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09/21/2008

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veronica

Really good article,Thanks a lot

jimbino

"These are exciting and troubling economic times for an economist-the general public can use less of both!"

Less of both what? -- times and economists?

Tom Rekdal

You make some extremely valuable points in this analysis--especially your scepticism about the total magnitude of the taxpayers' losses. Surely not all of the illiquid assets the Treasury takes onto its balance sheet will turn out to be totally worthless, so authority to make $700 billion in purchases does not necessarily imply $700 billion in losses.

The most troubling consequence of the government's intervention is the moral hazard it may create. I wonder if the very ad hoc character of this intervention may not turn out to be our best defense against the expectations that may lead to even riskier behavior. Is it really possible to predict, based upon anything the government has done so far, which firms might be "rescued" in the future? And if the "rescue" involves the total ruin of that firm's equity holders (and, ideally, bondholders as well), is that prospect not a better deterrent than any regulatory scheme we might concoct?

Matthew

"the government may well make money on its actions"

This is true. At the same time, though, the government could lose more than 700 million. It all depends on the structure of these assets. Most certainly, obligations associated with them could exceed their current market value. These aren't simple contracts like taking a long position in stock.

Additionally, we have to trust that the government can properly valuate these assets, so as not to have an immediate loss. Given that there isn't a competitive market to guide them, this is vital. If Goldman tells Paulson "This CDO is worth $1bn as evidenced by its last traded price two years ago," I hope that Paulson will at least counter with a calibrated Gaussian Copula valuation. Because if he takes a bank's word about assets' value, then taxpayers may use 700bn to buy 300bn dollars worth of rancid assets.

Daniel

Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities [...]

That isn't a problem, because the cause of the current crisis was excessive leverage -- too much debt and not enough equity. The extreme leverage was allowed by law. Presumably that will henceforth be forbidden by law now that it's obvious that such leverage places the economy at risk. So there will be no choice but to raise more equity and less debt than has been the case.

Many debtholders -- particularly holders of CMOs -- lost a lot of money. And, tellingly, the collapse in the market for commercial paper shows that buyers of the paper didn't trust it -- even though just days earlier the government effectively guaranteed the bonds of large financial institutions. A little moral hazard might have helped matters last week, but none was to be found.

But the discussion of moral hazard misses the point. Regardless of what the government does now, it is axiomatic that if the failure of private organizations/agreements can cause systemic failure, the government cannot allow those organizations/agreements to fail. Period. So it is always in the interest of organizations/agreements to become vital to the system. And it is always in the interest of the public to prevent them from doing so.

That is the function of financial regulation. But that point seems to have been lost over the last 20 years as people fixated on increasing the efficiency of financial markets (in non-crisis times). Moral hazard is the inevitable consequence of inadequate regulation.

Derek

excellent post professor. you always write in a lucid prose, so laymen folks like me can understand

Jim

This is the savings and loan fiasco by a different name and the same economist was largely responsible for both, ie. Alan Greenspan. He supported the deregulation of the s&ls and he reduced the interest rates to levels begging borrowers without regulations in place. The mortgage brokers then loosed their greed, the banks were just plain stupid and the investment banks were both greedy and stupid. The problem now is not the taxpayer burden as the losses will mostly be recuped through eventual asset sales but that the prevaing economic belief will be the greatest profit at the lowest cost. How about the caveat that that is OK as long as the profit benefits the society as a whole which is the only way capitalism will survive. Otherwise some convincing political moron is going to come around and convince the voters that capitalism SHOULD be dead. The givernment cannot control greed and stupidity but it can set parameters which make the exercise of those sins more difficult and less damaging.

neilehat

Some may find me somewhat callous in this response, but I find these "crises" on Wall Street and in the Financial Investment Banking world somewhat amusing. Here we have the very individuals who were most vociferous in extolling the "benefits" of deregulation and free markets, not too mention, condemning the "evils" of regulation and market controls over the last twenty five years or so in the same breath, are now crying another tune. Demanding bail-outs and regulation and an end to their ill-considered actions. Too bad we can't let them drown in the swamp of their own making.

