Saturday, October 04, 2008
So the bailout of the financial system passed this week. And I breathed a sigh of relief, sort of, and wondered what I would have done if that was my decision to make. I'm torn by two conflicting feelings: first, that we cannot afford to let the financial system collapse, and second, that we cannot afford to throw good money after bad.
Sometimes, of course, we have to let things die. But the overall financial system is not one of them. Financial instability is a vicious cycle: once the system becomes unstable, investors become afraid to invest money, making it hard for people and businesses to get money, causing more failures and instability. Put another way, Main Street depends on the jobs provided by businesses that depend on Wall Street's ability to lend money.
As I understand it, currently many businesses large and small depend on short-term loans for everything from operating capital to pay for stock in their warehouses to emergency funds to pay for the roof busted in last month's storm. They get this money from banks, who in turn get that money from you and me; they pay these loans back with interest, which the banks shave off as their cut before paying you and me our interest.
But banks right now are afraid to lend money, because so many banks, funds and businesses have recently collapsed. On paper, the banks have enough assets to loan out, just the same way as the average American with a decent-priced home has enough assets to buy a Lamborghini. However, most Americans can't buy a Lamborghini at the drop of a hat, even if they wanted to, because their wealth is tied up in longterm IRAs or CDs or in stocks which have dropped or homes with heavy mortgages. SO on paper you have the money to spend on a midlife crisismobile, but in practice you don't.
The technical term for this is illiquidity, which is just a fancy way of saying that have wealth on paper, but can't turn it into money without incurring terrible losses. A lot of banks are in precisely this situation: they want to loan money to a potential new homeowner or to a businessman trying to repair his roof, but their money is all tied up in investments they can't move without losing big --- in this case, mortgage-backed securities.
These "mortgage backed securities" arose because over the past several years housing prices were going up and up, and the government encouraged banks to make loans to people who traditionally were at higher risk than normal. These so-called subprime mortgages were packaged up into "investment vehicles" and "sold off" --- essentially meaning the banks that made the loans sold the rights to the interest that the mortgages would make to other people. That was a good deal while the economy was great because people were paying their mortgages or trading up to better homes. Then the economy started to stall and the housing bubble burst ... and suddenly people aren't making those payments.
This led to a "liquidity crisis" which is just another big fancy word for "runs on the banks". Perfectly good banks with great track records and billions of dollars on their books that hit a few rocky patches suddenly saw their money dry up in a number of weeks, leaving them with large short-term debts which in theory they could easily pay off ... except they couldn't move their mortage-backed securities. One bank failed after the other and in the end banks got afraid to loan money to anyone.
So the point of the bailout: those mortgage backed securities are not actually worthless. If the economy gets back on its feet (which, eventually, it almost certainly will) and home prices start to rise again (which, eventually, they almost certainly will), some huge percentage of those securities will pay off. It's just a long waiting game, a game which banks can't play because they're constantly lending and spending, but which the government can play, because of its deeper pocketbooks and constant source of real income from taxpayers. So the theory behind the bailout is, the government will buy those illiquid securities, allowing Wall Street to start lending money again, so business owners can stay in business, and Main Street can keep its jobs.
Which goes to my second concern, throwing good money after bad. Our civilization has experienced Dark Ages. Our country has experienced a Great Depression. What if we go through ten or twenty years of economic depression, and most of those mortgage backed securities are essentially worthless? That's over two thousand dollars out of the pocket of every taxpayer, another $700B on top of our $10T debt. Or, worse, what if the problems in our economic system are more systemic, and other banks are about to fail for other reasons? We might need that $700B for something else.
So, as I understand it, the bailout is needed. But, as I understand it, the bailout is risky. So what would I do if I was in charge? Well, here are a few rough ideas:
- First, go before the American people, and explain in clear terms what we are doing. Main Street's jobs depend on Wall Street's ability to lend money to businesses, but that's crippled right now because Wall Street tied up a lot of money in mortgages Main Street is having trouble repaying in this weak economy after the housing bubble burst. If the government takes over those loans, banks can start lending money again to keep business doors open and paychecks flowing, ultimately paying off those loans so that the government (and the taxpayer) is paid off for its investment.
- Second, demand oversight and accountability. This is seven hundred billion dollars we're talking about here. That's a year and a half's worth of defense spending, or almost enough to pay for the fireworks at the opening ceremonies of the Beijing Olympics. The original version of this plan gave massive powers to Treasury Secretary Paulson and made his actions immune to court challenge. That's a non-starter --- we understand the need for swift action, but it should be open, transparent, and if necessary subject to legal challenges.
- Third, demand foresight and forebearance. A necessary step in this process is to not just review the needs of the banks with mortgage backed securities, but to look at the health of the entire financial industry and to make sure there are no other trees that are rotted to the core and about to fall down. If other big problems are discovered, Secretary Paulson should have the authority to delay or defer spending that money and should go back to Congress if need be to ensure he has the right to apply this money where needed.
- Fourth, think outside the box. Could this money be applied in other ways? Could we take $70B of the $700B and use it to help homeowners who face foreclosures? I understand that homeowners taking on responsibilities they weren't prepared to handle helped cause this, but the banks are also to blame for lending the money. If we make it possible for the homeowners to pay off the banks ... how does that hurt the banks?
Some people have decried the culture of greed and called to make sure that none of this money goes into CEO's parachutes. I empathize with that but ultimately don't understand it. The problem here wasn't greed --- it was risk. We want people to be "greedy" in the sense we want them to take actions that benefit themselves --- to make a profit, in short. But in business you have what's called a "fiduciary duty" to make sound decisions for your shareholders. Some of the people who are involved in this really fucked up --- be they homeowners who got too big for their britches or CEOs who chomped one too many expensive cigars. But many other people played by the rules and then got caught by extraordinary circumstances.
Like a response to a hurricane, we need to come in and help the survivors without recriminations --- and then make sure that when it is time to rebuild we don't encourage people to put themselves at risk.