Worse Than a Bailout — A Blunder

October 20, 2008 • Commentary
This article appeared in National Review on October 20, 2008.

There are winners and losers every time the government sticks its clumsy fist into financial markets. But we can’t discover who has been helped and who has been hurt by using the word “bailout” indiscriminately.

For shareholders of Bear Stearns, Fannie Mae/​Freddie Mac, and AIG, surprise raids by Treasury secretary Hank Paulson and Fed chairman Ben Bernanke were a wipeout, not a bailout. Driving those share prices down to a few dollars (AIG) or a few cents (most others) did not restore confidence among investors who still held other financial stocks. On the contrary, it made them stampede for the exits.

Financial‐​stock prices fell dramatically as soon as it became known than the loan to AIG, carrying an 11.3 percent interest rate, would be tied to government expropriation of 80 percent of equity.

Collapsing share prices for financial firms that seemed vulnerable to that sort of government “help” meant that ratios of debt to equity became much worse. The firms had no additional debt, but much less equity. Such Treasury‐​led debasement of equity value, in turn, led regulators to boost affected firms’ capital requirements; but the exodus of investors from financial stocks often provoked downgraded credit ratings, making it impossible to sell shares or bonds to bolster capital.

In short, these previous “bailouts” exacerbated, or even caused, the problems they were supposed to solve. By late September, the problem of overleveraged investment banks had been resolved by destroying Wall Street. The five big investment banks previously known as “Wall Street” were either absorbed or transformed into commercial banks, with the surviving four raising $9 billion to $11 billion each in additional capital. Allowing Lehman to go bankrupt rather than facilitating its sale had the nasty side effect of provoking a mini‐​run on money‐​market funds, one of which had a paper loss of 3 cents on the dollar. But that anxiety was addressed with temporary insurance. So the biggest holes in the financial dike were already plugged by Sept. 29, when the House turned down the Emergency Economic Stabilization Act (EESA), a politically perverted version of Paulson’s plan to buy up to $700 billion of mortgage‐​backed securities.

Some of the most destructive legislation in history has been enacted in hasty response to economic problems, often with tremendous popular support. The infamous Smoot‐​Hawley tariff in 1930 comes to mind, as does Nixon’s wageprice freeze in 1971.

The Paulson proposal is not in that league, and might even prove helpful if purged of some dangerous congressional add‐​ons. But when so many interested parties are invoking the Great Depression to persuade Congress to move quickly, skepticism and prudence are called for. Stories about a proposed $700 billion taxpayer “bailout” for the Wall Street fat cats who got us into this mess made folks angry — so angry that EESA failed to pass the House, with half the progressive Democrats and three‐​fourths of conservative Republicans voting against it.

In truth, the story of a $700 billion bailout was a fraud. EESA was never a $700 billion expenditure, nor anything remotely close to it. The only way EESA could cost taxpayers $700 billion would be if the value of all the real estate behind mortgage‐​backed securities were to fall to zero. As for the “bailout” label, it is too late to bail out the investment banks we once knew as “Wall Street” — they no longer exist. It is also too late to bail out the executives of these failed institutions, including the bosses at insurance giant AIG, because those executives have all been fired and their accumulated stock and options have turned to trash. Obama’s ad denouncing golden parachutes is a sideshow.

The core idea of the Paulson plan was that the Treasury could offer to buy mortgagebacked securities at a deep discount. There is a plausible statistical argument that the securities the government bought would likely be sold at a tidy profit and earn income in the meantime. That issue is probably moot, however, because the “taxpayer protections” Congress added to the bill would make it necessary for bank executives to impoverish both their stockholders and themselves before dealing with the Treasury. Only companies in dire straits could be expected to participate, thus thwarting the intent of the program — which is to make it easier for thousands of fundamentally sound banks to lend.

The best thing that can be said for an unadulterated Paulson buyout plan is that it is less frightening than Paulson’s previous ad hoc wipeouts. In fact, the buyout is something we’ve done before. When the government nationalized Fannie Mae and Freddie Mac, they were doing exactly the same thing — using low‐​interest Treasury debt to buy up hundreds of billions of dollars’ worth of mortgage‐​backed debt. Yet many who had no objection to the buyout of Fannie and Freddie became surprisingly upset about the latest Paulson version. Some of the biggest problems with EESA came from congressional additions. The horse‐​trading became downright silly at times, with Democrats wanting to tack on $60 billion for pork and Republicans wanting to cut the capital‐​gains tax.

