40 to 1 ratio is unreasonable and highly quesionable. Did the accountants accept this as reasonable ? I think there are many more questions that need to be answered - and as I said I only have a basic, minimal understanding of all of this, but I repeat there are many more questions that I have and I would think need to be answered.
September 21, 2008 12:02 AM | Reply | Permalink
Great point-- let me bring you up to speed. Other nations have accounting principles. We have GAAP, which now says: losses are assets, profits are doubleplusprofits, up is down, black is white, etc. GAAP is an international joke: most major US institutions are insolvent. Real accounting practices would reveal this in a heartbeat-- which is why real accounting isn't allowed within 100 miles of Wall St.
September 21, 2008 1:36 AM | Reply | Permalink
Am I thinking straight here? I read that one firm (maybe AIG) was leveraged at 60 to l. So if I personally held $1 million in assets, I could sustain $60 million in debts? I keep thinking that can't be right so I must be missing something.
September 21, 2008 1:01 PM | Reply | Permalink
You are correct: they have been playing with zombie money here. While 60:1 might sound damning, in my opinion it's much more dire than that. More like 60:0. Think about it-- insolvent means 0 dollars, worthless, nada, zilch, zero. Can you even quantify "leverage" at that point? Can you leverage nothing? So something like 40, 50, 60:1 winds up being more like the infinity symbol. Zombie money. Trillions of dollars in zombie money.
September 21, 2008 4:25 PM | Reply | Permalink
The disproportionate beneficiaries of this bailout are the extraordinarily wealthy. Why is there not some sort of generational wealth transfer tax (Estate tax, Death tax, Ultra-high income tax) included in this deal? When you ask every man, woman and child in the country to absorb about $2300 in additional debt, it only seems fair to include some sort of proviso to recoup some of these costs. Any increase in income taxes or corporate taxes will likely burden the fragile economy further. But a serious estate tax on transferred wealth - free of trust loopholes - could encourage massive spending, philanthropy and movement of some of this stagnant money.
September 21, 2008 12:22 AM | Reply | Permalink
This is exactly the type of thinking Congress should now be doing. I would go a bit further and regain the progressive tax brackets, so those who gained by these financial shenanigans will be paying a much larger part of the bill for correcting them. But, absolutely, the inheritance tax needs to go up as a major step to recover some of the loot.
September 21, 2008 12:54 AM | Reply | Permalink
Go after tax shelters. The Caymans. Switzerland. This is where the real money is hidden. If we close loopholes, it's like locking the vault after the burglars have escaped.
September 21, 2008 1:32 AM | Reply | Permalink
Fox, out of hens? Please let me give you mine to take care of.
I admit I am over my head here, but is this the point at which we all get drowned in Norquist's bathtub? The shrinkage of government being not in size per se but in power or will to respond? I mean, while we are servicing this kind of corporate debt as taxpayers we won't be funding too many of those other kinds of "socialist" programs for the common good will we?
September 21, 2008 1:20 AM | Reply | Permalink
With 455 trillion worth of derivative side bets, this piddling little trillion dollar bailout is like trying to catch a falling anvil in a wine glass.
In the natural order a conspiracy is simply the layer of the food chain, or the level of emergent phenomena above yours. Just as humans manipulate the natural world, there are levels of society which manipulate those less organized than they are. This emergent level used to be religious and political, now it is economic and financial, with religion and politics as the intermediate tools.
The problem they face is that in a collapsing ecosystem, highly specialized top predators are vulnerable.
September 21, 2008 6:59 AM | Reply | Permalink
The government is just giving money away here with no accountability. And it is tax payer's money. Is the Bush/McCain government willing to fund medical insurance for the 40+ million uninsured? Of course not. This is pure and simple, socialism for the wealthy. Given the power corporations seem to hold over the government (no regulations etc.) it’s more accurately termed corporate fascism. There is a friendly, helpful government to the economic elite with nothing comparable for the masses. No medical insurance, “you’re on your own.” Need some help on your mortgage, “you’re on your own.”
The level of abuse people will accept in this country is really incredible.
September 21, 2008 8:21 AM | Reply | Permalink
Dean, the treasury or its bailout arm will have no authority to execute your Bailout Principal 4 when the assets being acquired are not mortgages but residential mortgage-based securities (RMBSes) -- which is going to be almost always. Changing the ownership of an RMBS doesn't change the parties controlling the underlying mortgages -- usually the Master Servicer and (maybe) the Trustee of the securitized investment pool, of which the RMBS is just a non-voting equity share.
The rule needs to be: If you want to dump off your junk RMBS on the government, you have to get all the parties connected to those RMBSes to agree to transfer actual management authority for the underlying mortgages (and REO properties).
Several of us who are deeply engaged in foreclosure issues in Cleveland sent a memo to Sherrod Brown Friday on this and related issues.
For more see
What communities like Cleveland need in the bank bailout bill.