Just one simple question, "Why didn't the government step in and save the American Industrial base"? It was and is (to a much lesser extent these days)the true basis of American Wealth. Or all real wealth for that matter.

hyokon

Thank you for the writing. I have been expecting for your views. I agree that this is not the end of capitalism. And I also worry a lot about the moral hazard. Some say the Wall Street was the symbol of global capitalism. I have always felt that the financial services sector is not representative of the free market. It does not have the look and feel of a 'typical' free market, like retail or Internet businesses. The key words that come to my mind are regulation, difficult to start as an entrepreneur, politics-influenced, moral hazard of participants, speculation opportunity created by government politics, herd instinct, etc.

Isn't the moral hazard a cause as well as a result of all this? I am just guessing, but isn't it possible for the people at large financial institutions were engaged in excessive risks because they did not act like owner-managers? An owner-manager (e.g. A CEO who owns 60% of a company) would hesitate to approve a use of a complex derivative that he does not understand himself or participate in mortgage lending if he views his firm is overly exposed.

Also, isn't it possible that the belief among market participants that "the US government will not let mortage and/or financial markets to suffer which will hurt Americans' dream of owning a home" made them biased towards taking more risks?

Third, isn't it possible that this kind of government intervention will cause financial market participants to move directionally together (bullish together and bearish together)? Because by moving together they are more likely to get government protection. If that happens, that means the financial market could become more likely to have system-wide risks.

Also, the mainstream(?) view that unless the government does something, the financial market will stop functioning ("nobody will lend money") may or may not be true. If there are lenders who view this as a great opportunity to make higher than normal profits, they will lend. It is hard to imagine there won't be any.

Lastly, it is very difficult to start a financial institution. That's true in Korea, which I am a citizen of, and I would guess it is also difficult in the US. If that's easy, I would imagine that there will be new entrants who would fill the empty space. I would be interested too.

It is pointless to complain about what happened already, but if there is one thing I would like to see happening, that is lowering entry barriers. Have entrepreneurs start new banks, IBs, and insurance companies with ease. Let them challenge the status quo.

mike harrold

Why believe that purchasing $700bb of "toxic" mortgages will ultimately be a "winner" for taxpayers?

Your hope that the Treasury will profit with TARP reminds me of Paul Wolfowitz's hope that toppling Saddam Hussein would ultimately pay for itself (by way of lower oil prices, more democratic regimes in the Middle East, etc.).

If the problem is declining creditworthiness due to overvalued real estate collateral, why believe that the Treasury's TARP will stabilize or reverse the downward trend of the underlying real estate collateral value, especially given that its ascent was due to one-time factors such as:

1) Greenspan keeping interest rates too low for too long.

2) the mortgage origination & securitization industry enabling dodgy borrowers access to credit.

Eliminating the least credit-worthy borrowers from the pool of potential homebuyers means reduced future demand for housing.

With less demand, the asset's price should continue to fall.

Since TARP will raise the federal debt as a percent of GDP, the price of credit default swaps (CDS) on UST-bonds is likely to rise.

Such an uptick is worrisome since it will precede a "run" on the dollar and other negative externalities.

mike harrold

Why believe that purchasing $700bb of "toxic" mortgages will ultimately be a "winner" for taxpayers?

Your hope that the Treasury will profit with TARP reminds me of Paul Wolfowitz's hope that toppling Saddam Hussein would ultimately pay for itself (by way of lower oil prices, etc.).

If the problem is declining creditworthiness due to overvalued real estate collateral, why believe that the Treasury's TARP will stabilize or reverse the downward trend of the underlying real estate collateral value, especially given that its ascent was due to one-time factors such as:

1) Greenspan keeping interest rates too low for too long.

2) the mortgage origination & securitization industry enabling dodgy borrowers access to credit.

Eliminating the least credit-worthy borrowers from the pool of potential homebuyers means a reduced number of bidders for housing.

With less demand, the asset's price should continue to fall.

Since TARP will raise the federal debt as a percent of GDP, the price of credit default swaps (CDS) on UST-bonds is likely to rise.

Such an uptick is worrisome since it will precede a "run" on the dollar and other negative externalities.

Chris Graves

Let me ask some questions that might be needed to ferret out some unjustified assumptions in Professor Becker and Judge Posner's comments.