Although $300 billion had already been approved to help homeowners, Democrats wanted more loot for that purpose, too. They also wanted to invite bankruptcy judges to shrink the size of troubled mortgages, which would obviously reduce the value of the securities the plan calls for taxpayers to purchase.

What survived in the bill was no more sensible. For their part, Republicans insisted on the alternative of offering feebased insurance for such securities, as if that posed little risk; they must have forgotten the cost of insuring savings‐​and‐ loan depositors in the 1980s. Such insurance could not be actuarially sound unless fees varied with risk. Otherwise, the mandatory fee would become a tax on the safest securities to subsidize the riskiest.

Unfortunately, there is not enough history or market data to determine what the appropriate risk‐​adjusted fee should be for all these illiquid and diverse bonds. If the fees end up too high, the program must weaken the securities it was supposed to help; too low and taxpayers would be at grave risk of making up the losses. Each side had bad ideas; when they agreed, it was worse. Both parties agreed that taxpayers should get something in return from companies that become profitable and see their share prices go up. Taxpayers would get something, of course — namely, 35 percent of any improvement in corporate profits, 35 percent of any executive pay gains, and 15 percent of capital gains.

EESA demanded much more “a warrant giving the right to the Secretary [of the Treasury] to receive non‐​voting common stock or preferred stock in such financial institution,” with the exercise price “set by the Secretary, in the interest of the taxpayers.” Some legislators pointed approvingly to the precedent of warrants in the AIG deal, without realizing that this is precisely what scared the pants off the stock market and thereby destroyed hundreds of billions of dollars’ worth of private‐​equity capital throughout the financial sector.

Conservative legislators who expressed fear about letting the Treasury buy mortgage‐​backed bonds were strangely enthusiastic about inviting the Treasury to acquire equity in companies. Critics of derivatives became enthusiasts for warrants, which are themselves derivatives, similar to long‐​term call options. They would give the Treasury secretary virtually unlimited power to confiscate the wealth of stockholders of any company foolhardy enough to play this game.

Ironically, the warrants would make it more expensive for the Treasury to buy mortgage‐​backed securities, and therefore make it less likely for those securities to be resold at a profit to taxpayers. As Congressional Budget Office chairman Peter Orszag explained: “Since the warrants or debt instruments would have value, Treasury would generally face higher prices because sellers would seek compensation for both the value of the troubled asset and the value of the warrant or debt instrument.”

Public ownership of mortgage‐​backed bonds is merely an investment — a good or bad investment depending on prices when the bonds are bought and sold. Public ownership of equity is socialism. Once such a precedent is set (as it already has been, to some extent), it becomes difficult to have publicly traded banks in the United States, since shares in such companies would have to bear a formidable premium to compensate for the risk that some future Congress would once again rip off common‐​stock investors by taking preferred shares. The Emergency Economic Stabilization Act as presented on Sept. 29 was seriously flawed — not because public investment in mortgage‐​backed bonds is necessarily awful, but because expanding public investment in bank equity would be a dangerous precedent.

Alternatives to the bill are not promising. Increasing the size of deposits insured by the FDIC would be a useful Band‐​Aid, but it doesn’t get to the root of problems with the frozen market for mortgage‐​backed securities, and the FDIC does not have unlimited funds. Alarmist rhetoric and dubious policy advice often come from people who are not disinterested. Warren Buffett is wise and likable, but Berkshire Hathaway has huge investments in insurance and banking.

Famed bond trader Bill Gross, managing director of PIMCO, has strong opinions but may also have weak assets in some of his bond funds. In a Wall Street Journal op‐​ed, hedge‐​fund manager John Paulson advocated having the Treasury buy equity rather than bonds, a move that would deeply devalue bank stocks and keep the market for mortgage‐​backed bonds illiquid and depressed. John Paulson has made billions shorting such assets.

The better approach is to enact the original Hank Paulson plan, with ample oversight, but strip out Congress’s too‐​clever additions. That would probably be more prudent than just standing aside, and surely better than reverting to the ad hoc wipeout policies that helped get us into this fix. Those claiming the alternative to EESA is another Great Depression or a ten‐​year stagnation like the one suffered by Japan are simply revealing their excitability and ignorance. People who abuse such historical analogies need to study economic history with much greater care.

About the Author