Economics

Don't Save Wall Street's Whales!

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In the Wash Post, Allan Sloan of Fortune has a sharp piece about double standards when it comes to bailing out big economic players vs. smaller borrowers:

Wall Street loves to talk about letting financial markets weed out the weak. But when the Street itself gets in trouble, it sticks out its little tin cup, asking for help. And gets it.

The meltdown in the subprime mortgage market is a classic example of the way the small fry gets devoured, but the whales of Wall Street get rescued. Here's the deal: People with crummy credit who took out mortgages are being allowed to fail in record numbers. The mortgage companies that made those loans are being allowed to fail.

The Street itself? It's bailout city. Even before the Fed made a symbolic half-point cut in the discount rate, it and other central banks from Switzerland to Singapore were trying to rescue the Street by injecting hundreds of billions of dollars into the financial markets and announcing they would put up more, if needed.

Hello? If you believe in markets, which I do, this rescue is especially galling, because Wall Street enabled this mess in the first place. How so? By happily sucking up hundreds of billions of dollars' worth of suspect mortgages from marginal U.S. borrowers—and begging mortgage makers to create more of them….

But the world's central banks aren't letting the big guys fail. Think of it as the Escape of the Enablers. The reason this is happening, of course, is the same reason that the Fed orchestrated a bailout of the infamous Long-Term Capital Management hedge fund a decade ago—and about 20 years ago didn't close some of the nation's biggest banks, even though they were effectively insolvent because unrealized losses had wiped out their capital.

Read the whole thing here.

Hat Tip: Alan Vanneman (aka AMVHUCK), film critic extraordinaire and persuasive Ratatouille declaimer.

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  1. Sleeping Beauty, lousy??? That’s just crazy talk.

  2. Great time to post Mad Money Cramer holding out his hand. Truly, must see TV.

    http://www.cnbc.com/id/15840232?video=452808336&play=1

  3. Yeah, it’s crummy, but a true credit crunch is a sure-fire way to kick off a recession or a depression, for that matter.

  4. Correct if me if Im wrong, but this is not a bailout in the usual sense of the word, they are injecting money and the fed is dropping the rate inorder to battle a perceived liquidity problem, trying to calm the market and offset some of the uncertainty in the market. The small borower is not being bailed out either because they have defaulted on the loan, wall street is being ‘bailed’ out because it has not really defaulted on anything yet.

  5. Welfare is still welfare when it is give to corporations. I have lost 11% during this correction, but I think the market as a whole would be more stable if there were consequences when players take excessive risk.

  6. What de stijl and val said. A credit crunch would have repercussions all the way down to the little guys–mortgage rates would go way up, 401Ks way down, and everybody except Gillespie would be miserable.This wasn’t a bail out, rather it was an acceptable use of Fed powers. There are still plenty of consequences–the hedge funds that got burned and their parent companies have NOT been bailed out, if you will notice.
    Markets, contrary to much of what’s said here, can be extremely emotional in the short run. In the long run, of course, they are wonderful things. But the damage done when the fear or greed meter hits ’11’ can be devastating. The Fed is trying to avoid that.

  7. See, that is the thing:

    Everyone can justify, in the short term, why bailing out these big corporations is a good idea. Of course, the long term effect is to teach the corporations that they can lend frivilously, behave irresponsibly, and someone will bail them out.

    It might have negative effects on the economy if we let these corporations fail. It *SHOULD* have a negative effect on the economy if we let these corporations fail. And in the future, maybe mortgage companies will lend more carefully.

    Welfare is still welfare when it is give to corporations.

    Welfare for corporations is even worse than welfare for people. With welfare for people, it is the welfare recipients who are most devistated by welfare – Welfare for the poor is designed as a way of removing power from the poor and keeping them dependent and obedient to a specific political party. Welfare recipients are punished by having their communities destoyed by ‘welfare’, and becoming vote slaves. No one in their right mind desires to be on welfare, it is a trap sprung on those in poverty who have no choice.

    Corporations, on the other hand, make a profit from corporate welfare. Unlike welfare for the poor, corporate welfare isn’t designed to oppress the corporations. Welfare for corporations is nothing but the benefit for corporations.

  8. A bailout is a bailout. The same practical effect would happen if the government would pay the loans. Of course, the poor are deadbeats. Since it’s a perceived liquidity risk, there would be short-term turmoil and then a shakeout, but the markets would fix themselves as conservatives, like Buffett, soak up great deal. It’s painful, but that’s capitalism.

