A $700-Billion-Dollar “TARP” Won’t Cover Over Economic Realities

I’ve posted a copy of the proposed bailout legislation online in html format, which is easier to read, copy, and paste. Considering its size and significance, I urge you to review it and share it with others.

We have several experts on the bailout at Cato, and our media producer Caleb Brown has ably drawn them out. Give a listen to his podcasts with Bill Niskanen, Jagadeesh Gokhale, Jim Dorn, Arnold Kling, Gerald P. O’Driscoll, and John Samples. [all mp3 format]

There are a couple of elements of the legislation where I might add some insight, so here goes.

Congressional Oversight? Nope. $700 Billion Spent

The bill made available Sunday devotes a good deal of verbiage to oversight of the proposed $700 billion bailout. But it doesn’t do anything to prevent that money being spent.

The major impediment to blowing through all the money is in Section 115, entitled “Graduated Authorization to Purchase.” It would immediately grant the Treasury Secretary authority to spend $250 billion. At any time, the President could send a certification to Congress and the spending authority would rise $100 billion more. After that certification, the President would have only to submit a plan to spend yet more and the Secretary’s authority would rise to the full $700 billion.

Only if Congress introduced and passed legislation to stop further spending would it be capped at $350 billion. Congress would almost certainly not pass such legislation, and even if it did the President could veto it, requiring an impossible-to-reach supermajority in both houses to stop the spending.

Passage of the “Emergency Economic Stabilization Act of 2008” would cause $700 billion to be spent - gone - just like earlier proposals. There is no effective limit on spending in this bill.

Yes, there are a number of oversight mechanisms, and no grant of unreviewable discretion as appeared in a ham-handed earlier proposal. These improvements are all about how the barn door will be closed once the $700 billion is gone.

Covering Over Economic Reality With a “TARP”?

The central feature of the bill is the creation of “TARP,” the “Troubled Asset Relief Program,” in Section 101. The TARP would exist to “purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary … .”

We know that mostly these are going to be mortgage-backed securities of the type issued by Fannie Mae and Freddie Mac. Fran and Fred issued these - and financial institutions bought them - with abandon because of the implicit (and now realized) government backing Fannie and Freddie enjoyed.

Currently, these securities have no value - “worthless paper,” everyone says. This is not because they are valueless, but because there is enough uncertainty about their value that nobody knows how to price them, so nobody is currently buying.

The idea behind the bailout plan, it seems, is to remake a market for this paper by having the federal government buy it. But it won’t work. And here’s why.

(N.B., I’m a lawyer and strictly an amateur with economics. There are weaknesses and disanalogies in what you’re about to read, but this is the best non-economic “Man on the Clapham Omnibus” explanation I’ve been able to assemble so far.)

Imagine there was a burgeoning trade in beach sand. Because of all the profits others had made on buying and selling beach sand, people came in to the beach sand market and bid up the price, hoping to get their cut of the money to be made.

Then one day, someone pointed out to all the beach sand traders that there’s beach sand all over the place at the beach. There’s so much beach sand that it can’t possibly be worth what people are paying.

Immediately, the market for beach sand would stop functioning, as everyone who held beach sand would not be able to find someone who would buy it at a price they could accept.

What’s the solution to this problem? A downward repricing of beach sand.

There is no alternative but for the market to reform around lower-priced beach sand.

Now, what if the government came in and bought $700 billion dollars worth of beach sand? Current holders of beach sand would get a tremendous windfall, and the government would get a lot of beach sand, but the market for beach sand would not be restored. It would only return when beach sand was again priced at a value that people believed was right. Taxpayers would be out $700 billion and the market for beach sand would be no stronger than before.

Now, there are disanalogies between what I’ve said and the proposed financial services bailout. Unlike beach sand, which is essentially infinite and thus very cheap, mortgage-backed securities actually do have some value. The market just has to discover what it is.

There are good buys right now, and some of the financial services firms that over-committed to mortgage-backed securities and other precarious financial instruments are good buys for smarter players too. These securities and the companies that held them need to be repriced, and there’s nothing the government can do to change that - or control their prices.

