We might live in the postindustrial era, but economic booms and busts have not disappeared. Unfortunately, these days the taxpayers seem to get stuck with the losses.
The current crisis results from expanded mortgage lending, much of it financed by subprime loans secured through “collateralized debt obligations” (CDOs) by private investors and the government-sponsored enterprises Fannie Mae and Freddie Mac. The federal government spurred lending at every turn: Banks had been targeted for “red-lining”—not lending in poor neighborhoods. Fannie Mae/Freddie Mac subsidized ever more mortgage lending. The Federal Reserve’s expansive monetary policy artificially inflated property and commodity values.
Rising housing prices caused borrowers, lenders, and investors to treat subprime loans as a no-lose proposition. Even if a borrower got into trouble, the home could be sold for a profit, making everyone whole.
Eventually, the housing market slowed, causing the entire “don’t worry, be happy” mortgage-based system to collapse. Prices fell, foreclosures rose, mortgage repayments dropped, and the value of mortgage-backed securities collapsed. This set off an ever-worsening financial cycle, taking down homeowners, brokers, mortgage firms, commercial banks, and investment banks.
To date, total subprime losses and write-downs are about $500 billion. We may have another $500 billion worth to go.
Government policies accelerated the downward spiral. Fair Value Accounting and “mark to market” rules, endorsed by government regulatory agencies, force asset write-downs based on current sales. In unsettled markets where values are uncertain, the rule poisons corporate balance sheets by treating long-term, cash-producing assets as essentially valueless.
At the same time, the prospect of a government bailout discouraged private action. Why act when the government might cover the loss? Moreover, the Bear Stearns, Fannie/Freddie, and AIG bailouts sacrificed shareholders to bondholders. That made it harder for firms such as Lehman to raise additional capital, since potential investors feared they would be the first ones tossed overboard if the enterprise failed.
So far Washington has provided $300 billion to refinance failed mortgages, $200 billion in bank loans through the Federal Reserve’s Term Auction Facility, $200 billion to purchase Fannie Mae/Freddie Mac stock, $87 billion in loans for JPMorgan Chase to finance Lehman trades, $85 billion for AIG, and $29 billion to finance JPMorgan Chase’s purchase of Bear Stearns.
There is more: Federal Reserve cash infusions to the financial markets; Treasury Department plans to purchase mortgage-backed securities directly; Treasury setting aside $50 billion to guarantee money-market funds. The government’s takeover of Fannie/Freddie put the taxpayers on the hook for a multitude of bad mortgages.
In mid-September the Bush administration proposed the mother of all bailouts: buying up $700 billion in bad mortgages and other assets. The presidential candidates and congressional leaders all voiced their general assent. Their only disagreement was whether everyone else, such as Main Street and “working families,” should be bailed out too.
There is an argument for the Federal Reserve to help maintain liquidity for creditworthy financial institutions facing a temporary cash crunch. But the presumption should be against bailouts. Where the entities are quasigovernmental, such as Fannie/Freddie, the government may have fewer choices. Even then, however, any support should be combined with full privatization, with no more political interference, lower-interest loans, or implicit guarantees.
Ultimately, the bad mortgage assets that underlay the financial crisis must be liquidated. But government purchases merely shift the pain from foolish businesses and individuals to innocent taxpayers. The Paulson plan would enshrine loss-free capitalism, creating incentives for even worse corporate misbehavior and larger bailouts in the future.
Better, not more, regulation is necessary. The financial markets already answer to the Sarbanes-Oxley Act, Federal Deposit Insurance Corporation, Securities and Exchange Commission, Office of the Comptroller of the Currency, Federal Reserve, state authorities, and international standards. The deregulation of the 1990’s helped spur a lengthy period of strong economic growth. In contrast, no institutions were managed more directly by government than Fannie/Freddie, with disastrous results.
Streamlining rules and agencies and emphasizing transparency makes sense. The lack of transparency, and failure to understand how highly leveraged market participants had become through subprime CDOs, was a major cause of our present difficulties. Unfortunately, we can’t trust those who have presided over the current mess—and who have given us a $9.5 trillion national debt and $100 trillion in unfunded liabilities for Social Security and Medicare—to fix the financial system.
The best antidote to the financial crisis is a stronger, growing economy. That requires growth-oriented policies and federal fiscal responsibility. Imposing counterproductive regulation and enacting wasteful bailouts would undermine the overall economy.
Financial adjustment is inevitable. Government cannot save us from paying the cost of past mistakes. The long-term solution requires America to start living within her means.
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