    The long term consequence of this is that without these sorts of failures and knowledge of a bailout, firms are going to continue to take high risk investments and we’ll have to deal with this all over again. We need to take short term pain for long term stability.

    “Capitalism without failure is like religion without sin, it just doesn’t work.”

  9. I largely agree with Rex. “But something bad might happen” is not an excuse to bail out big lenders/business. Bad investments should not be rewarded.. that sets up an incentive structure that we most definitely don’t want.

  10. I’m not saying I disagree with the gist of this piece, but…

    “The Street itself? It’s bailout city. Even before the Fed made a symbolic half-point cut in the discount rate, it and other central banks from Switzerland to Singapore were trying to rescue the Street by injecting hundreds of billions of dollars into the financial markets and announcing they would put up more, if needed.”

    I’m not so sure injecting liquidity is the same thing as a “bailout”. …that’s a fishy use of that term in this context.

    “By happily sucking up hundreds of billions of dollars’ worth of suspect mortgages from marginal U.S. borrowers — and begging mortgage makers to create more of them….”

    Everybody was supposed to have been able to predict the future in hindsight. …especially when there’s blood in the streets.

    I suspect we haven’t heard the last of the accusations against some of the ratings agencies, and I’ll bet the rating agencies have a likely candidate to point a finger at too. But regardless of who’s to blame, no one’s to blame for not being able to predict the future.

    I didn’t expect to see someone condemning Wall Street for finding ways to extend credit to people who don’t deserve it never had access to it before. …in a piece about not screwing the little guy.

    If Wall Street found a way to extend credit to people of little means and confine the losses, mostly, to loan originators and speculators, then Wall Street should be getting a pat on the back.

  11. There is no such thing as an economy in a permanent “boom” cycle. Recessions are necessary to clear out bad investments. The Fed’s actions have merely postponed the adjustment and will make the recession when it ultimately [and inevitably] comes.

    The only beneficiaries of this are the Wall Street fat cats. The poor working stiff will wind up carrying the can.

  12. @ 11:11 AM Should read:

    The Fed’s actions have merely postponed the adjustment and will make the recession worse when it ultimately [and inevitably] comes.

    [preview, preview, preview]

  13. Ken Schultz

    I didn’t expect to see someone condemning Wall Street for finding ways to extend credit to people who don’t deserve it never had access to it before. …in a piece about not screwing the little guy.

    As a former banker, I can tell you that the very worst thing you can do to someone creditwise is to give them a loan they can’t pay back. Inability to meet payments has caused more divorces, heartbreak and suicides than any other cause.

    “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

    -Mr. Micauber in David Copperfield; Charles Dickens

  14. No “bailout” is happening in the true sense of the word – Countrywide is not getting a lump of cash from the Fed. Hedge funds are being allowed to fail. Mortgage companies that were subprime heavy are being allowed to fail – many already have. Countrywide got an $11 billion loan last week but it still may fail.

    From Reuters:

    The Federal Reserve added $19 billion in temporary funds to the banking system through the purchase of mortgage-backed securities to help meet demand for cash amid a rout in bonds backed by home loans to riskier borrowers.

    The Fed accepted only mortgage-backed debt as collateral for this morning’s weekend repurchase agreement. Losses in U.S. subprime mortgage investments have been rippling through global credit markets, driving interest rates higher and sinking share prices. The Fed also added $24 billion yesterday, the most since April, as demand for cash increased.

    They are basically trying to avert a credit crunch in Mortgage Backed Securities by injecting liquidity into the market by purchasing MBS’s from firms trying to sell them.

  15. Ken,
    There’s a reason Wall Street was getting outsized returns on their investments, there’s a lot of risk involved. If I went out tomorrow and sold a call that was waaaay out of the money. If I have pay out a lot because of it doesn’t mean that it’s my fault that something highly unlikely happened. Same with these guys, the fact that a lot of these loans went bad wasn’t a surprise, neither was the flight to quality that happened afterwards. They shouldn’t get sympathy for investments that went bad.

  16. No “bailout” is happening in the true sense of the word …

    They are basically trying to avert a credit crunch in Mortgage Backed Securities by injecting liquidity into the market by purchasing MBS’s from firms trying to sell them.

    Sounds like the firms holding MBSes are being bailed out.

  17. Sounds like the firms holding MBSes are being bailed out.

    I guess we’ll have to agree to disagree on what the word bailout means, then.

