Since my belated realization that this was a serious policy proposal and not merely a trial balloon, I’ve been meaning to write a post criticising it. But it appears that Arnold Kling has saved me the trouble.
In addition to Kling’s objection that the plan is absurdly expensive, I’ll add the criticism that the plan would create a huge amount of moral hazard (the effect of firms taking stupid risks with the expectation that they’ll get a bailout if things go south), virtually guaranteeing that we’ll have the same problem again in a few years unless we massively increase regulation of the financial sector (which has a whole boatload of problems all by itself, not least of which being the very real possibility that firms will find a way to fail spectacularly despite the regulations, and will come crying to the Treasury and the Fed for another bailout).
I’ve been mildly supportive of the bailouts to date on the grounds that they’ve been narrowly tailored to generate a large amount of damage containment for a small amount of moral hazard, in particular by making sure that shareholders of Fannie, Freddie, AIG, and Bear Stearns (who had been reaping the profit during the boom from the risky activities that lead to this mess)Â lost their shirts despite the bailout. This proposal does not have even that saving grace, as it’s a proposal to buy $700 billion in risky or worthless securities from solvent firms (thus subsidizing their bad decisions) at well above market prices.
Update: Newt Gingrich also hates the proposal. I don’t entirely agree with his alternative proposals (I agree with his proposal to repeal Sarbanes Oxley, disagree with his modification to mark-to-market, and think the total tax rate on investment income (capital gains + corporate income tax) should be as close as possible to the total tax rate on wage income), but I strongly prefer his proposals to the Bush/Paulson plan.
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This seems similar to the Savings and Loan bailout of the late 1980s. Especially if you factor in inflation and population growth.
I’m having trouble getting deeply interested in this. Seems to me the system’s basically working the way it’s supposed to.
This seems similar to the Savings and Loan bailout of the late 1980s. Especially if you factor in inflation and population growth.
It’s not really similar. The resolution trust corporations took over the assets of failed Savings and Loans, and eventually sold them off. The Savings and Loans that had made the bad loans had gone out of business and been taken over by the federal government.
In this case the federal government is going to buy illiquid derivative bonds which are based on bad mortgages from banks at some price. No one is talking about how that price will be determined. The banks that created all this bad debt are not going out of business or being taken over by the government.
What is to stop the banks from doing this all over again and expecting to be bailed out again in a few years?
This plan needs some serious rethinking.
It’s not completely the same but it certainly looks similar to me; the S&L crisis of the ’80s was caused by problems with how Savings and Loans were handling mortgages, lending out far more money than they could safely cover.
Also, where do you get the idea that that bailout was only done to S&Ls that went under? The entire bailout was created to prevent this from happening, wasn’t it? The whole point was that something like 80% of the nation’s S&Ls were insolvent, mostly due to loans they couldn’t cover. The bailout was to prevent that 80% or so of S&Ls from going toes-up.
The entire bailout was created to prevent this from happening, wasn’t it?
No, the RTC was created AFTER the S&L crisis to dispose of the assets from failed S&L’s. The feds had guaranteed those deposits and was attempting to recoup some of those costs by selling the assets.
The major difference is that the feds had guarantees on the table BEFORE the S&L problems. There is no Fed guarantee of free market investments in general.
I’m having trouble getting deeply interested in this. Seems to me the system’s basically working the way it’s supposed to.
That ain’t the way the free market was explained to me. Risk is essential for its proper functioning. Getting bystanders to pay for one’s bad investments isn’t in any economics text book I know of.Â
You might want to take a look at Brad DeLong’s mostly interesting post about strategies in dealing with financial crises, particularly his observations at the end of the post. Basically, the time to have been thinking about moral hazard was before the problems not during them.
I agree with MikeCa and RogerR. As far as I know, the RTC was about handling the assets of insolvent S&Ls, not with propping up S&Ls still in business by buying bad assets off of them at inflated prices.
