The Bailout’s Essential Brazenness

By Jay Cochran
This article appeared on on October 1, 2008

One of the more galling arguments put forth in support of the Treasury’s $700 billion bailout, is the suggestion that the government might actually profit from being a hold-tomaturity investor in the illiquid mortgage instruments currently clogging the arteries of high finance. Laying aside the thorny issue of whether the Treasury Secretary and his overseers have the means to discover the correct price for securities that the market itself cannot price (hence the illiquidity), it is breathtakingly brazen that the supporters of this scheme think it somehow proper for the government to earn even one basis point of net return from a problem that is of its own making.

Congress and the executive branch, established the rules and institutions that all but guaranteed the outcome we taxpayers see unfolding and are being asked to pay for today. Government leaders had multiple opportunities to correct problems identified years before, but instead dithered and calculated. To suggest now-in malice, greed, or fear-that it is somehow proper for government to make a net return on the assets it purchases, is as unjust as allowing a referee to make money gambling on the outcome of a game he oversees.

To be clear, this is not an argument for or against the bailout per se. Moreover, in principle, I am not opposed to taxpayers reaping profits from any bailout they finance, provided those benefits can be proportionately distributed back to the taxpayers who funded them in the first place. The more likely outcome, however, seems to be that taxpayers will fund the bailout, while the profits (if there are any) flow to politically connected groups (such as ACORN, in the draft language of the bill for example), or stay in the government to fund future programs. In short, the taxpayers foot the bill, while the government, one of the principal enablers of the current mess, grows.

Consider the following (incomplete) list of government failures that enabled and set in motion the mess we see unfolding today:

Increased Leverage for Investment Banks. In 2004, the SEC acceded to requests from a variety of investment banks to raise their maximum permissible leverage from 12 times capital (already higher than that employed by most commercial banks), to 30 times capital. Leverage, as any decent student of finance knows, is a 2-edged sword. Yes, it magnifies returns to the upside, but it also cuts equally sharply on the down stroke. A 12 times levered firm might have survived recent adverse events, but its 30 times levered incarnation never had a chance.

Promiscuous Rate Cutting as the panacea for every financial ailment. Whether in response to the Russian crisis, the failure of LTCM, the disastrous potential of Y2K, or to mitigate the fallout from the collapse, the Fed’s typical response is first, last, and always to cut rates. After all, if your only tool is a hammer…

The current chairman has added a few new tools to his kit bag and dusted off old reliable, Discount Window lending, but the net result is still the same: provide copious amounts of money and credit on easy terms. (Never mind that in doing so the Fed’s own data indicate total US indebtedness has grown at an 8.6% annual clip since 1995, or nearly three times faster than real GDP-that is, nearly three times faster than our ability to repay.) Once the crisis passes, then the response is to tighten rates, hope that a new disaster does not occur, but if it does, be prepared to lower rates again. It’s like being driven around by a drunk who can’t decide whether to drive fast or slow, so he averages it out by alternating erratically between both extremes, all the while making his passengers sick.

NRSROs, or Nationally Recognized Statistical Rating Organizations. Early in the 1970s, the SEC, with the creation of the NRSRO designation, essentially awarded a duopoly franchise to S&P and Moody’s (with Fitch to be added later). In those sleepy days, a grade for credit quality that took weeks to compute and assign was not as problematic as it is in today’s larger, more diverse, and fast moving credit markets. Being shielded from competition by government fiat, however, the credit rating oligopoly had little incentive to upgrade their ratings practices. Not surprisingly, today’s downgrades always seem to occur today well after the credit horse is out of the barn.

Consider also the inherent conflicts of interest that permeated the ratings process for various tranches of collateralized debt obligations (CDOs, or securities derived from a collection of credit obligations or loans). The ability to conjure AAA-rated securities out of pure credit junk was truly remarkable, and could only be accomplished with the acquiescence of a pliant ratings organization carrying the imprimatur of government approval (not to mention the desire of the ratings agencies to win other business from the rated client). The sleepy ratings agencies were played by the CDO sausage makers like rubes fresh off the turnip truck.

Government Sponsored Enterprises (GSEs). These gargantuan enterprises, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, were originally designed to be conduits between mortgage originators and mortgage investors. That conduit function created a secondary market in mortgages, which made mortgages more liquid thereby enhancing banks’ willingness to make long-term mortgages. Not content with the relatively low returns such a business model generated, the GSEs instead used more than 20 times leverage and held trillions of dollars of mortgages in portfolio rather than selling them to investors. In so doing, they magnified their own returns during good times all while concentrating risks in one place in the economy.

Congress granted the GSEs special privileges worth billions and then allowed them to trade on their privileged positions in return for about 50 basis points (half of one percent) of savings on a 30 year fixed rate mortgage versus what rates would have been without the GSEs. (For more details on GSE costs, benefits, and their histories, see a study Catherine England and I wrote in 2002, “Neither Fish nor Fowl: An Overview of the Big Three Mortgage GSEs.” That study also contains bibliographical references to related studies and data.) The rest of the monetary value of the GSEs’ privileges apparently was absorbed in the pocket linings of their executives and shareholders, and in a variety of political risk management activities.

No policymaker can credibly claim they did not know the GSEs would end badly. The GSEs remain the true epicenter of the housing bubble and of its currently unfolding collapse. I for one (not alone, but in concert with many others), warned repeatedly in Congressional testimony, commentary, and studies, that a massive taxpayer bailout stood at the end of this quasi-private quasi-public road. Here’s what I wrote, for example, nearly five years ago to the day in Regulation magazine:

“…incentives exist for [the GSEs] to concentrate risks in order to increase returns available to their shareholders. So long as risks and returns follow expected patterns, all is well. Should the day ever come, however, when expected probability distributions [for risk] do not match reality or when GSE hedging operations do not work as anticipated, then the costs of any resulting bailout are likely to be passed along to the long-suffering American taxpayer.”

Sadly, the taxpayers’ day of reckoning arrived a couple of weeks ago.

The preceding list is only a taste of government failures in banking and finance. One could also add obtuse capital standards imported from Europe, highly pro-cyclical markto- market rules, hastily crafted and ham-fisted disclosure requirements of Sarbanes-Oxley, and even the fragmentary and poorly integrated nature of US commercial banking itself nearly 15 years after interstate banking was finally enacted. (Incidentally, the enactment of interstate banking occurred only after decades of Congressional dithering made previous problems created by interstate banking restrictions too obvious even for Congress to ignore).

Ironically, the same group of people who are willing to let government profit from the errors of its own making have the effrontery now to suggest that more stringent government regulation is needed to be sure a similar crisis does not happen again. Does anyone seriously believe that the same group of people who got us into this mess have the incentives and intellectual wherewithal to design a set of rules that will keep it from happening again? If memory serves, we heard this exact same promise in the 1990s in response to our last banking crisis. How much more evidence is required for people to understand that government is not the solution it’s the problem?

Dr. Cochran is an Adjunct Professor of Economics at George Mason University.