Things I am passionate about. Injustice, stupidity, intolerance, bigotry and small-mindedness. Oh and there might just be some humor to offset the whole thing.


Posted by morganwrites on October 3, 2008

Suppose a group of astrophysicists sat you down and told you a giant asteroid was headed toward Earth. You’d be unable to verify what they were telling you, unless you were an astrophysicist too. But you’d probably feel irresponsible if you didn’t support dramatic action to avert disaster.

Something like this scenario is playing out in Washington, where Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson have informed Congress that an asteroid is about to crash into the U.S. economy, precipitating a long economic slump. The danger now is that the rocket scientists in Congress will design a solution that’s worse than the problem.

Paulson has put before Congress a plan to avoid catastrophe by restoring function to the nation’s stricken credit markets. He is seeking $700 billion and the authority to buy bad assets from struggling firms before they take the economy down with them. He reasons that once these firms have clean balance sheets, they can resume the borrowing and lending activities that keep the economy going.

The plan is a bailout pure and simple. But as we have stated before, viable options for taxpayers currently range from bad to worse. Here are the other alternatives:

1. Do nothing: If Congress does nothing, it is clear that the Fed and the Treasury Department will continue to use their existing authority to bail out firms on an ad hoc basis, resulting in a wide variety of arrangements at a high cost to taxpayers. First, the Fed facilitated the sale of Bear Stearns to JPMorgan Chase by guaranteeing $29 billion of its assets. Then, Treasury nationalized Fannie Mae and Freddie Mac, putting several hundred billion more at risk. And last week, the Fed effectively bought insurance giant American International Group (AIG) at a cost of $85 billion. The feds may only succeed in spending lots of money, while still not avoiding the financial calamity they fear.

2. Suspend “mark to market” accounting rules: Under current accounting rules, a firm’s assets must be “marked to market,” or valued at the going price, which for mortgage-backed securities is often pennies on the dollar. As the housing bubble burst, a few fire sales set prices for the market, and firms that owned lots of these securities were forced to write down billions in losses, eroding their capital base and making it harder to meet their short-term borrowing needs. But most people are still paying their mortgages, which means that mark-to-market accounting may fail to capture the real value of these assets. If the Securities and Exchange Commission temporarily suspended mark-to-market rules — just for mortgage-backed assets — firms could hold them to maturity (or until the market settles) without having to take crippling write-downs in the process. But this could be too little, too late, in which case we’re back to Option 1.

3. Buy equity in struggling firms: Senate Banking Committee chairman Chris Dodd has proposed an alternative to Paulson’s plan that would essentially nationalize the U.S. banking system. Under Dodd’s plan, companies selling assets to the government would also have to give up an equity share, agree to limited executive compensation and submit to whatever other conditions Dodd can think up between now and when the bill reaches the floor. This is the same approach the Fed took with AIG. The Treasury Department has rejected this approach because it would discourage firms from selling bad assets until they were on the brink of failure, thus prolonging the current period of uncertainty and crisis.

Option 1 clearly isn’t working. At the rate things are going, the price tag of future ad hoc bailouts could reach well north of $700 billion, and the government could end up owning half the nation’s financial firms without stabilizing the market.

Option 2 would be a good idea regardless of what Congress does, and SEC chairman Chris Cox should show a little responsiveness to the crisis by abandoning his misguided war on short-sellers and temporarily suspending mark-to-market rules for mortgage-backed securities. But that alone might not be enough.

Option 3, Dodd’s plan, has punitive features that would discourage firms from taking advantage of the Treasury facility until they are about to fail. Perhaps that is a desirable end, but let’s call it what it is: a grander version of Option 1.

The Paulson plan itself has drawbacks, besides the enormous cost. First, it puts the government in the position of trying to assign the correct value to a set of esoteric financial products that Wall Street itself doesn’t know how to price. There’s some risk that if Treasury pays too little for these assets, it could weaken the banks and exacerbate the crisis; if it pays too much, the taxpayers lose. Second, it vests in the Treasury Secretary tremendous power with virtually no oversight. Conservatives are rightly wary of how Paulson would use this power, and their fears are compounded by the knowledge that, come January, that power could be in the hands of a Democratic Treasury Secretary with an unknowable agenda.

Paulson and Bernanke are testifying before Congress today. We are eager to hear how they address these concerns, and others. Any plan that shields irresponsible actors from the full consequences of their decisions creates moral hazard, encouraging riskier behavior in the future. But that asteroid could indeed be hurtling toward us, making even a highly unpalatable option necessary. We know the Paulson plan is unpalatable, but it also might be necessary.


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