  18. Sounds like the firms holding MBSes are being bailed out.

    I guess we’ll have to agree to disagree on what the word bailout means, then.

    So if those MBSes go bad while the Fed holds them, who is left holding the bag?

  19. Whether it a “bailout” in the truest sense of the word, the Feds actions are creating a moral hazard.

    http://bigpicture.typepad.com/comments/2007/08/fed-treads-mora.html

  20. “As a former banker, I can tell you that the very worst thing you can do to someone creditwise is to give them a loan they can’t pay back. Inability to meet payments has caused more divorces, heartbreak and suicides than any other cause.”

    I see the same logic used to support the Drug War.

  21. So if those MBSes go bad while the Fed holds them, who is left holding the bag?

    Is this a rhetorical question?

    Look, it’s clear you want to call it a bailout and I do not.

  22. I see the same logic used to support the Drug War.

    Except no one is trying to make subprime loans illegal. Just that they’re a bad idea. I think even drug war opponents would say the same thing about drug abuse.

  23. They are basically trying to avert a credit crunch in Mortgage Backed Securities by injecting liquidity into the market by purchasing MBS’s from firms trying to sell them.

    I’ve got a 1993 Mazda that I can’t get anyone to buy at my full purchase price. Will the Fed buy it from me? As described, that wouldn’t be a bailout either.

  24. There is a great deal of confusion here. First, the Federal Reserve (“The Fed”) uses open market operations ALL THE TIME to keep short term interest rates near the “Fed Funds Target Rate.”

    The Fed’s Open Market Operations consist of accepting collateral (a Mortgage Backed Security, for example) from a bank, giving the bank cash (minus a haircut), with the bank agreeing to buy back the bond at a later date (maybe even the next day). This is referred to as a repurchase agreement or a “Repo.” It is not unusual for the Fed, or any other bank, to engage in Repo transactions using MBS. The MBS that the Fed accepts are Prime, Conventional MBS that are guaranteed by Fannie Mae or Freddie Mac. These are high quality borrowers and loans (less than 417k loan size + 80% LTV or mortgage insurance). These are NOT subprime mortgages.

    In recent days, banks became fearful that their peers would not be able to pay back their short -term loans because of the uncertainty surrounding what banks have what exposure to subprime mortgages. As a result, the interbank lending rates soared far above the Fed’s target rate.

    The Fed, along with the European Central Bank (ECB) “injected liquidity” by transacting more in the Repo market: they simply lent more money in that market to bring the short term borrowing rates for banks down to their target.

    These actions ARE NOT bailing out any of the mortgage lenders or the players in the subprime market. They simply maintained the short term interbank lending that is crucial to the financial system.

    My personal view is that the Fed should be abolished, but that is beside the point here.

  25. “Except no one is trying to make subprime loans illegal. Just that they’re a bad idea. I think even drug war opponents would say the same thing about drug abuse.”

    I understand there are plenty of people who want to regulate subprime loans. …and I’m not so sure subprimes are a bad idea for everybody.

    My understanding is that more than 85% of those are still performing–and I don’t think that includes all the subprimes who managed to refi.

  26. Calling it a “bailout” makes it sound more scary.

    It’s inaccurate, as the Fed is simply making short-term (try “Three day”) loans (and yes, these loans include interest) and taking those securities as collateral.

    Sure, it’s possible some bank my default — but the Fed wasn’t loaning to tiny banks, and banks aren’t the ones with the real problem.

    If the Feds were making this deal directly to Hedge funds and some of the stupider mortgage companies, then they’d have a high risk of default and I’d call that more of a bailout.

    But making three day loans, complete with interest, is a “bailout”? Jesus, the torture some of you put the English language through.

  27. “These actions ARE NOT bailing out any of the mortgage lenders or the players in the subprime market. They simply maintained the short term interbank lending that is crucial to the financial system.”

    They apparently are accepting subprime as (highly discounted) collateral at the discount window.

    …but that’s not really a “bailout” as far as I’m concerned.

  28. Welfare for corporations is even worse than welfare for people. With welfare for people, it is the welfare recipients who are most devistated by welfare – Welfare for the poor is designed as a way of removing power from the poor and keeping them dependent and obedient to a specific political party.

    How do you figure? How can it be bad for someone if you’re not taking away any of their options, but simply giving them money (which expands the person’s range of economic options)? And if welfare for people does hurt the poor, wouldn’t that make it worse than welfare for corporations?