September 21, 2008 1:10 PM | Reply | Permalink
What communities like Cleveland need in the bank bailout bill
good stuff.
September 21, 2008 5:44 PM | Reply | Permalink
Re 60:1 leverage, you are correct that one cannot hold $60 million in debts with only $1 million in assets. Such would make you insolvent.
The trick with leverage is that it is not 'debt' (at least not immediately). 60:1 leverage means that for every $1 million in assets, you are risking $60 million. Which means that you can get away with it so long as your bets pay off (at least mostly), or temporarily (at least until your markers are called in).
The problem is that this kind of leverage is extremely risky: if your bets begin not to pay off, your losses can very quickly become real debts that wipe out your assets -- and leave you insolvent.
And leverage isn't necessarily a bad thing. Most people who own their homes do (or did) so using leverage. That is, if you put 5% down, then you are basically leveraging at 20:1 -- if you have $10K in assets and are buying a $200K house, for example. And if you act prudently -- getting a mortgage that you can actually pay off -- then the leverage is unlikely to cause you any harm, at least if you carry the mortgage for the full 30 (or however many) years. When you finally close out the mortgage, you are left with no debt and an asset that is almost certainly worth something (even if the value of your house falls by 50%, you are still $100K in the black). But you can get stuck if you need to unwind your leverage early. If you decide to sell off after five years, then it is likely that you haven't paid off much of your principal, and you probably still owe at least 95% of the original loan. And if the value of your house has fallen by 20%, then you might find yourself in trouble, because your debts (what you still owe the bank) are now $180K, while your assets (the house) are only $160K.
All of which indicates that "leverage" is not necessarily a bad thing, but one needs to be prudent when using it. Leverage used to buy tangible assets may be a good idea, but used to make a bet it is probably a bad one. It also, I think, illustrates how the unexpected unwinding of leveraged investments can create unexpected problems.
September 21, 2008 7:44 PM | Reply | Permalink
gby, what you said is true, but there is a difference.
How wise would this scenario be if the mortgage in question were an "interest only" loan? I didn't pay cash for my house. But I will be able to pay it off (with any luck).
The banks and investors we're talking about were not taking on 60:1 leverage and making monthly payments that would pay the debt off in some number of years. Instead, they were paying interest only, and betting that they could sell what they bought for more than they paid for it. Otherwise, they were going to be screwed.
Or, perhaps I should say, "Otherwise, we were going to be screwed." Because that's what it happening.
-- ARG
September 21, 2008 10:15 PM | Reply | Permalink
Sorry if this is a duplicate post.
Your analogy breaks down for the following reason: If I get a mortgage, I pay interest and principal and eventually pay the loan off.
The financial institutions in question never made any payments toward retiring their 60:1 leveraged debt. At most they paid "interest only" (mortgage equivalent). They counted on selling the debts for more than they paid.
If the value goes down, they're screwed. Or maybe I should say, "we're screwed", because we are.
-- ARG
September 21, 2008 10:27 PM | Reply | Permalink
ARG, you are correct about the dangers, which is why I said that leverage used to make a bet is a bad idea. And, in fact, this is basically what one is doing with an interest-only mortgage: making a bet that the value of your asset will rise so that you can pay back the principal.
That said, even a 'bet' is sometimes reasonable. For example, insurance companies are normally leveraged in more or less the same way. That is, if the houses of everyone having fire insurance written by company X were to burn down tomorrow, it is likely that company X would be in serious trouble, as they have written insurance based on their models for only a small number of houses burning down in a given year. But the insurance company will (or should) have very good actuarial data indicating how much they can safely risk, based on models that have been very well tested over a very long time.
Unfortunately, such was not the case with the financial models used by many of those offering insurance-like products in the financial services sector.
September 23, 2008 7:04 AM | Reply | Permalink
I have to take issue with a lot of this.
1. There is considerably urgency to do this right and ZERO urgency to screw it up.
We have no way of knowing whether throwing $700 billion at this problem as proposed will fix it so we could just be making a $700 billion mistake. That would leave us with a $700 billion hole and all the disastrous consequences of inaction you outline still on the table.
2. Having the government buy bad assets from the private sectors is wrong on every possible grounds whether you are a right wingnut or a bomb-throwing radical. It will make the problem worse, not better.
If these financial institutions want government money, then they can part with some equity, and not just ordinary share, preferential share. The deal has to have at least some upside potential for the government, not downside for the government and upside for the people who created the problem.
They are currently scrambling to figure out ways to avoid foreclosures and making some progress. If they can just hand this problem to the feds, they are off the hook, a MAJOR moral hazard that completely undermines the entire screwed up economic system.
If they have to hold the poorly underwritten loans, they will figure out more efficient ways to do that or go under. (They may need some help in this regard from the federal government in terms of changing laws, not doling out cash.)
