No Randites in Financial Crises

Dean Baker has a nice rant about the disappearance of reliance on "market forces" now that the Princes of Wall Street are staring disaster in the face without government help:

What Happened to "Free-Market" Conservatives (or Neo-liberals)?: With the housing bubble in full meltdown, our political leaders are busily ignoring all the things they have said about the market over the last quarter century and looking to throw all the money that they can find to sustain the bubble. This would be comical, if it weren't so painful.

Remember all the steel workers and autoworkers who lost their jobs due to trade agreements that were supposed to advance economic efficiency over the last quarter century? How about the workers in the airline, trucking, and telecommunications industry who lost jobs due to deregulation, which was also supposed to increase economic efficiency?

Well, it's a new day. Nothing these people (or their economists) said matters anymore. It housing bubble support time!

For years, economic policy was supposed to be guided by market principles. If our autoworkers couldn't compete with their counterparts in Mexico or China, who got paid $1 an hour, then it would be inefficient to have trade protection that would keep them employed here. The same applied to regulations that might keep high paying jobs in key sectors of the economy. Educated people all knew that interfering with the market was harmful to the economy, and if we ever forgot this basic truth, the Washington Post regularly ran sanctimonious editorials to remind us.

Well, it's a new day. The housing bubble is melting down and Congress and the Fed are throwing money everywhere. After all, this isn't about auto workers and truckers, it's about Wall Street banks, and the politicians are pulling out all the stops to come to the rescue. In addition to the money that the Fed is throwing at the banks through subsidized loans at its discount window, it is also granting free insurance to the investment banks -- a gift that is potentially worth hundreds of billions of dollars.

Now Congress is jumping into the act. Remember way back in the fall when they couldn't find $7 billion to expand the State Children's Health Insurance Program? Well, now Congress can finds hundreds of billions of dollars to support a housing bubble. It's a worthy goal. After all, the Wall Street crew might lose their shirts if the housing bubble continues to meltdown.

Congress will not be able to support the housing bubble indefinitely, but they might be able to do it long enough to allow the big boys to cash out and pass more of their bad loans onto the taxpayers and other suckers.

The political support for this bailout package may make it unstoppable, but if it does go through, we should be clear that there are new rules. In the post bailout world, anyone who makes claims about forcing workers or the poor to take pay cuts or do without benefits in the name of economic efficiency is simply a fool or liar.

Anyone who cared about economic efficiency would be yelling at the top of their lungs against this bailout. Anyone who can throw untold hundreds of billions of taxpayer dollars at the rich to save their hides, has no concerns about economic efficiency, they just want to help the rich. In such a world, the rest of us have the right to demand the same sort of handouts from the government. And those who stand in the way are simply lackeys of the rich and powerful, who pretend to care about principles of economics.

Comments

[bigTom]

We keep being told that we are doing this to avoid severe collateral damage. So I guess discussion of the merits of that argument are in order. I was rather amazed to see JP Morgan raise their BS buyout from $2 to $10. Is this an indicator that the government is being too generous with it's bailout? Are we really avoiding serious collateral damage -or just putting it off a little longer at great public expense? What are the guarantees that the taxpayer getting the best possible bang for his buck?

[CN]

We're just now finding out that the free-market-worshipper types are liars and hypocrites?

Some of us could see that all along.

[anon]

Ms. Rand went to a Leningrad State University in Russia per the Ayn Rand internet site.

Too Big to Bail
By Alex Epstein
http://www.aynrand.org/

Excerpt:

For decades our government has had a semi-official policy that large financial institutions are too big to fail--and therefore must be bailed out when they risk insolvency--a policy that creates perverse incentives for them to take on far more risk than they otherwise would. "Too big to fail" is implemented through a network of government bodies that protect financial institutions from the long-term consequences of their decisions at taxpayer expense--a phenomenon we can observe right now.

[...]

However, when the long term loses its meaning, when institutions are told they can never fail, managers are given an incentive to put more capital at risk. If the investments go well in the short term, as subprime investments did for several years, the profit potential is huge. If they eventually fail, the downside is only so bad; the government will "do something" to keep the firms afloat.

[...]

Any doctrine that encourages overly-risky investing, and punishes sound risk-taking is unfair and destructive. We need to phase out "too big to fail" and replace it with a free market in banking, which would reward sound long-term lending and borrowing practices and punish irresponsible ones. Otherwise, the next financial market fiasco is just a matter of time.