    As a former banker, I can tell you that the very worst thing you can do to someone creditwise is to give them a loan they can’t pay back. Inability to meet payments has caused more divorces, heartbreak and suicides than any other cause.

    I see your point. The counterpoint, I guess, is that its better to give the person the benefit of the doubt: assume that they know what they’re doing when they take out the loan, have some reasonable idea of how they will pay it back, and benefit from having some money sooner rather than later.

    I think the best solution is to educate people more about responsible credit usage, rather than have a working presumption that people will take out loans they can’t repay if given the chance. Of course, a lender that wants to stay in business may have no choice but to have that presumption for some people with bad credit/low income/whatever.

    As for the topic of this thread, I’m not sure what the fed should do. I don’t have a problem with large lenders who made overly-risky loans losing money or going out of business. I don’t think the Fed should assume the risk associated with questionable mortgages just to take the pressure off Wall Street lenders. But I don’t necessarily have a problem with them lowering the discount rate or making loans to companies that are only slightly involved with the subprime mess and have enough loans in good standing to be viable in the long run.

  29. “It’s inaccurate, as the Fed is simply making short-term (try “Three day”) loans (and yes, these loans include interest) and taking those securities as collateral.”

    My understanding is that it’s been extended to 30 days for the time being.

  30. The discount window carries a different rate and has different rules about collateral:

    http://www.frbdiscountwindow.org/pledging.cfm?genid=13&desc=Pledging%20Collateral&url=pledging.cfm

  31. Just throwing it out there as a suggestion, Mr. Gillespie, and I hope I’m not offending anyone who’s already been assigned this task if I haven’t noticed…

    I know that everybody at Reason is a little bit econ and a little bit rock & roll, but Reason could use someone devoted to financial markets, someone who does for financial markets coverage what Bailey does for science and what Sullum does for the War on Drugs.

    If Reason had somebody that took financial (rather than econ) issues and made the freedom hugging, libertarian argument both plain as day and compelling for ordinary folk, well that would be super duper.

    I suppose that would be a really challenging job, but if a journalist is lookin’ for a libertarian issue to cover, being pro sub-prime and anti-bailout should make him or her unpopular with just about everybody, and isn’t that what being a libertarian journalist is all about?

  32. What Bernanke and the rest are trying to do is not so much “bail out” the system as to keep the damn system liquid. Everyone has frozen up on commercial paper (see stampede into Treasuries) because nobody now trusts the labels any more, nor do they know what is in the commercial paper. That’s the problem–unknown risks inherent in black box financial products. And people are just now realizing that the ratings mean jack sh*t. A “AAA” on a gov’t bond now means something entirely different from a “AAA” on a CDO. Ooops….

    Second, everyone is terrified that there are all these undiscovered grenades lying around tied to commercial paper just waiting to explode, especially with the predicted resetting of the ARMs.

    The whole thing will unwind, but it’s going to take time. All those wonderfully complicated CDOs etc are going to have to be broken up and the prices and ratings explained. Either that, or the sellers of such instruments will have to discount heavily in order to move the stuff, given the unknown values and the unknown risks now inherent.

    This isn’t rocket science. Anyone with a little brain could have seen this coming. I and my business partner got out of the hedge fund we were invested in because we saw this coming down the pike. Anyone who has a strong stomach for risk can do a little research, pick over the pile of dross, and judiciously pick up undervalued commercial paper in a few weeks. (Wouldn’t suggest right now, because the stuff still hasn’t reset to a real price yet.)

  33. CDOs won’t be “broken up,” they already have financing for the life of the fund. They might yield losses for the lower rated investors, but they won’t be “broken up.”

    If you wait weeks to get into CP, you’re going to miss the boat.

  34. It’s inaccurate, as the Fed is simply making short-term (try “Three day”) loans (and yes, these loans include interest) and taking those securities as collateral.

    Try getting a 3 day payday loan and see what interest rate you get on it. Same thing, completely different interest rate.

    After I graduated from graduate school and before I got my first paycheck from my job, I was limping along on the last bits of my savings. I had substantial funds guaranteed to me on a set date (due to a contract). I also had a liquidity shortage and a 7 year old car. I would’ve loved to let someone borrow my car for a price no one would pay (the KBB price), waited until I got my first paycheck and then paid, essentially a risk free rate. But I didn’t, I sucked it up, survived a few weeks living lean and got through it.

