Transcendental Generalization

This article on NPR and a similar explanation provided by Salon.com made me question my objection to the government bailout.

However, I began to wonder if this wouldn’t play out like Y2K: There were predictions of doom and gloom. Enormous amounts of money were spent. Urban myths proliferated. But when the moment actually came, almost nothing happened. Much of the expenditure was discovered to have been wasted.

The discussion of the TED spread is key. The credit crunch described in the articles arose from uncertainty—each bank’s uncertainty about the value of other banks’ assets. Under such circumstances, a bank failure creates certainty: We know that the value of the failed bank is now zero, and the prices of any assets it held are established—with a generous margin of safety—as they are doled out “at pennies on the dollar” to expert buyers. A fire sale is still a sale. Liquidation promotes liquidity.

It seems to me that direct government intervention in this process can serve only to increase or at least prolong uncertainty. When the government purchases assets, it does establish their value—but much uncertainty remains about whether the government might have overpaid and might undersell later. Although we talk about “government” intervention, it is really intervention by the American public, who will pay for the intervention with higher taxes or by borrowing from foreign countries (= devaluing the US dollar). Either way, uncertainty is compounded by concerns about the future purchasing power of the US tax payer, who plays a critical role in the global economy.

Unlike Y2K, something bad will happen. The key questions are how long the uncertainty will last, whether the liquidations triggered by the uncertainty happen all at once, or over a long period of time.  If the pain and recovery are fast, then we will see a stock market dip. If they are slow then we will see a recession or a depression.

As in Y2K, there is the possibility of wasted expenditures. I would prefer the government to employ its resources on keeping liquidations fast and localized and on recovering from them rapidly, rather than on spreading the effects over time and across current and future tax payers.

Naked Capitalism says it extremely well, describing Paulson’s plan as “a financial coup d’etat”:

there is simply huge amounts of cash ready to bottom fish in housing-related assets (we saw an estimate of $400 billion a couple of months ago). The issue is not lack of willing buyers; it’s that the prospective sellers are not willing to accept prices that reflect the weak and deteriorating prospects for housing.

…this [Paulson’s] program is going to swing into action with the clear but not honestly disclosed intent of buying assets at above market prices when future markets and the analysts with the best track records on forecasting this decline…believe it has considerably further to fall.

…The US needs to wean itself of unsustainable overconsumption, and since consumption has come to depend on growth in indebtedness, a reversal, however painful, is necessary. Our excesses have been so great that there is no way out of this that does not lead to a general fall in living standards…Thus, a sharp contraction in lending seems inevitable; the trick is to prevent it from crossing the tipping point into a vicious, accelerating downward spiral.

But regardless, there has been broad agreement that private capital will not enter the mortgage/housing market until investors have confidence that a bottom is nigh. The Treasury program, by quite deliberately propping up asset prices, will delay finding a market clearing level and thus attenuate the financial crisis.

AlterNet had a more cynical perspective, but said the following, highlighting Henry Paulson’s connections to Wall Street:

Contrary to what the Bush administration says, it is not the case that banks’ troubled mortgage assets cannot be sold in the private market. Those are the so-called “Level III” assets that banks say they cannot value. But that is only a dodge that the banks use to postpone taking losses.

…Investment banks typically hold about $30 of securities for every $1 of capital, so a 3% write-down would leave them insolvent. Lehman Brothers classified 14% of its assets as Level III at the end of the first quarter; Goldman Sachs was at 13%. Why is Lehman bankrupt, and Goldman Sachs still in business? If Secretary Paulson, the former head of Goldman Sachs, had not proposed a general bailout last week, we might already have had the answer to that question.

…For the Paulson bailout to be helpful to the banks, it must buy their securities at much higher prices than the private market is willing to pay. Otherwise it makes no sense at all, for the banks could sell at any moment to the hedge funds. But that is a subsidy to private banks, administered at the whim of the Treasury Secretary, without oversight and without the possibility of legal recourse.

Dear Representatives:

You are faced with a decision to expand the powers of the Treasury in unprecedented ways, to bring a critical component of the global economy under US government control.

Two things brought us to this point:

• Foolhardy investors at the helm of giant institutions (sovereign wealth funds, domestic and foreign investment banks, and hedge funds), greedy for superior returns, poured money into assets whose true value they did not understand.
• Simultaneously, assets of questionable value were produced by Fannie Mae, Freddie Mac, and other institutions.  These institutions apparently looked the other way while their suppliers, predatory lenders, fed off American home buyers and speculators.

The market should be allowed to punish these institutions just as it frequently punishes every other irresponsible speculator in every other market.

You have heard predictions of doom and gloom if more of these institutions are allowed to go bankrupt.  Please use your own common sense when you consider what will happen under that circumstance.

The economic forces that will dominate are very simple:  Loans will continue being made.  However, lenders will simply start considering carefully what their money will be used for, and how a purchased asset will yield a return.  This is what they should have been doing in the first place.

Yes, some money will temporarily flow out of the housing market, but not all the money that is there currently belongs there.

Yes, large-scale institutional investors will suffer losses, but they will start demanding transparency of asset values and shift their remaining money into fundamentally sound sectors of the global economy.