[low-tech cyclist]

It's good to see someone besides me using the word 'lackeys' these days.

Because the word's far more applicable now than it was forty years ago.

[ThomasW]

It needed to be said.

And we thank you for it.

[Pickled Shark]

I'm glad at least someone at the fed is thinking this through. Not a stones chance in hell it'd ever go through with vested wall street interests and an ignorant populace. Hell if only GWB allowed us private Social Security accounts so we too could have invested in leveraged MBS derrivatives. I'm sure we would have saved social security by now. LOL. BTW if Lehman is so proud to show off it can raise money from the street whenever it wants to, why are they not willing to name the institution(s) or persons who purchased the convertibles? Is it because it is some off balance sheet entity it controls somewhere in the caymans?

http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/03/31/cnfed131.xml

Fed eyes Nordic-style nationalisation of US banks

By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:13am BST 02/04/2008

The US Federal Reserve is examining the Nordic bank nationalisations of the 1990s as a possible interim solution to the US financial crisis.

The US Federal Reserve
The Fed has been criticised for its rescue of Bear Stearns, which critics say has degenerated into a taxpayer gift to rich bankers

The Fed has been criticised for its rescue of Bear Stearns, which critics say has degenerated into a taxpayer gift to rich bankers.

A senior official at one of the Scandinavian central banks told The Daily Telegraph that Fed strategists had stepped up contacts to learn how Norway, Sweden and Finland managed their traumatic crisis from 1991 to 1993, which brought the region's economy to its knees.

It is understood that Fed vice-chairman Don Kohn remains very concerned by the depth of the US crisis and is eyeing the Nordic approach for contingency options.

Scandinavia's bank rescue proved successful and is now a model for central bankers, unlike Japan's drawn-out response, where ailing banks were propped up in a half-public limbo for years.

While the responses varied in each Nordic country, there a was major effort to avoid the sort of "moral hazard" that has bedevilled efforts by the Fed and the Bank of England in trying to stabilise their banking systems.

Norway ensured that shareholders of insolvent lenders received nothing and the senior management was entirely purged. Two of the country's top four banks - Christiania Bank and Fokus - were seized by force majeure.

"We were determined not to get caught in the game we've seen with Bear Stearns where shareholders make money out of the rescue," said one Norwegian adviser.

"The law was amended so that we could take 100pc control of any bank where its equity had fallen below zero. Shareholders were left with nothing. It was very controversial," he said.

Stefan Ingves, governor of Sweden's Riksbank, said his country passed an act so it could seize banks where the capital adequacy ratio had fallen below 2pc. Efforts were also made to protect against "blackmail" by shareholders.

Mr Ingves said there were parallels with the US crisis, citing the use of off-balance sheet vehicles to speculate on property. All the Nordic banks were nursed back to health and refloated or merged.

The tough policies contrast with the Fed's bail-out of Bear Stearns, where shareholders forced JP Morgan to increase its Fed-led rescue offer from $2 to $10 a share. Christopher Wood, chief strategist at brokers CLSA, says the Fed's piecemeal approach has led to "appalling moral hazard".

"Shareholders have been able to lobby for a higher share price only because the Fed took over the credit risk on $30bn of the investment bank's dubious paper. The whole affair also amounts to a colossal subsidy for JP Morgan," he said.

[Robert Waldmann]

How, exactly does a bubble melt ? In my experience they tend to burst.

Has the libertarian squid sung its swan song ? Look I'm glad that Baker tossed this jack-hammer into the melting pot of our debate, but, what is it about financial crises that make people mix metaphors ?

I mean what does the financial crisis have to do with mixing things until they have no connection with any real entity that can be pictured (or foreclosed) ?

Hmm yes I can diversify my dead metaphor risk by pooling metaphors then sell the AAA rated tranch (no-one wants the mezzanine tranch of dying metaphors (maybe they should have called it the atrium tranch although that does bring cardiac surgery to mind )).

[Robert Waldmann]

Seriously though, there is a reason to rescue banks (recall Bagehot). They are leveraged so a dollar of bank equity is many dollars of credit for the economy. I have no problem with giving public money to banks.

However, I don't want to give any public money to bankers. They, and other financial operators, have compensated themselves very richly in the past decade. This is appalling and more irksome given how poorly they seem to have done their jobs.

