On the Bailout

I’m not a fan.

First, I think Ace is on the right track when he reminds us that these assets that the government proposes to buy are not worthless and that the government stands to recover some of the cost. However, the people predicting a 20-25% return on this “investment” are wildly speculating based on very little information.

The claim is that none of the banks which currently hold mortgage-backed securities can properly value the securities (they are opaque) so none of them can buy or sell them (they are illiquid). The idea behind the bailout is that a government agency will be created that will take a guess at a price, purchase them, then determine their actual value, make that information public, and auction them back into the market. Dafydd calls it a “reset button.”

Why can’t the financial services institutions do all that themselves? Because in the meantime the securities are valueless. That represents a serious loss and the institutions are finding out that they have far less capital than they previously thought. Some institutions are simply worth less, but they’ll live through it. Others are declaring bankruptcy or threatening the government that they will declare bankruptcy in an attempt to get a handout.

We are being asked to rely on a few assumptions here that we shouldn’t. Proponents of the bailout emphasize that the purchases of these securities will be at very low, bargain-bin, “huge discount” prices and so (they claim) it’s very possible that the government will be able to sell them for a profit after they’ve been properly valued.

The problem with this is that the point of buying these securities is to keep the financial services institutions from crumbling. This means the price is not going to be set according to a low-ball evaluation of the security. Rather, it’s going to be whatever each financial services institution claims it needs to keep itself in business. Given how much the value of these securities was overestimated in the first place (in other words, how much the banks need to make up in order to keep from collapsing), that price is going to be much too high to realize an extraordinary profit…if it makes a profit at all.

More than that, I’m skeptical of the claim that the financial institutions have absolutely no idea of the value of these securities. They may not be able to pin a price to them, but they’ve probably got some idea which ones are in better shape and which ones are the lowest of the low. Guess which ones are going to get sold to the government first.

We’re also assuming that the act of evaluating the securities and auctioning them will be fairly inexpensive. But if that were true, it would already have been done and the government would never have needed to get involved. TANSTAAFL.

Some argue that we need to keep these financial institutions in good shape or there will be a “credit meltdown” or “credit crash.” I don’t think that’s the case. This comes from a misunderstanding of just where credit comes from. It doesn’t, doesn’t, doesn’t come from financial institutions (well, okay, it does sometimes, but not exclusively or even predominantly; I overdid the hyperbole).

A bank-lender is just a middleman. He’s taking someone else’s money and letting you borrow it so as to make some profit on the interest (presumably, you’re going to do something productive with it or be able to pay it off even if you don’t). And, of course, the bank skims a little off the top. If the bank goes out of business, the person offering it for loans is still there. All that has happened is the person who wants to lend it and the person who wants to borrow it need to find another middleman. In other words, credit is still available so long as the person wants to lend it, no matter what happens to the bank. And he will want to lend it, so long as he believes there are promising investment opportunities.

When you get right down to it, if we’re so worried about credit drying up then the government can simply become a lender to those types of investors who face a credit crunch. Perhaps, say, to the tune of $700 billion dollars? Now that’s an investment where we’ve got a better chance of making a profit. By the way, there isn’t a credit crunch right now. Lending is still on the rise for consumer, industrial, commercial, and real estate loans. People keep saying the credit crisis will appear if we don’t bail out the banks.

Since Congress seems determined to do something just so they can say they did, fending off a credit crisis directly rather than as a derivative effect of bailing out banks who have already shown they do not deserve to be saved is the better choice. This has the added benefit of avoiding the moral hazard in repeatedly bailing out failing industries. And it also keeps Congress from getting itself involved in resolving the mortgage meltdown.

Democrats want to rewrite mortgages so the banks can’t foreclose on delinquent borrowers. Of course, that will put some of the banks in even worse financial shape than they are now, which will necessitate larger bailouts from the government (that is, the taxpayer). The Democrats also want to extend the new agency’s authority to purchase beyond just mortgaged-backed securities to any financial instrument which affects market stability. In other words, all of them.

This is a disaster waiting to happen. The best course of action for Congress is to do nothing and let the situation resolve itself. In short order we will have new market champions. If it absolutely has to do something, it can announce new lending programs to fend off a credit crunch (though this puts more pressure on private financial institutions and shouldn’t really be done unless the credit crunch materializes).

But the wrong thing to do right now is take a wild-ass guess at an investment scheme that has already proven to be a failure while simultaneously giving the people who created the problem a do-over. That’s not a good idea. And the absolute worst idea is letting the Democrats create a new federal agency which has long-term, intimate control of the financial services industry.

Whatever Congress does we are going to be stuck with the result for some time to come. The bailout proposals are not short-term fixes. Whatever agency or department is borne out of this, our children will know (and curse) its name. We owe it to ourselves and to them to not rush this decision.

~ by Gabriel Malor on September 25, 2008.

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