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Wednesday, September 24, 2008

Pro-bailout: since we failed to stop government from creating this mess, we had better not stop government from cleaning it up

Letting failing businesses fail is almost always the best medicine. Certainly this is the case when market forces are working properly and the market is just separating the productive economic experiments from the unproductive ones.

Letting failures fail is usually the best course even when market forces are not working properly, but have been mucked up by improper government interference. If people let themselves get lured into unproductive circumstances by government-distorted incentives, it can be unfair for them to lose their shirts, when the blame is not all their own, but it is still usually the best thing for the economy, partly because it forces people to see through brain-dead government incentive schemes, but more importantly because the benefits of the bailout (rewarding bad decisions) are not worth the tax burden (which equivalently punishes good decisions).

But these are not normal circumstances. Government so skewed incentives for so long that massive bailout is now necessary to stop massive and propagating financial collapse. What we needed to do was to defeat Dodd and Obama and Kerry and Barney Frank and all the other corrupt Fannie and Freddie enablers at the ballot box and on the legislative votes. Since we lost those battles, and allowed government to create this mess, we had damned well better let government clean it up, notwithstanding the horrendous cost. The alternative--propagating economic collapse--is far worse.

That's the thing about bankruptcy: it propagates. When people can't pay their bills, the people they owe can't pay their bills. Let this occur on a large enough scale and all kinds of otherwise sound enterprises will become part of the tsunami. As lender of last resort, government has the power to keep that from happening, and we MUST keep that from happening.

Just learn the lesson. Stop the Dodds and the Obamas BEFORE they can create such disasters. The American people don't HAVE to elect these a$$holes.

A note on the "bailout" term

Technically, the plan is to buy up the frozen assets. Does the fact that they are "frozen" mean that their market price is kaput, and that the government is paying most of the proposed 700 billion price tag for assets of insignificant value? (i.e. That we are giving it away?)

Normally one would think so, but an element of this crisis is new financial instruments that supposedly separated the safe part of risky assets from the risky part and were thought to be as safe as t-bills, making them appear highly liquid, until the real-estate meltdown started and triggers in the instruments started going off that weren't supposed to go off in any expected circumstance, causing the liquidity to disappear and freezing up the market.

No, I don't understand the details of the instruments involved, and can only give the gist of it from talking to people who do. Maybe they would actually have worked as designed, if they hadn't fundamentally altered the playing field, effectively creating huge expansions of leverage that enabled a boom and bust cycle that they couldn't survive.

The point is that the underlying problem isn't just the value of the assets. It is the legal and contractual structure that has caused them to freeze up. ("Fake banks" is what one friend calls these paper arrangements.) This is a big part of what the buyout is wiping clean, and it means that We the People are not necessarily getting THAT bad a deal on the assets.

Yes the asset prices got inflated, and we should insure that we aren't paying inflated prices for them. (We should be getting deeply discounted prices for them, and I presume we will.) In particular, the people who participated in these deals should lose every penny of profit and equity. We just want them still be able to work: to act as financial intermediaries and pay their corporate bills so that the propagation of bankruptcy can be stemmed. Anything we can do to sharpen that line is good.

What a mess

We had Fannie and Freddie pushing sub-prime loans, "fake banks" packaging them into supposedly safe assets, and everybody looking past the suspicious details because they all assumed that Fannie and Freddie, as quasi-government entities, were never going to be allowed to go into default.

The regulatory failure on the Fannie and Freddie side was allowing government to get involved with the home loan business in the first place, and then distorting the market by giving implicit guarantees to worse and worse loans. The regulatory failure on the financial industry side was not keeping an eye on leverage.

Regulators were trying to analyze the details of these arcane instruments. Instead of just looking at these deals from the inside, they should have looked at the effect: the creation of leverage, which needed to be limited according to historical standards for limiting leverage.

We know from forever that too much leverage tends to power price bubbles that at some point will trigger a deflationary cycle, where prices do not just "pop," but get forcefully driven down as leveraged asset holders have to sell off assets to cover their margins, which forces prices down still further, forcing more selling, etcetera.