So how about a Libertarian deal with free contracting between different agents (one of whom can sell T-bills with a yield of 0.25% for reasons that we don't want to mention to libertarians).

How about, (cast of characters BB= Ben Bernanke BBB = big bad banker)

BB: so Mr Bank Chairman, the FED is willing to guarantee $ 10 billion of your junk if you guarantee $ 1 billion.

BBB: but we are already guaranteeing all of it with our full faith and credit.

BB: No not the Bank, you personally Mr B. B. Banker esquire.

BBB: That would be a crazy investment. My money is my money. I convinced myself that I earned it fair and square by brilliantly buying AAA tranches of pooled mezzanine tranches of bonds backed by liars loans.

BB: Look Mr Banker, I'm a busy man. There are five other Bank chairmen in my office. Perhaps one of them would be willing to buy your bank for $2 a share.

BBB: This is extortion. I refuse to even discuss it.

BB: OK explain to your shareholders how you concluded that the deal was not in their interests. Oh and if they sue you, you don't want to call me as a witness.

To a libertarian such negotiations would be legitimate and any resulting contract should be enforced.

I mean if we don't want bank failures and we don't want to encourage moral hazard, we can offer officers of banks deals, which are painful to them, but which they can't refuse.

[Robert Waldmann]

Seriously though, there is a reason to rescue banks (recall Bagehot). They are leveraged so a dollar of bank equity is many dollars of credit for the economy. I have no problem with giving public money to banks.

However, I don't want to give any public money to bankers. They, and other financial operators, have compensated themselves very richly in the past decade. This is appalling and more irksome given how poorly they seem to have done their jobs.

So how about a Libertarian deal with free contracting between different agents (one of whom can sell T-bills with a yield of 0.25% for reasons that we don't want to mention to libertarians).

How about, (cast of characters BB= Ben Bernanke BBB = big bad banker)

BB: so Mr Bank Chairman, the FED is willing to guarantee $ 10 billion of your junk if you guarantee $ 1 billion.

BBB: but we are already guaranteeing all of it with our full faith and credit.

BB: No not the Bank, you personally Mr B. B. Banker esquire.

BBB: That would be a crazy investment. My money is my money. I convinced myself that I earned it fair and square by brilliantly buying AAA tranches of pooled mezzanine tranches of bonds backed by liars loans.

BB: Look Mr Banker, I'm a busy man. There are five other Bank chairmen in my office. Perhaps one of them would be willing to buy your bank for $2 a share.

BBB: This is extortion. I refuse to even discuss it.

BB: OK explain to your shareholders how you concluded that the deal was not in their interests. Oh and if they sue you, you don't want to call me as a witness.

To a libertarian such negotiations would be legitimate and any resulting contract should be enforced.

I mean if we don't want bank failures and we don't want to encourage moral hazard, we can offer officers of banks deals, which are painful to them, but which they can't refuse.

[Robert Waldmann]

Seriously though, there is a reason to rescue banks (recall Bagehot). They are leveraged so a dollar of bank equity is many dollars of credit for the economy. I have no problem with giving public money to banks.

However, I don't want to give any public money to bankers. They, and other financial operators, have compensated themselves very richly in the past decade. This is appalling and more irksome given how poorly they seem to have done their jobs.

So how about a Libertarian deal with free contracting between different agents (one of whom can sell T-bills with a yield of 0.25% for reasons that we don't want to mention to libertarians).

How about, (cast of characters BB= Ben Bernanke BBB = big bad banker)

BB: so Mr Bank Chairman, the FED is willing to guarantee $ 10 billion of your junk if you guarantee $ 1 billion.

BBB: but we are already guaranteeing all of it with our full faith and credit.

BB: No not the Bank, you personally Mr B. B. Banker esquire.

BBB: That would be a crazy investment. My money is my money. I convinced myself that I earned it fair and square by brilliantly buying AAA tranches of pooled mezzanine tranches of bonds backed by liars loans.

BB: Look Mr Banker, I'm a busy man. There are five other Bank chairmen in my office. Perhaps one of them would be willing to buy your bank for $2 a share.

BBB: This is extortion. I refuse to even discuss it.

BB: OK explain to your shareholders how you concluded that the deal was not in their interests. Oh and if they sue you, you don't want to call me as a witness.

To a libertarian such negotiations would be legitimate and any resulting contract should be enforced.