Another weakness in my story is that it omits the other roles that beach sand-traders might have. The financial services firms that got hung up on mortgage-backed securities do lots of other lending that lubricates our economy, and they might have a rough time doing it now. Say beach-sand traders are also integral to the glass industry - we’re looking at glass shortages because of the collapse in the sand market. But we had better face that reality rather than trying to avoid it with bigger, more audacious manipulations of economic value than we saw in Fannie Mae and Freddie Mac.

Government attempts to support the prices of mortgage-backed securities, of the housing stock, or of our country’s financial services firms will almost certainly end in disaster.

There is no putting a “TARP” over these economic realities, and there is nothing better we can do than to get on with letting the losers lose. No bailout.

Only When Necessary

In his speech on the financial crisis, President Bush remarked:

Our system of free enterprise rests on the conviction that the federal government should interfere in the marketplace only when necessary.

Hmm.  I wonder what happens if I substitute other words for “free enterprise” and “in the marketplace.”

Our system of free speech rests on the conviction that the federal government should interfere in the marketplace of ideas only when necessary.

Eeew.  I don’t like the sound of that.  But I guess it’s consistent with the Bush administration’s policy of paying columnists for sympathetic opeds.  Let’s venture on.

Our system of a free press rests on the conviction that the federal government should interfere in the media only when necessary.

Well … The New York Times might object … but I guess if George W. Bush says it’s necessary …

Our system of freedom of religion rests on the conviction that the federal government should interfere in your church only when necessary.

Holy smokes.

Our system of freedom from unreasonable search rests on the conviction that the federal government should interfere in your phone calls only when necessary.

It isn’t interfering if they’re just listening in … is it?

Of course, I’m being snarky and completely unfair to the president.  After all, economic freedom – the right to control what you produce – isn’t nearly as important as the rights to think, write, or worship.  (Or so say those who want to control what you produce, without being told what to think, write, or worship.)

Obama’s Free Ride on Fannie Mae

A page one Washington Post headline reports, “Credit Crisis Has Given Obama a Distinct Edge.” Which must be really frustrating for McCain, because McCain did try to reform Fannie Mae and Freddie Mac back in 2006. Obama, meanwhile, as I reported at the American Spectator, received more donations from Fannie Mae in four years than any other senator (except Banking Committee chairman Chris Dodd) received in twenty years. That’s quite an accomplishment–more money from a primary creator of the financial meltdown in just four years than senior members of Congress like Nancy Pelosi, Barney Frank, Richard Shelby, Spencer, Bachus, John Kerry, and Roy Blunt got in entire 20 years that the Center for Responsive Politics tallied. And of course, Obama chose former Fannie Mae CEO James Johnson, who was found to have jiggered the books, to head his search for a vice president.

Shouldn’t somebody in the media ask Obama why he was Fannie Mae’s favorite senator?

The Risk-Free Society Comes into View

Peter Bernstein draws a conclusion from the current problems in the financial markets:

The subprime mortgage mess, the huge leverage throughout the system, the insidious impact of new kinds of derivatives and other financial paper, and, at the roots, the vast underestimation of risk could not have happened in a planned economy.

Oh really? Another story from today’s New York Times reports:

The banking giant JPMorgan Chase, for instance, has 70 regulators from the Federal Reserve and the comptroller’s agency in its offices every day. Those regulators have open access to its books, trading floors and back-office operations. (That’s not to say stronger regulators would prevent losses. Citigroup, which on paper is highly regulated, suffered huge write-downs on risky mortgage securities bets.)

Goldman-Sachs, which was largely unregulated, mostly avoided losses related to the mortgage market through prudent hedging. Citigroup, which was highly regulated, suffered such losses. Expect state control without the promised payoff in a planned economy.

There’s a larger point here that Bernstein neglects completely. A prosperous society requires risk taking. Bernstein is correct: historically a planned economy has prevented such risk taking. Not surprisingly, such societies have not been prosperous, to put it mildly.

More important, they have not been free societies. Preventing the downside of risk requires control over people’s choices. Seventy bureaucrats reviewing your trades. More generally, the best and the brightest continually uttering imperative sentences. Stay away from that cake! Avoid that derivative! Think correct thoughts! The risk-free society will be a society filled with hectored serfs.

Right now, at this moment of hysteria, the political class suffers from availability bias. Like Bernstein, they see only the downside of risk and conclude the necessity of the planned economy. A more complex and nuanced view would see both sides of risk and the enduring value of liberty.