The bailouts of these institutions will serve only to enlarge and extend the housing bubble by artificially increasing the value of bad loans.  It will create an enormous tax burden, either on our children or on Americans who were sensible enough to stay out of bad debt.

It would be a tragic hypocrisy if we punished oil speculators or short sellers while rewarding larger scale and more extreme speculation in credit derivatives. Please do not spend the American public’s money to provide corporate welfare to these domestic and foreign speculators.  Public money is far better spent rescuing American borrowers who were defrauded and punishing the predatory lenders who victimized them.

I don’t envy your position, but I urge you again to use your common sense in this consideration.  I will be following your actions with interest.

Thank you.

–  Milind S. Pandit

Fannie Mae and Freddie Mac were Government Sponsored Entities (GSEs) but they were no different from any bank that profits by borrowing money at one interest rate and loaning it at a higher one.

In the case of the consumer banks we are accustomed to, the money we deposit in our checking and savings account is money borrowed by the bank. On this, the bank pays a low (or, in the case of many checking accounts, 0%) interest rate. When we take out a mortgage from a bank, it is money loaned (a “loan purchased”) by the bank. On this, the bank earns a relatively high (5% or more) interest rate. The difference is profit, and that simple principle makes the (financial) world go ’round.

Now Fannie Mae and Freddie Mac made mortgage loans, but they did not take consumer deposits. They got the money for these mortgage loans by selling the loans at a premium to (primarily foreign) investors. This meant the borrowers owed money to these investors, not Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac further profited from fees for this service. Investment banks have similar money-making operations going. The profit margin on each such transaction would have been quite small, so to maximize profit, the GSEs became adept at making and then selling large numbers of loans.

Like so many banks, these GSEs ran into two problems:

• On the supply side, it became increasingly difficult to find good-quality borrowers
• As people began defaulting on their loans, it created a problem in the middle, on the books of these GSEs. The loans in their inventory were worth less than what the GSEs purchased them for (and in some cases, worthless)
• On the demand side, investors began to question the value of the assets they were purchasing, thereby further depressing the value of the GSE’s inventory.

Of course, the dynamic process of buying and selling large numbers of loans did not stop suddenly. As the GSEs discovered they had bought loans for more than they were worth, and had to sell loans at a loss, they began to burn cash and head to bankruptcy.

My question is: so what? Terry Gross’s guest, Michael Greenberger, described the market for these loans as “shadow” and unregulated. Well, you know what? When you take stupid financial risks, you lose money. When you buy something you don’t fully understand, you don’t realize until later how stupid your risk was. Any personally responsible individual investor knows this, and has felt it in his or her brokerage account. Why should the fat cats invested in GSE stocks and bonds, the people running enormous sovereign wealth funds, have any protection from the losses of big risks, when individual investors don’t?

By bailing out these GSEs (and who knows what else) the government has accomplished two things:

• artificially inflating the value of bad loans by promising to pay them off and
• allowing bad loans to continue being made, with the promise to pay them off

I could be missing something, but it seems to me any one with half a brain would see how transparently stupid this is. Well, the market has more than half a brain, and that is why this action served only to confirm the degraded value of assets across the financial industry. As Joe Nocera of the NY Times put it, “the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence” The result was the failure of even more banks.

It reminds me of scenes from holocaust movies where a group of oppressed refugees hide somewhere in utter silence from their pursuers. As long as everyone is quiet, there is a chance they will escape, but one of them coughs, so they all fall into the hands of their captors.

Our government coughed. Merril Lynch, Lehman Brothers, and AIG have all fallen.

One credible rationalization for this action is that future economic growth will compensate for the recent overspend by the population (measured by mortgage defaults) and the current enormous expenditure by the government (measured by the price tag on bailouts). But, the government doesn’t generate revenue directly from economic growth—its money comes from two places: taxes or the mint’s printing presses. Printing more money will cause inflation and dilute the value of prospective buyers’ current holdings. So taxes it shall be.

Even my favorite ten-year-old understands that while these bailouts may allow (foolish or fooled) borrowers to remain in their homes, the tax burden and inflation may drive many non-borrowers out of their homes in years to come.

You know all those cheap Chinese goods on the shelves at Wal-Mart? Buy them now on your credit card! Interest rates are artificially low! Soon, with higher taxes and higher interest rates, you won’t be able to afford them!

In other words, our children will pay for our folly. Unfortunately, there is no way to put lipstick on that pig. This is why the bailouts have been presented to us as preventing a global financial catastrophe. Personally, I can’t see how it could be any worse.

The other rationalization is more insidious, but was brought to my attention by conservative personal finance advisor Dave Ramsey: the Republican administration is goosing the stock market in the short term to ensure McCain’s election in November. Even the possibility of such an abuse of power argues for smaller, less powerful government. Isn’t that what the Republican Party used to stand for?

George Will said on This Week With George Stephanapoulos,

You [Stephanapoulos] asked the Treasury Secretary, “Is this socialism?” He answered, “No, it’s not socialism; it’s necessary.”…When the British Labor Party was socialist, it defined socialism as government control of the commanding heights of the economy—which in Britain at that time was coal, steel, and railroads. The commanding heights of the American economy are financial services and they are now controlled by the government.”