    No one trust a lot of highly rated paper, not because people are afraid to lend, but because they use complex accounting to mix and match all sorts of asset classes on their balance sheet. They are being penalized for lack of transparency and uncertainty. IF GE offered a collateral back loan on a piece of machinery with explicit terms, they would have little problem getting debt. If people are refusing to lend to transparent, highly credit worthy borrowers, like any of the AAA guys being, there is a lending opportunity for other people.

    I don’t see why this argument works on why free markets work to stop discrimination, fix health care, etc, but not in financial markets.

  35. grumpy beat me to it

  36. As said, if they can’t break up the CDOs, they’re going to have to discount them heavily to move them.

    All those financial black boxes getting traded back and forth in a game of Pass The Parcel. Now the players are discovering it’s more like a game of Hot Potato.

    I wonder how long it will be before CP starts moving again. The markets seem to have already priced in a 1.25% rate cut (according to the FT.) Now the question is whether Bernanke et al. are actually going to go ahead and do it. Rate cuts can’t do much about lack of transparency in financial instruments, which is where the real problem lies.

    I do hope however that someone starts a class-action suit against the rating agencies and starts cracking them open. Either they should be forced to stand behind their ratings or stop slapping AAA on everything.

  37. I think there is a time limit here.

    Ultimately those failed mortgages are worth the homes behind them. Yeah, it’s tough to liquidate a home right now, especially with no activity in the subprime sector, and homes, like everything else, are priced on the margin.

    …but there are only about 9 months of inventory out there, and home builders have been slowing down their activity. The available inventory did shrink last time around, and prices will have a bottom, where that is in some markets is an open question, but in others, they may have found it already.

    Still, some mortgages are yet to reset, and that could bring more inventory back onto the market. So, no, I’m not making any predictions here, and the commercial paper market will have to sort itself out anyway. …but give us another six months, and I won’t be terribly surprised if the housing market isn’t anywhere near as bad as it is now.

    …and all those homes are worth something, subprime debt or no subprime debt. Cap rates were out of line anyway in my area, and I hear rental rates are going up pretty much everywhere. …except for Detroit.

  38. In late breaking news, the Wall Street Jounal reports:

    How FHA Could Help Borrowers–
    Bush Backs Giving Agency
    Flexibility to Offer Options
    For Mortgage Refinancing

    “The administration is looking to FHA to offer refinancing options to homeowners, including those who aren’t yet in default or foreclosure, but who are at risk of falling behind in their payments on mortgages that were structured to offer payments that were very low at first but then escalated.”

    http://online.wsj.com/article/SB118774225399404746.html?mod=hps_us_whats_news

    (Subscription Required)

    This is further evidence of something I’ve suspected for a long time–that George W. Bush assumed the Presidency with the sole aim of somehow beating out Johnson for the title, “Worst President Since World War II”.

    …I mean, it’s obvious! Throwing kerosene on the subprime fire–how else could he compete with the man that brought us both the escalation in Vietnam and The Great Society?

    P.S. Now that’s a “bailout”.

  39. Not necessarily (aside from the very fact of something being under the FHA aegis making people think there is less risk than there actually is.) If they redo the ARM and balloon rate mortgages into something that doesn’t increase rates quite as fast and stretches out the payment period, why should it not work out?

    Still, there are probably going to be a lot of people who were coaxed into buying more house then they really could afford, period. It’s those that we have to find a gentle landing slope for.

    Reason why we don’t let these people just hang: because every foreclosed house in the neighborhood will pull down the value of every other house by 1% or so (forget the exact numbers.) You can smugly pat yourself on your back about your thriftiness and forethought, but when the potential collapse of your neighbors does a ding in your own house value, you may think it may be more productive in the long run to find a way for them to hold on to their properties, no matter how libertarian you claim yourself to be.

  40. It’s certainly more of a bailout than injecting liquidity.

    If bailing out borrowers isn’t bailing out the the people who hold their mortgages, what is?

    And yeah, if bailing these people out presents some kind of morale hazard to lenders, what does bailing people out who aren’t even in trouble yet do?

  41. Oh, and assuming that any legislation authorizing FHA to help these people, or to authorize Fannie Mae and Freddie Mac to buy more mortgages for their portfolios, won’t also include new regulations for subprime lenders, I’m sure you’ll agree that that would be a pretty bad bet. …which is very bad news for people trying to get a leg up in life.

    If this happens, by the way… Is there anyone out there who doesn’t think this might lengthen this correction and future corrections too?

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