Dave, in my mind it’s always a good time to think about moral hazard, because there’s always going to be a next time someone who is arguably too big to fail will fail. Moral hazard in these situations comes from firms counting on the assumption that if and when they need a bailout, the powers that be will decide that it’s too late to be thinking about moral hazard.
What this IS similar to is The Great Depression.
Think about history, very briefly stated, the banks back then put customers savings account money into the stock market. In otherwords, gambling with other peoples money. When the market crashed the banks didn’t have the money to payback their customers.
Therefore, in 1933 the FDR administration passed the Glass Steagall Act. This law seperated commercial banks and investment banks. Also the FDIC was born. This was all done to keep banks from playing the market with customers money.
Jump forward to 1999, when Clinton was President. The republican senate (Gramm) was trying to repeal the above law. It was basically split down party lines and Clinton vowed to veto the law as written. In other words, this new bill would have died. However, Clinton asked the Senate to rewrite the bill and include wording about minorities. The new version easily passed both the senate and house. Clinton signed the Gramm Leach Bliley act into law in 1999.
Now I am not blaming Clinton alone. After all Congress wrote the law. But all these people are now making millions and millions each year and we are getting screwed.
Washington is broken and I don’t see it getting fixed anytime soon.
I keep asking myself, "Why should we give 1 trillion dollars to the very people that screwed this up, to fix it?" But what do I know?
Rob
http://www.teasemeteas.com/robspersonalblog.htm
Gramm Leach Bliley is a red herring. The major insolvent institutions so far have been three pure investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch), one pure depositary bank (Countrywide Financial), one insurance company (AIG), and two government-sponsored enterprises (Fannie Mae and Freddie Mac), none of which would have been prohibited under Glass Steagall.
Arguable, the current mess may have been worse without Gramm Leach Bliley — three of the insolvent institutions were bought by private companies with no need for government intervention (Countrywide, Lehman, and Merrill Lynch), and one of those (Bank of America’s purchase of Merrill Lynch) would have been prohibitted had Glass Steagall still been in effect. Two other pure investment banks (Morgan Stanley and Goldman Sachs) have just announced plans to restructure into hybrid investment/depositary banks in order to diversify their risk exposures.
If Bank of America shows up at the Treasury’s door with a begging bowl, then we can complain about Gramm Leach Bliley.
Hmm. OK, I still don’t think GLB is a read herring. But I will argee that it wasn’t/isn’t all bad. You make a great point and I will agree there are positive aspects to GLB. It is reckless to generalize. Shame on me!
However, the original topic above is about the $700B bailout. This is not about the previous failures, like Lehman, this is about the desire to buy up nearly worthless securities from solvent institutions.
I stand by my comment that the GLB Act did contribute to the banking crisis that the Treasury now wants to bailout. It did contribute to the sub-prime "situation" we are now in. Banks made loans they probably shouldn’t have made and Freddie and Fanny purchased these sub-prime mortgages and they didn’t have the capital to stay liquid.
Rob
http://www.teasemeteas.com/robspersonalblog.htm
I think my reply went bye-bye. Geesh.
Basically I typed that the GLB Act is not a red herring. Yes, there are good point but there are also bad points.
The previous failures like Lehman, are seperate from this $700B bailout. This bailout is about the Treasury buying near worthless securities from solvent institutions. Lending institutions made sub-prime loans, loans they probably wouldn’t have made pre-GLB, and Freddie and Fanny purchased these sub-prime mortgages. When the housing market slowed down F&F couldn’t remain liquid, not enough capital.
My reply that went bye-bye was longer and explained it in better detail.
Rob
http://www.teasemeteas.com/robspersonalblog.htm
No, you may be right. I’m just not seeing problems that can be traced back to GLB, but if I’m wrong, this won’t be the first time.
As for dissappearing comments, the spam filter is a bit overzealous and it tends to seemingly-randomly drop comments with links in them into the moderation queue. If you lose another comment, post a comment mentioning it in the thread, and someone with moderation privileges (usually Dean) will pull your original comment out of the queue.
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