Regardless of HOW the leverage is being generated, the one thing we know for certain is that too much leverage creates financial instability. Regulators got caught up in trying to understand the details of these new financial instruments and failed to attend to this most basic of all market fundamentals.

Part of the problem is our patchwork of regulators, assigned to monitor different parts of the financial industry. That can allow innovations, like paper banks, to slip through the cracks. We should have a single financial regulatory agency with oversight responsibility for ALL financial sectors so that this cannot happen again.

Big Lizards has an interesting account of the "frozen assets" problem, and dire warnings about Democrat plans to use the bailout bill to create even greater government participation in (instead of regulation of) financial markets: more socialization; more screwed up mortgages; a much more expensive bill; and even court involvement that could keep the value of the frozen assets up in the air.

Like I said, we don't HAVE to keep electing these a$$holes. THEY are the real problem, and until we get them out of power, we will continue to suffer one mega-disaster after another.

UPDATE: Okay, this is what I was worried about. Some Republicans are apparently trying to assert an anti-bailout principle, causing progress on the bailout bill to break down. The time to assert principles of government non-interference in the market was BEFORE government interference caused this gigantic meltdown. These legislators failed to achieve this principled role of government over decades of Fannie and Freddie corruption. Now when that record of failure has created a situation where government intervention is NEEDED, they are finally going to put their feet down? Insane. Hence the title of this post.

The only description of the alternative plan that is given in the AP story sounds like a joke. Can this be accurate?
Meanwhile a group of House GOP lawmakers circulated an alternative that would put much less focus on a government takeover of failing institutions' sour assets. This proposal would have the government provide insurance to companies that agree to hold frozen assets, rather than have the U.S. purchase the assets.
Thus the frozen assets would remain frozen, and the implicit guarantee of the government to bail out the whole mess when it does explode becomes an explicit guarantee. As things stand now, the government can buy up the frozen assets at fire-sale prices, but under an explicit insurance arrangement, We the People would have to make the investment banks whole. And since these banks are in no position to PAY the actual value of such insurance (hundreds of billions of dollars) the plan can only be to give it to them for some token price.

Anyone who thinks this is a principled position is just an idiot.

A bailout is needed but we must be sure that we do not accept a bailout that is loaded with hidden features. For example:



DEPOSITS.Not less than 20 percent of any profit realized on the sale of each troubled asset purchased under this Act shall be deposited as provided in paragraph (2).

USE OF DEPOSITS.Of the amount referred to in paragraph (1)

65 percent shall be deposited into the Housing Trust Fund established under section 1338 of the Federal Housing Enterprises Regulatory Reform Act of 1992 (12 U.S.C. 4568); and

35 percent shall be deposited into the Capital Magnet Fund established under section 1339 of that Act (12 U.S.C. 4569).

REMAINDER DEPOSITED IN THE TREASURY.All amounts remaining after payments under paragraph (1) shall be paid into the General Fund of the Treasury for reduction of the public debt.
Many are interpreting this to mean funding a slush fund for ACORN, et al.

I inferred from Big Lizard that part of the problem was the forcing of institutions to devest themselves from tainted but performing assets because they had not market value. Why not allow a government formula for these by valuing them based on each prior years income? That and limiting the percent of these vehicles that an institution can hold in the future may limit the fallout.

During the S&L crisis, these same bozos forced the S&Ls to dump all of their junk simultaneously even though 90% of it turned out to be sound.

I am only interested in a bailout if it is free of gimmicks and doesn't make the problem worse as the S&L take overs did.
I agree. It will take a lot of vigilance to make sure that the Paulson-Bernanke plan does not get corrupted by the Democrats. That makes it all the worse that our Republican representatives are off chasing a wild goose. We need them in there fighting for a clean bill.
Thanks for posting this; I'm working on a paper for school and it has been immensely useful.
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