September 17, 2008 • Commentary
By Jagadeesh Gokhale and Kent Smetters
This article appeared in Forbes​.com on September 17, 2008

Bear Stearns–OK; Fan and Fred–OK; Lehman–No; AIG–OK. Can anyone fathom what the message is here?

About $1 trillion of taxpayer funds are committed to rescuing financial firms that made bad decisions. The officials at the Fed may claim that the government’s getting control of valuable assets and that all will be fine when markets calm down. Can we be sure?

The private sector is unwilling to purchase those same assets. The lack of transparency about asset quality involving immensely complicated derivative structures has even financial experts perplexed. Why do we think that the Fed would do a better job?

To be sure, the Fed and Treasury might only be performing their function of lenders of last resort. When financial firms cannot sustain their values, the government must step in. Otherwise, credit to good production enterprises–main street firms–may dry up and the economy will tank. But it still raises fundamental questions about the government’s role in markets, contingent fiscal exposures and moving targets.

Unfortunately, there’s no guarantee about when the private demand for mortgage‐​backed assets enmeshed in complicated derivative contracts will recover, because there’s no transparency about their value. Nobody–not the credit rating agencies, private CFOs or government financial experts–has any way of sorting out relatively soon what these contracts contain in terms of the reliability of underlying financial flows.

All of this will take time to sort out, so the “orderly resolution” of these financial instruments–value discovery and placement with proper institutions that can tolerate the risks–will take many months. And here’s the bottom line–the problem is likely to become worse in the meantime and the Fed and Treasury have no mechanism to call for a “time out.” The hope here seems to be that merely the passage of time is needed for markets to settle down.

So far, however, the evidence suggests that investors are becoming more, not less, fearful about whether the value of their positions is sustainable and are seeking to unload their holdings of questionable assets.

Continued government intrusion right now creates a precedent for additional bailouts, but with no formal apparatus for containing the risk or for charging risk‐​adjusted premiums beforehand to those entities who are creating most of the risk. Instead, the government’s simple afterthought litmus test is simply whether an entity is too big to fail.

Taxpayers, as a result, are on the hook for about $1 trillion already–an amount that is likely to grow larger if other large financial firms get into trouble. Americans already face enormous challenges in unfunded promises to pay Social Security, Medicare and Medicaid benefits–amounting to many scores of trillions according to official estimates. The nation’s Pension Benefit Guarantee Corp. also faces massive projected shortfalls. The subprime, entitlement and PBGC is a troika disaster that will soon unravel unless action is taken now.

Committing taxpayer funds for bailing out financial firms time and again threatens to use up the black powder that we will need in the future. Moreover, bailouts of such magnitude carry the wrong message to investors and financial firms–that they could continue unbridled expansion into risky ventures without fear of suffering losses–because the government won’t have the nerve to stand pat.

About the Authors
Jagadeesh Gokhale is a senior fellow at the Cato Institute. Kent Smetters is an associate professor at Wharton.