Sunday, October 5, 2008

More on Free Market Criticisms of the Bailout (Part One)

As you know, on Friday the House passed a “sweetened” (ie. larded up with politically popular measures) version of the bailout package it rejected last Monday.  President Bush promptly signed the legislation into law, and Treasury Secretary Paulson is expected to begin implementing the securities-buying component of the plan within the next couple of weeks (which is as soon as the mechanisms to do so can be set up). Almost sixty Congressmen switched their votes from Monday, but the plan still has plenty of critics, left and right.

Conservative opponents of the plan continued to beat the drum on three points: (1) the plan won’t work, (2) the plan will create moral hazard (ie. it will reward lenders who made loans with little scrutiny of borrowers’ ability to repay, encouraging them to make similar loans in the future), and (3) the plan represents a major expansion of government’s role in the economy --even a step towards socialism.  The first two objections are certainly legitimate concerns, but are fairly easily overcome.  Every intellectually honest observer concedes there’s no guarantee the plan will unfreeze the credit markets, but conservative opponents haven’t been able to put forward any practical alternative that would be obviously better at providing short-term relief.  (The idea that completely getting rid of the mark-to-marketing accounting rule would a confidence-restoring panacea was a particularly gimmicky and embarrassing  proposal.)  Concerns about moral hazard have abated as we’ve seen that even the largest financial services companies have been badly wounded, a number of them fatally, by the severe consequences of loose lending.  The charge that the bailout represents an unjustifiable, indeed socialist expansion of the federal government’s role requires somewhat greater examination.  In the end, however, that examination reveals that this attack is just as off-base as the others.

Let’s begin looking at the merits of the major-step-towards-socialism argument a bit legalistically.  It is comprised of two assertions: first, that the rescue plan involves a massive expansion of the federal government’s role in the economy and, second, that expansion is an unwise and morally unjustified curtailing of free market principles.  Both are incorrect.

How can one contest that the rescue plan involves a massive expansion of the federal government’s role in the economy?  After all, under the new law the Treasury will spend up to $700 billion buying private assets and then holding and managing them until they can be sold at reasonable prices. 

But this only appears to be a major expansion of the federal government’s role to those who haven’t been paying attention to the actions the federal government, through the Treasury Department, the Federal Reserve, and other agencies have been doing over the past seven months or so. Some of the most prominent examples:

-  In March, in a transaction unprecedented in modern times the Federal Reserve made a $29 billion loan to JPMorgan Chase as part of a deal for that company to purchase Bear Sterns, heading off the possibility that the shock of Bear’s collapse would cause a domino effect in the financial system.  As part of that agreement, the Fed agreed to accept Bear’s (now JPMorgan’s) mortgage-backed assets as collateral for the loan, putting those on the Fed’s balance sheet. 

-  In September, the Treasury announced (as everyone expected) that it would extend up to $200 billion in funding guarantees to back Fannie Mae and Freddie Mac; the two GSEs (Government-Sponsored Enterprises) had become unable to get sufficient funding from the credit markets on their own credit to say afloat.

-  Then, of course, came Bloody Sunday: September 15. The news hit that Lehman Brothers, Merrill Lynch, and AIG were all facing collapse. The Fed and Treasury were intimately involved in facilitating the sale of Merrill to Bank of America. Though it let Lehman go into bankruptcy, the Fed loaned JPMorgan Chase almost $80 billion for that company to help unwind some of the many financial relationships that Lehman was involved in across the financial industry.  And the government (arguably) essentially bought AIG, the world’s largest insurer, giving it access to up to $85 billion in funds in exchange for warrants for a 79.9 percent share of ownership in the company. 

- Eight days later, the FDIC seized Washington Mutual and sold its deposits and branches to JPMorgan Chase.

-  Last week the Fed, the FDIC, and Treasury were heavily involved in negotiating the sale of the distressed bank Wachovia to Citigroup, with the FDIC entering into a “loss sharing agreement” with Citi to share the risk of potential further losses in Wachovia’s higher-risk loan holdings, getting a potential double-digit stake in American’s largest bank (by assets) in return (though that deal is now in some doubt because of  Wells Fargo’s attempt break up the deal and buy Wachovia itself ).