It is estimated that a foreclosed loan costs around $60,000. That should be incentive enough to prevent the loan from going to foreclosure, even if the only way to do that is a short sale.
3. Executive compensation is a distraction and we should not be wasting even a second thinking about it. There are some big problems to solve and the best way to deal with this is to force those who created the problem to clean it up with all the attendant costs while preventing a melt down of the global financial system.
All the other principles and suggestions make sense, but they should not be on the table this week.
Right now, we should be concentrating on not allowing the White House and Congress to buy $700 billion worth of trash.
September 22, 2008 2:48 PM | Reply | Permalink
A proposal for acquring distressed mortgages
Basic ideaHomeowners facing foreclosure get to have their loan principal
renegotiated to current appraised value. However, the loan owner get a lien worth the difference between this appraised value and the original loan amount.
This lien gives them first right on the portion of revenue from a future sale of the house that is above the appraised value.
Example
If the loan amount is $400k, and the appraised value is $350k, the loan principal is reduced to $350k.
If in t years the homeowner sells the house for $380k, the homeowner gets $350k (minus whatever is owed on the principal), and the lien holder gets $30k.
You could tweak this a number of ways.
* the lien is treated like a loan, so it increases at the rate of interest (thus, in t years the lien would be worth 50 *r^t k$, where r is the interest rate (i.e. 1.06).
* The homeowner can always pay down the lien as desired.
* The lien can be seperated from the property, and sold to speculators
* etc etc
The idea is to appropriately help the naïve, but not necessarily duplicitous, dopes who bought these houses in the first place. And to slow down overly large drop in housing prices due to a bump in supply caused by foreclosures. But in a way that doesn't punish the prudent renters who have been waiting for prices to drop.
September 24, 2008 11:20 AM | Reply | Permalink
Barney and John Rains are the ones to blame for this mess. They forced the Fannies to make loans to people who had no business ever having a mortgage in the first place. It does not take any smarts to know if you have no credit rating, and no income, you will default on your loan. What are we all stupid.!!! I am sick of people trying to place the blame on responsible consertives that have been sounding the alarm for two years.
October 1, 2008 6:16 PM | Reply | Permalink
A big part of our financial problems stems from the corruption rating processes. This occurred both at the level of home appraisals in the mortgage industry and at the level of the bond rating agencies who gave investment grade ratings to mortgage backed securities and derivative instruments that did not deserve this status. Auto transporting
June 25, 2010 9:55 AM | Reply | Permalink
A big part of our financial problems stems from the corruption rating processes. This occurred both at the level of home appraisals in the mortgage industry and at the level of the bond rating agencies who gave investment grade ratings to mortgage backed securities and derivative instruments that did not deserve this status.
June 25, 2010 9:55 AM | Reply | Permalink
The idea is to appropriately help the naïve, but not necessarily duplicitous, dopes who bought these houses in the first place. And to slow down overly large drop in housing prices due to a bump in supply caused by foreclosures. But in a way that doesn't punish the prudent renters who have been waiting for prices to drop. auto shipping transporter cost
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Shouldn't they have raised a red flag in all of this ? Did these investment banks receive an unqualified opinion in their yearly audits ? It seems to me that leveraging at a 40 to 1 ratio is unreasonable and highly questionable. rac breakdown service
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In the case of delinquent mortgages that come into the government's possession, there should be an effort to work out an arrangement that allows the homeowner to remain in her tech house as owner.
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December 16, 2010 2:06 PM | Reply | Permalink
The progressive suggestions in the article are a step in the right direction. The only thing is that we are in the largest land grab since the days of manifest destiny, so the great ideas of giving the assets to the people won't be implemented, it's government, not a charity. Should government bail out companies by buying their assets (foreclosed homes) then the government owns the homes and property. Sure, you can rent this home, but you'll have to sign this contract that allows for searches at any time and monitoring in any way we like. Maybe I've been reading too much Orwell, but with all the street cams and property grabbing, it seems pretty possible.
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December 19, 2010 4:50 AM | Reply | Permalink
That's quite a list, most of which can be distilled down to reform of the rating agencies, deprivatization of F&F, return of the uptick rule, and using the Treasury as an auction house for illiquid securities.
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Not sure about you folks, but I'm done contributing to the federal government and its party of the wealthy. I suggest every american stop supporting the federal government in all things. I, for the life of me, can not think of one good thing the government has done or stands for as present. Everything is corrupted and cronyism. Leave the banksters, corporate elitists and gov officials to themselves.
Let's see how they do WITHOUT us and our money, and our blood, sweat and braindumps tears.
Its my guess that we'll have another drop in the markets to scare the heck out of those americans that cannot think without intimidation or gov press releases. They'll bring their garbage cans full of lies and BS to scoop out onto americans. And you know what, I bet a majority would still support the gov and additional ccna voice dumps bailouts. THAT's what makes me sick and disgusted.
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