I mean if we don't want bank failures and we don't want to encourage moral hazard, we can offer officers of banks deals, which are painful to them, but which they can't refuse.

[Luis Enrique]

Is this even right?

Can you make the comparison between, say, protectionist trade measures and emergency liquidity loans to banks?

Is what's going on really motivated by wanting to help out fat cats, or is it about trying to avert the collapse of the financial system that would have much more serious consequences for the non-fat cats than importing cheap cars (because after all, while some workers lose their jobs, others buy cheaper cars and have more money to spend - can you say the same of a titanic recession, widespread negative housing equity etc.?)

[Tomas]

Ah luis, but the question is the distribution. When protections for certain industries are removed and the workers lose their jobs, what you would hear is that the market mechanism must be allowed to function and no compensation should be given to the "losers" of the policy.

There are two policies that might be thought of (for the sake of argument) to be a net social benifit: Freeing up trade creates a net gain from trade and preventing a meltdown in the financial system also produces a net gain (or prevents a net loss, whatever). However there are many ways of achieving this with different distritutionary outcomes.

For instance, to prevent a meltdown one might nationalize the banks and fire all the CEO´s of banking without parachutes but with liability to be sued for whatever they might be sued for. Or one could take the taxpayers money and give them to the Banks to they can be bailed out and can pay christmas bonuses and golden parachutes for senior management. The effect of both actions is to prevent a meltdown and produce a net social gain, but the outcomes for senior management is very different.

Similarly, for trade, one might liberalise trade and compensate displaced workers with lifetime pensions financed with a tax on the winners, say lattedrinking, priusdriving professionals. Or one could just let "market force" play out and let the winners win and the losers lose.

The point is than when the losers are steelworkers, the serious opinion du jour (TM) is that market forces should function without constraint and that any attempt to compensate the losers with taxes is an abomination. But when the losers are "fat cats" then no expense must be spared in saving their well earn priviledges and the income they have come to expect.

[Luis Enrique]

Thomas,

The fact that the CEOs etc. of these banks all seem to enjoy absurd employment contracts whereby they apparently get paid millions no matter how badly they screw up, is I think indefensible, but is also tangential to the point in hand.

These bailouts are not about saving those fat-cat salaries (which I strongly suspect would still get paid if the bank went under), they are stopping banks from going under, and all the bad things that entails. If there was a way of bailing out the banks and denying the CEOs their bonuses etc. I'd be all for it - but I don't think that's the issue at stake here - it's not what Dean Baker was writing about.

If there was an analogous crisis in the autoindustry, where otherwise viable manufacturers risked folding because of a liquidity crisis, as opposed to losing to foreign competition, are you so sure we wouldn't see a bail out? If Wall Street was losing to foreign competition, are you so sure we would see protection for it? Baker has a point if it turns out Wall Street would get protection but Detroit wouldn't, or if Wall Street would get emergency liquidity loans bout Detroit wouldn't, but unless I'm missing something that's not what we're seeing here it it*?

These bailouts are also loans / purchases of impaired assets (I think, I could be wrong) which need not leave the public worse off (although there is that risk). That's not the same thing as, say, subsidizing or protecting the auto-industry, which involves a real, year after year, cost to car buyers.

By the by, I see no contradiction between the policies of free trade, and compensating losers from trade

* not than I can think of a situation where a auto-maker would need liquidity loans that it couldn't get from a bank - so auto-making is different from banking.

[Baradir]

Dean Baker's anger does seem misdirected. I've heard Barney Frank's plan and it leans in favor of helping homeowners, not the note holders, who will wind up getting crammed down by 25 or 30% I imagine. In addition, no one in government or wall street claims to be able to do anything to prop up home values, which will inevitably come down as homebuilder inventory gets liquidated (meaning no one is supporting the bubble - only working to mitigate the fallout from its pop). And if taxpayers have to wind up footing a several billion $ bill to avert $100s of billions in losses from mass foreclosures and destructive fire selling of assets, well, that doesn't seem so bad to me.

[steve]

It's strange that no one has related this to the current election year, particularly given Brad's presentation of a striking chart showing how Republicans manage to goose the economy at such times. Also consistent with this chart is the likely outcome that higher income deciles will likely derive more benefit than lower ones.

