Well, that didn't last long.
Last weekend, the federal government finally mustered the fortitude to
allow a big boy, Lehman Brothers, to go bankrupt.
By Tuesday, the Federal Reserve had basically bought an insurance company
to which no one else was willing to lend money.
At this point, it's clear that Treasury Secretary Henry Paulson and Fed
Chairman Ben Bernanke are flying by the seat of their pants, making
sequential ad hoc decisions that are roiling markets rather than calming
There is simply no rationale or standard by which it is OK for Lehman to go
through bankruptcy but taxpayers have to assume huge liabilities and risks
to prevent Bear Sterns, Fannie Mae, Freddie Mac and AIG from doing so.
The systemic risk allegedly posed by AIG wasn't its main insurance
business, which is subject to separate capitalization requirements that by
all accounts are adequate. Instead, the alleged systemic risk was the role
AIG played in guaranteeing the debt instruments of others, including
But if those guarantees were put into question by AIG going into
bankruptcy, the mortgage-backed securities held by others wouldn't suddenly
They would become worth less, since defaults might not be covered. But they
would still be producing income. After all, over 90 percent of mortgages
are still current. Even two-thirds of subprime mortgages are still current.
Revaluating such debt instruments is something markets can do, if given the
chance and time.
Meanwhile, the two presidential candidates took the opportunity of the
financial melodrama to engage in senseless babbling.
According to Barack Obama, the difficulties in the financial sector were
caused by Bush administration deregulation. This is a falsity of
breathtaking and brazen scope.
There has been no material change in the regulation of the financial sector
under Bush. The Bush administration, however, did propose increased
regulation of Fannie Mae and Freddie Mac. It wanted to increase their
capital requirements and limit the amount of mortgage-backed securities
they could own for investment.
If the Bush regulations had been adopted when proposed, putting taxpayers
on the hook for their mortgage-securities guarantees might have been
avoided. But congressional Democrats, supported by too many Republicans,
Preventing this meltdown from occurring through regulation would have
required making it more difficult for people to buy homes. Don't recall any
Democrats proposing that.
John McCain, for his part, is saying he should be elected because he is a
tough guy who will go beat the crap out of all those Wall Street bastards
who did this. He's even taken out an ad in which he boosts: "I've taken on
tougher guys than this before."
Contrary to Obama and McCain, the turmoil in the finance sector wasn't
caused by corruption, fraud or dishonesty. It was caused by an
overinvestment in housing and excessive and imprudent use of debt.
The federal government is significantly complicit in this. A persistently
loose monetary policy favored debt. And a favored relationship with Fannie
and Freddie stifled the development of more responsible ways to create a
secondary market for mortgages, in which originators stay on the hook for
Market corrections are necessary to wring out these excesses. Housing
prices have to find a bottom. Credit has to shrink.
These corrections will be painful. But government efforts to smooth or ease
them run a large risk of prolonging them and making them worse.
Ideally, government would let these market corrections run their course,
perhaps increasing income supports for vulnerable populations, but letting
big boys go broke.
If the federal government is simply incapable of doing that, as appears to
be the case, a much better approach than Paulson and Bernanke's ad hoc
decisions about who lives and dies, would be the proposal floated by former
Fed Chairman Paul Volcker and others.
That is for the federal government to set up an entity that would purchase
distressed debt instruments, particularly mortgaged-backed securities. The
entity could hold the paper, collect the income from performing mortgages,
and exercise forbearance on foreclosures.
This would require a substantial upfront capital contribution from
taxpayers. But it's better than continuing to proceed ad hoc, with unknown
costs and results. And it's better for the federal government to hold paper
than owning mortgage and insurance companies and being in the business of
providing mortgage refinancing and guarantees.
Meanwhile, there's a presidential election going on. And on this issue, the
choice appears to be between Tweedledum and Tweedledee.