- The Fed recently announced that it will guarantee the principle for investments in normally ultra-safe money market funds, after the problems in the commercial paper markets caused a few large funds to decline in value.


Moreover, though the above events are undoubtedly important, perhaps the most important elements of the federal government’s expanding involvement in the financial system have drawn much less attention, at least from those who don’t follow the markets closely. Over the past year, as private lending in the credit markets has slowed the Fed has, measure by measure, taken on more and more of the task of keeping some minimally adequate level of credit flowing.  Even before the fall of Bear Sterns in March the Fed was mounting increasingly direct efforts to recreate some kind of market for mortgage-backed securities. As credit markets deteriorated over the following months the Fed took unprecedented steps to expand the availability of emergency loans from it to large financial institutions, most notably allowing investment banks to directly access loans and then altering its policies to allow institutions to put up higher-risk assets like (yes) mortgage-backed securities as collateral.  Now, with bank-to-bank short-term lending having seized up in recent weeks, we’ve reached the point where the Fed has gone from being a lender of last resort to troubled banks to being a lender of first (and for some, only) resort for fairly sound banks.  It is difficult to underestimate how critical a role the Fed is playing right now in keeping the whole U.S. financial system from going under.

The meaning of all this?  Those who think that the just-passed bailout represents an major change in the federal government’s role in the economy are simply wrong.  The change has already come, and the $700 billion asset purchase plan simply differs in some details of implementation from what federal entities have already done.  (Indeed, from a sheer dollar-number standpoint the pre-bailout federal commitments [those mentioned above plus a few other items] total more than $1 trillion.)  We must try to ensure that this intervention lasts only as long necessary, goes only as far as necessary, and is conducted as completely as possible.  But if major federal action to support financial institutions with bad assets is the Rubicon between capitalism and socialism, we crossed it well before Friday.

But one may of course argue, on moral and/or straight economic policy grounds, that the Fed, Treasury, etc. shouldn’t have done all that they have and shouldn’t be permitted to do more in the same vein.  As this item has grown long enough, I’ll take up that up in Part Two.


Bryan said...

One reason that its worth mentioning (or outright complaining about) "moral hazard" and the Federal Government's role as lender of last/first resort is that the conjunction of the two has sidelined some private enterprises from stepping in to deal with (at least some of) the problems. For example, if you look back through the articles from around the time of Lehman's collapse (or the AIG bridge loan), you'll see that a number of private equity and hedge funds have been trying to buy the mortgage backed securities off the investment banks (or loan AIG money). But in both cases, the firms have preferred to deal with the government instead.

Now its possible that the offered terms were extremely abusive (or were unacceptable for other reasons). However, the existence of those offers does undermine the assertions that the Federal Government was their only option, and call into question just why the corporate higher-ups are choosing federal help over free market deals.

Bryan said...

One quick note about suspending "mark to market" accounting. If you believe that the writedowns on the mortgage based securities is the key factor in this crisis (or at least a major one), then temporarily suspending the rule could work.

However, for it to be more than a band-aid, we'd have to get some sort of grip on just what the real "hold to maturity" value is. And that would require getting a grasp on just how many risky mortgages there are, and how they're distributed among the mortgage based securities.

But since that would involve an intensive (probably expensive) review of all of the subprime (and many of the Alt-A) mortgages, it would take some serious effort to actually get it done. Furthermore, there would be substantial opposition to doing such a review - it would turn up any patterns of suspicious lending activities, and even the holders of mortgage based securities (after all, no one would want to find out they ended up with a disproportionately risky MBSs).

So, Brian, while I agree with you that actually suspending "mark-to-market" would be a bad thing, I do so because I think people would screw up the implementation, either through lack of effort or through efforts to "fudge" the numbers.

Alex said...

Looks like I was wrong. Sorry, Bryan. Welcome to the blog.