[Baradir]

Slocum -
The short answer to your first question is yes. It shouldn't be a public policy goal to make sure people realize capital gains from being an owner occupant of residential property (by making sure they recover that 25% value plus some). Nor does it necessarily create financial hardship when a mortgage balance is worth more than the home - its problems with debt service coverage, not loan to value, that cause far and away the most foreclosures on owner-occupiers. Obviously debt service is a function of the loan amount, which is itself sized based on the lender's valuation of the property. My point is that an upside-down loan to value by itself doesn't put the borrower up the creek (keeping with the aquatic metaphors).

In response to the second question, I'm not sure. It depends on the details of the program. If the Fed and/or the FHA does even a cursory review of a given collateral pool then they would be able to see which mortgagors have the financial wherewithal to pay and which don't, irrespective of the value of the property securing the loan. They would then make haircuts to each loan based on relatively simple Debt service coverage formulas, and then build up an aggregate haircut that would apply to the whole pool. If the servicer accepts that then they get an FHA guarantee on the performance of the pool.

I admit one problem that will definitely arise is getting accurate information on the borrowers, since so much of this was sloppily underwritten using stated income documentation. I'd agree with you that there will be false positives and negatives in any pool adjustment. But based on what I know its the least bad option we have, at least in the short term. If anyone has better knowledge of the details with this plan, I'd like to hear them.

[underwater]

"Wouldn't that encourage more borrowers to stop paying the mortgage in order to get their mortgage balances reduced?"

It would indeed.

[Baradir]

But if FHA could determine that a borrower was able but unwilling to pay their mortgage (based on a history of delinquency when there's clearly ample income to pay debt service) there's no way they would guarantee it. That was the point of the LTV vs. DSC as a measure of financial distress. So I don't see a lot of room for borrowers to game the system like that.

[Baradir]

Your point that there will be some homeowners out there who don't "deserve" the bail-out is well taken. The scenario you describe will happen and I think the idea of withholding equity is reasonable. Do keep in mind though that investor-owners are excluded from the plan which does limit the reward for speculation.

But you raised a different point in your first response - that if Frank's plan is enacted (I think there's a very good chance it will be), otherwise solvent borrowers will stop paying their mortgages in order to get a hefty debt reduction. Based on my read of the plan I don't think this is the case. Anyway you slice it though, my original point was that it's the note holders, not the borrowers, that eat the losses. And that's why I think Dean Baker's indignation is more than a little over the top.

[zak822]

"they are stopping banks from going under"

Shouldn't we, for this discussion, make a clear distinction between investment banks and commercial banks, like the place we have our checking acccounts?

[Baradir]

Slocum - Actually come to think of it, I think what you suggest about withholding equity is part of the plan. The portion of the face value that gets written down becomes "negative equity paper", which gets repaid if and when the house recovers value and is sold. It would basically be a soft-second lien - paid only out of net sales proceeds, with any part left over paid down through subsequent sales. At least this was part of the Office of Thrift Supervision plan; I'm not positive it made it into Frank's...

[Jack]

Dean is exactly, precisely, completely right. Just as there are no atheists in foxholes, there are no libertarians during financial crises. Being a libertarian (neo-liberal, free-market advocate, Republican, etc.) really means "When I'm on top, I don't want to share. But when I'm not doing well, I have a right to use your money to help me out!" I don't know what kind of institutions, cultural forces, or historical accidents have bred this type of evil into our country, but those who share in the responsibility for this (and that means not a few economists) ought to atone by, say, giving away all of their stuff and living on the streets where they can't do much more harm.

[Tracy Lightcap]

Ah, one reads this post and remembers ...

Brad's little film about the relevance of Karl Marx to modern economics, in particular. I watched in interest waiting, waiting for the one thing Marx delivers that other economists since haven't ... then the film ends!

What was that one thing, the thing this posts illustrates so conclusively and so well?

CLASS STRUGGLE, OF COURSE!

Brad, like most modern economists, would like to ignore class struggle. But how can it be denied in the face of this kind of evidence? Has there ever been a better illustration of how "in the last instance" (i.e. when the chips are really down) the state in a capitalist society like ours is "the executive committee of the ruling class"? How else would you explain the disparities cited in this post? The need to keep the financial system from collapsing is real and overwhelming because in a capitalist society the capitalists rule. They rule indirectly and with an eye to controlling class struggles through their agents so that class consciousness is thwarted (they call it "pluralism"), but they DO rule.

And that is Uncle Charley's main contribution to economics and the main lesson that can be learned from him. Revise accordingly, Brad; Sammuelson was right.