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Tuesday, September 23, 2008

Thoughtful analysis on the scope and necessity of the proposed bailout.

Donald Luskin hits all the right notes in this essay. Looks like I'll have to temper my praise of Secretary Paulson:

There’s simply no objective way to know whether the banking system is as close to disaster as top officials at the Treasury and Federal Reserve claim. They themselves don’t really know. This is a "banking crisis," they say. But then again, other politicians claim there is a "health care crisis," an "immigration crisis," an "energy crisis," and so on.

There’s no doubt that there is serious turmoil in the banking system and financial markets. But that doesn’t mean the proposed extraordinary intervention by the government in private markets is justified, considering that throughout history we have periodically gone through convulsions worse than today’s and survived them without such interventions.

According to the Federal Deposit Insurance Corporation there have been 15 bank failures in the U.S. between 2007 and today. We had thousands over a few years in the late 1980s and early 1990s. Since the stock market hit an all-time high last October, the S&P 500 has fallen 23 percent. It fell more than twice that — 49 percent — during the last bear market, between March 2000 to October 2002.

Even if you grant that this really is a "crisis," and that it justifies an extraordinary intervention, there can be no doubt that the $700 billion authority being sought for the purchase of distressed mortgage-related securities is far too great an amount. Of the $1.26 trillion in non-prime mortgages — that is, "sub-prime" and "Alt-A" mortgages — $743 billion is already either owned or guaranteed by Fannie Mae and Freddie Mac, companies that were shored up by a government rescue earlier this month. That leaves $521 billion, which means the Treasury’s $700 billion would be more than enough to buy them all. And that’s even if the Treasury paid full value. In fact, the Treasury will get a steep discount, considering that many of the mortgages in question are in delinquency or default. Does the Treasury really have to buy every single non-prime mortgage — even the healthy ones — twice over?

* * *

And assuming that it is necessary, and assuming that it is likely to work, is this epoch-making intervention in private markets morally justifiable? Die-hard conservatives — especially deficit-hawks and free-market libertarians — would say no. But some mitigating circumstances should be considered.

It seems at first blush that spending $700 billion to buy mortgage-related securities would be a budget buster. But remember, this is not government "spending." It is government "investment." The Treasury would issue bonds, pay a low interest rate on those bonds, and use the proceeds to buy mortgage-related bonds that pay a high interest rate and can probably be sold at a profit in the future.

It also seems at first blush that the government ought to not bail out banks that made terrible investments they now regret. But remember, many of these bad investments were the result of government meddling. Would we be experiencing a sharp housing downturn, and a wave of mortgage defaults, if the Federal Reserve had not created a housing bubble and a mortgage bubble in the first place by artificially lowering interest rates to 1 percent in 2003 and 2004? And how much was the housing bubble inflated by the highly leveraged mortgage buying spree of government-sponsored and government-influenced Fannie Mae and Freddie Mac? Shouldn’t the government shoulder some responsibility for its own mistakes?

Skepticism seems to be growing on the Hill.

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