Christmas in October
The secret history of the bailout bill
The Senate is overly fond of referring to itself as the "world's greatest deliberative body." Barely 48 hours after the House rejected the Treasury's bailout plan, the august body took a previously passed House bill mandating that insurance companies cover mental health benefits, added in the core $700 billion bailout, laced in money for rural school districts and disaster relief, expanded FDIC deposit insurance coverage, and topped it off with over $150 billion in old and new tax breaks for businesses, individuals in high-income states, individuals living in states without an income tax, and various interests such as wooden-arrow makers and film production crews. GOP Leader Mitch McConnell, almost choking back tears after the Chamber passed the 451-page monster, said it was the Senate "at its finest." The Age of Pericles this ain't.
I'll leave it to others to comment on this mother-of-all-Christmas tree bills. The bulk of the Senate legislation is essentially the same as that rejected by the House. It authorizes the Treasury Department to use $700 billion to buy up bad loans. Certain banks get cleaner balance sheets immediately and the feds supposedly will minimize the risk to taxpayers by selling the bad loans when the market "stabilizes" and the prices of the loans have improved.
To paraphrase Mencken, this solution is neat, plausible, and wrong. The first failing is something that is only now being openly stated: Treasury expects to pay some unknown premium above any current market price for mortgage-backed securities (MBS). We don't know what the premium will be nor how it will be determined. Well, in a sense we do. It will mostly be determined by politics, not economics. This is the foundational flaw in the Treasury plan.
Once signed into law, Treasury would begin a process to determine the assets it will buy and the manner it will set a price. Like everything in government, this is a moment that is lobby-able. Expect swarms of financial services lobbyists, investor groups, housing advocates, and others to try to game the system for their individual clients or members. The further away from economics these decisions are made, the more risk there is for taxpayers. The higher the premium over any current market price, the longer the government will have to hold the assets.
The risk here is particularly high given the complicated and rather opaque nature of the financial instruments involved. Few on Wall Street, let alone in Washington, understand these products. I have strong reservations about whether federal bureaucrats have the capacity to appropriately price and manage these instruments. Apparently, I'm not the only one with these doubts. The bailout would authorize Treasury to bypass normal contracting rules and hire outside private firms to handle the purchases and manage the toxic assets. That these private firms have ongoing relationships with the banks selling the bad assets creates one hell of a conflict of interest.
Some commentators have drawn parallels to the Savings & Loan bailout in the 1980s, when the government established the Resolution Trust Corporation to dispose of the assets of failed thrifts. They mean the comparison favorably. But, that is of a piece different than the proposal at hand. The RTC took possession of a host of assets as thrifts went bankrupt. They received whatever assets the failed thrift possessed. Under this plan, however, federal bureaucrats and their outside contractors would decide which assets to buy. They would ostensibly go from institution to institution, review the books, and say, "We'll buy this and that; you hang on to those." The government will be actively investing taxpayer funds in individual securities and then managing the portfolio until such time as it decides to sell.
One doesn't have to be paranoid to envision the political dynamics that will shape these decisions. Will Fidelity out of Boston have a special edge because Rep. Barney Frank (D-Mass.) chairs the Financial Services Committee? Will Nutmeg State-based hedge funds have an advantage because of their close ties to "Friend of Angelo" Sen. Christopher Dodd (D-Conn.)? That we don't even fully know who will be making these decisions, as a new administration takes office in just four months, warrants no further comment.
Neither do we need to say much about the moral hazard raised by taking bad debt off the books of private companies. While the government, unfortunately, has in the past taken steps to shore up individual companies or even certain sectors, I don't think it has ever before proposed to take such an active role in the markets. Secretary Paulson is proposing our very own sovereign wealth fund. Once government has dipped its toe into this water, it is hard to see it leaving the pool, especially if the government is able to earn a "profit" when it sells the assets in a rebounding market.
It is hard to imagine the government resisting calls to take the "toxic" pension costs off of automakers' books. Or some of the "toxic' legacy costs of the big airlines. Let's remember, this is one of those rare cases where the "victims," the bankers and investment bankers, are the very people who made the mistakes. It is possible that, absent government intervention, we can get through this upheaval with no one else actually getting hurt. This isn't like the former Enron employees who lost their life savings through no fault of their own. This is financial institutions failing because of the very specific mistakes they made.
Probably the most troubling is the proposal to give the government equity stakes in the companies participating in the bailout. It's bad enough for the government to purchase these companies' bad debt. The bailout, however, would make the government an owner in the companies themselves. This is unchartered territory, and raises lots of troubling questions. Would the government get seats on the board of directors? How would the government dispose of the equity? When? Will there be firewalls to prevent government, or government officials, from using the equity stake to influence the business decisions of the company?
The bailout passed by the Senate also contains provisions to limit executive compensation for participating companies. It is entirely unclear how this would work. The populist appeal is easy to understand, but if the restriction is too draconian, companies may decline to participate. Beyond practicality, however, it is another dangerous precedent. We are perhaps too far removed from the wage-and-price-control days of Nixon to remember how destabilizing they were.
These are the things we know. Certainly, there will be a host of new regulations that will only emerge in the days, weeks, even months after final passage. And, unfortunately, these will likely be with us long after the government has sold off the last of the bad debt. We could be entering an era where the financial services sector evolves into a kind of regulated utility. Not only would this stifle future innovations in finance, it would also probably jeopardize the U.S.'s status as the global leader in capital markets.
It is hard to see a systemic regulatory failing that allowed the current situation to arise. There does seem to have been a comprehensive failure by the ratings agencies to appropriately analyze the MBS, but torts are a better way than new regulations to correct this. Besides, regulations are usually backward looking. Regulators rarely identify problems before they arise. Chiefly they sort out what happened and who's responsible after the fact.
Remember, wrongdoing at Enron wasn't uncovered by regulators. It was uncovered by the market, as analysts realized that much of the company's story was fiction. Markets with free flows of information are the best guard against meltdowns. The slightly less free market we are entering will make them more common.
Also, while I have no real reason to question Hank Paulson's motives in his rampant cheerleading for a bank bailout, I would feel a whole lot better if he weren't sitting on a few hundred thousand options to buy shares in Goldman Sachs.
This is something like a 50,000 mile wide Rubicon. Once we've crossed into this unchartered, constitutionally suspect territory, it is hard to see us ever going back. We will never again have free-flowing, free-wheeling or free capital markets.