Forestalling the Market

I have been telling reporters there is plenty of private money available for deals.  Witness Bank of America’s purchasing Merrill Lynch; Buffett’s $5 billion investment in Goldman Sachs; and JP Morgan Chase’s purchase of WAMU.  But sellers will now hold out for the expected baillout price from Treasury, and that will price private money out.  A former colleague on Wall Street confirmed my position this afternoon.

Deal or No Deal?

Arnold Kling makes an important observation that “Democrats want to [pass the Paulson-Bernanke bailout proposal] without deliberation, because putting the financial sector under government control is what they want.”

Despite the sturm und drang of the Left blogosphere (not to mention protesters) over the proposal, it is not their Blue Team heroes who are standing against the proposed bailout. Instead, a bloc of limited-government Republicans is providing the only significant congressional impediment to the proposal. Meanwhile, Capitol Hill Democrats are ready to embrace Paulson-Bernanke and the Left punditocracy is miffed that John McCain helped to disrupt the endgame.

Why would a cadre of Republicans side against a plan drawn up by a Republican Treasury secretary and Fed chair, while Democrats favor it? One reason, as Arnold diagnoses, is that the bailout would give Congress justification to intervene (further) in financial markets. That should worry us because earlier congressional mischief deserves much blame for the current financial mess — and portends future mischief and crises.

The meltdown of recently developed products in the financial markets — like the sale of tranches of collateralized debt obligations and derivatives connected with those products, primarily credit-default swaps — are at the heart of the financial crisis. It is important to remember who fueled the market for those products: congressional puppets Freddie Mac and Fannie Mae.

For decades, the federal government (and other levels of government) have pursued the (questionable) goal of ever-higher homeownership rates. However, politicians (correctly, I suspect) believed that the public would oppose a broad, explicit taxpayer subsidy program for homebuyers.  So federal lawmakers encouraged the development of elaborate financial products to provide loans for higher-risk mortgage borrowers — the financial products that have now gone toxic following the collapse of the real estate bubble.

Fannie and Freddie did not issue these higher-risk subprime and “Alt-A” mortgages as part of their traditional operation of purchasing and packaging low-risk “conforming” loans in the secondary market. However, as Charles Calomiris and Peter Wallison explain in their excellent Tuesday WSJ op-ed, Freddie and Fannie became the dominant players in the subprime and Alt-A market, sinking (along with their GSE brethren) more than $1 trillion into the riskier mortgages and growing them from 8 percent of all U.S. mortgage originations in 2003 to more than 20 percent by 2006.

Freddie and Fannie arguably have more government oversight than any other corporations in the United States, with their own federal regulator, regular congressional oversight, and board members appointed by the White House. Yet, all that oversight did not keep the firms from fueling the high-risk mortgage industry; as Chris Edwards notes, their regulator gave them a clean bill of financial health less than a year ago.

Why the forbearance? Because Fannie and Freddie’s government overseers wanted the firms to achieve political goals, despite the risk that posed. Calomiris and Wallison have the money quote from Rep. Barney Frank (D-Mass.), now chair of the House committee that oversees Freddie and Fannie:

“Fannie Mae and Freddie Mac have played a very useful role in helping to make housing more affordable … a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing.”

One can appreciate Frank’s sentiment. He highly values homeownership for low-income Americans, and he believed that allowing Freddie and Fannie to play (heavily) in the subprime and Alt-A markets would bring the American dream to poor people without (directly) burdening American taxpayers. However, these machinations proved too clever by half.

If the Paulson-Bernanke plan gives Congress enduring justification to become more involved in financial markets, can you imagine how much more clever lawmakers will get?

Postscript: Hat tip to Susan Semeleer for sending along this Barney Frank quote from the 2003 effort to increase regulatory oversight of Fannie and Freddie:

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” 

Fannie and Freddie

The IBD has an excellent front page summary of the 1990s roots to the Fannie Mae and Freddie Mac disaster.

One issue IBD touches on is the ineffectiveness of the regulating agency OFHEO. Here is OFHEO giving Fannie and Freddie a clean bill of health just last December.

One reason that having regulatory agencies is worse than having no suchagencies is the false sense of security provided to markets by such apparently off-base seals of approval.