Saturday, September 20, 2008

Treasury's bailout proposal considered

(Updated below, 9/21)
The Paulson bailout plan is Illogical in that it doesn't address the reasons behind this spectacular market failure, or offer taxpayers protection from a similar crisis unfolding in the near future.

First in our coverage, Robert Borosage is dead on in latest editorial his latest Op-Ed for the Huffington Post. He makes several very compelling arguments here, most notably that the flawed logic of using taxpayer money to bail out quasi-public entities without simultaneously putting in place the right kind of incentives to prevent an inevitable relapse puts taxpayers at greater risk.

Referring explicitly to the Treasury Department's massive rescue of Freddie Mac and Fannie May, he makes this point:
These enterprises are operating on our tab now -- completely. Why not just nationalize them, as even that font of economic convention, Sabastian Mallaby suggested yesterday in the Washington Post. Sure, we'd have to add the $5 trillion in debt to the federal balance sheet, but we could add the assets also. And after Paulson's announcement, global investors are already toting up their debts onto the federal balance sheet.

Why pay dividends to shareholders when they are essentially playing with our money? Why pay managers of public enterprises the bloated pay packages of Wall Street speculators? Why allow them to finance lobbyists to shield them from accountability? The fiction of their separate existence has been exploded; let's save the dough and run them efficiently.

(For that ever-reliable stalwart of the free-market Sebastian Mallaby's cited editorial in the Washington Post, see here.)

To roughly paraphrase Borosage, here is essentially what has happened. The Fed, under Helicopter Ben Bernanke, has figured out how to solve the Freddie and Fanny mess. After these two agencies cooked their balance sheets and were laid low by the collapse of the subprime mortgage market last year, it had to be the taxpayers to take responsibility.

Yes, thanks to the Fed, taxpayers like you and me are currently the guarantors not only of the financial institutions that it regulates, but even those entities it doesn't. Says Borosage: "After the bailout of Bear Sterns, they basically are gambling with our money. The Federal Reserve has now traded more than $500 billion in federal bonds for the toxic paper of private banks and investment houses, some $200 billion of it in mortgage backed securities, worth dimes on the dollar. This massive subsidy -- justified as necessary to keep the banking system afloat -- is not accompanied by limits on what gambles the speculators can make, how much debt they can take on, what rewards they can pocket. They are playing with house money -- not exactly an incentive for prudence."

I do think that there is one argument Borosage attempts to make in his article that is markedly weaker than his aforementioned critique. He seems to lay the blame, at least for this situation, squarely on the GOP and what he (accurately) perceives as its culture of shifting financial risk from multibillion dollar financial institutions and heavily rigged "free markets." I think this argument requires a whole other blog post from me, but the deep, structural flaws that have resided for decades within the Neoliberal view of capitalism and global markets is very much a bipartisan one. As just one quick illustration, witness the long-lasting damage done to this country's economy by Clinton Treasury Secretary Robert Rubin.

Likewise, It should go without saying that I find merit in the inevitable response to this critique of Paulson's plan that it's better to do something than nothing - which would result in a catastrophe for the global economy. While this is most certainly correct, it evades the more important point, which is that in between doing nothing and rushing forward with the administration's demanded bailout for the powerful lobbying force of the financial services industry without reflecting on the latter's serious defects (in matters of policy policy and motivation), there are better ideas, including some of the one's offered below.

Next, the New York Times' Gretchen Morgenson reports on the latest outrageous development from Congress, which is now debating whether to create what Treasury chief Paulson is calling the "Troubled Asset Relief Program." This concept, which is clearly a no-winner for taxpayers but a huge boon for the financial services industry, is so creates such conflict of interest from the industry supposedly being regulated that it's breathtaking. She notes, for example than in bailing out insurance giant AIG, the Fed has left taxpayers on the hook to pay off the same wealthy financial players - we don't know which, naturally - that made the risky countertrades (i.e. credit default swaps) that threatened AIG with bankruptcy!

The $85 billion taxpayer loan to AIG was really, she explains, a bailout of the company’s counterparties or trading partners who had purchased mortgage-backed derivative contracts that saw their market value collapse.

And Morgenson recommends the following to economic policymakers and the Federal government that has been ignoring financial regulation for the past eight years: "Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight."

Update: And credit where it's due, Warren Buffett accurately predicted this collapse years ago, and he also correctly fingered one of the chief culprits here: the exploding market of complex financial derivatives. I think this will require its own post as well, but basically over the past decade financiers and credit agencies bundled worthless securities together (called securitization), backed by undesirable and unmarketable assets, slapped on a meaningless credit rating and successfully sold them to pension funds and other institutional investors. The market value for these types of securities has without hyperbole exploded in the last few years, a troubling development given the increasingly interdependent and globalized world economy as well as the purposefully unregulated and unexamined nature of the asset class in question.

I know a thing or two about this field of "alternative investments" because as a financial journalist, I worked to uncover how Moody's and Standard & Poor's (the two major credit rating agencies) dropped the ball in informing their sophisticated investor clientele know how much derivative-embedded bonds launched by US airlines (back via sketchy securitization of either airplanes or airplane leases), insured by monolines like Ambac and MBIA and bought up by other investors. These deals are usually referred to as "structured bonds," or in aircraft finance, EETCs.

Then, in a situation frighteningly similar to what we are now dealing with, in the aftermath of the 2001 recession and the 9/11 terrorist attacks (which used commercial airlines as their tools of destruction) the demand for air travel dropped like a rock. Consequently, these asset-backed securities, which were valued by investors precisely based on the value of the issuing carrier's airline fleet - as opposed to the airline's (usually below investment-grade) corporate credit rating, lost a lot of their value and left the investors to fight over the crumbs in bankruptcy court.

Update #2: Upon further investigation, I see that the Brookings Institution's resident expert Douglas Elmendorf also agrees with Borosage and Mallaby; arguing that government would be much better advised to just nationalize these troubled institutions themselves, as opposed to just sliding their bad assets over to workers' personal balance sheet.

Here's the important distinction to keep in mind: The latter will definitely make future generations even more financially burdened, adding to our already existing budget and trade deficits, after the US is forced to borrow money from our typical sources of credit such as China - just to be able to repay a fraction of this additional debt of trillions of dollars!



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