1. Why is heading off a major depression justified at all costs?

2. Are there any benefits from a major depression, socially as well as economically?

3. Did Federal Reserve monetary policy (mis)signal investors that there were sufficient savings to finance the expansion of credit over the past twenty years or so?

4. Did governmental policy to outlaw racially discriminatory policy in lending (so-called “red-lining”) create market distortions in the credit market coupled with an active policy at Freddie Mac and Fannie May to lend to those who could not afford to pay home loans in the private credit market?

5. A related possible problem to the ones raised in Question 4 is what role did the 1977 Community Reinvestment Act (CRA) play in this overinvestment in low income housing? What role did community organizers such as ACORN play in this process?

6. Could the combination of concerns raised in Questions 3, 4, & 5 create a huge malinvestment in real estate over the past twenty years or more?

7. Could the expectation of a bailout blind Boards of Directors to foolishly agree to terms with CEO’s that protected the CEO’s against downturns in the fortunes of the company or the market as they provided incentives for high short-run performance?

8. Since much of the distortions in the financial markets came from packaging highly risky loans to people unlikely to be able to repay them if interest rates increased with a host of other sounder investments in order to deceive the buyers, would more personal face-to-face ways of buying and selling make such unethical selling less likely? Has the fact that capitalism as it has become unmoored from personal relationships with those whom one is likely to consider at least a person and engage in business with again loosened a constraint on exploitive behavior?

9. Given Robert Axelrod’s analysis of cooperative behavior being fostered by the ability to retaliate against people one consistently interacts with over time, how can global capitalism that trades on transience and impersonal exchanges promote mutually beneficial cooperation in markets?

10. Why does the Swiss banking system rarely have a bank failure or a credit crisis? Could it have to do with their more tranquil social order, which is similar to the Jeffersonian vision in the U.S.?

11. As people move into banking (or any field) only to make money instead of taking up a profession as a calling, has such a move interfered with the development of a special expertise in the field so that the players are less likely to intuitively sense long-term prospects for investment strategies? Consider here Hubert Dreyfus’ work on expert knowledge where an emotional attachment to the skill being exhibited must occur if the person is to advance past the intermediate level to the expert skill level.

Dan

I would echo Chris Graves' sentiment in his question #8 above. The baby is in some filthy bathwater, with rumblings of widespread fraud -- or at the very least a staggering lack of due diligence on the part of investment banks in mortgage packaging.

The secondary market was flooded with paper whose value was greatly inflated, whether by reason of fraud or monumental failure to properly assess risk.

I think the concern should be for the market's susceptibility to manipulation and/or distortion. Marx said capitalism's excesses would be its undoing, but nothing in the capitalist model endorses outright fraud or quasi-fraud through extreme lack of transparency in publicly traded securities.

Tom Grey

It's way past the time to pass a big clawback tax on "windfall incompetence bonuses" -- those undeserved million dollar bonuses (or severance packages).
The US President makes what, some $200 000/year.

If a company needs gov't bailout money, its leaders making more than that are 'obviously' overpaid. Past bonuses (over the last 5 years?) should be subject to very high "incompetent profit taxes", up to 90% on amounts over $2 mil (10*President salary).

The top decision makers at the big companies need to have the fear of Personal Wealth Reduction to become more prudent.

Too bad letting Fannie Mae fail, go bankrupt, and having shareholder lawsuits galore against all of its leaders and auditors would be too expensive for the real economy. I'm glad Lehman Brothers went belly up, Bear Stearns should probably have been allowed to try Chapter 11, too-- and more court ordered debt to equity clearances...

I'm enraged at top CEOs not taking more protective measures over the last year. I don't think I'm alone. And yes, if the Big Boys become 'too cautious', that will allow more room for real risk takers to offer new, better, but untested financial instruments -- and not be 'too big to fail'.

Handmaiden to the Translational Biomedical Sciences

It's so cute the way you write about "Stanley Morgan" and "Bears Stern," you ol' absent-minded professor, you. BTW, there actually was an excellent NFL wide receiver named Stanley Morgan in the 1980s.

Bharat

Excellent and thought provoking articles by both Becker and Posner. I have also read the following article by Prof. Rajan with great interest:
http://www.ft.com/cms/s/0/13a60574-862b-11dd-959e-0000779fd18c.html

A few comments:
- The moral hazard issue is adequately stated in the post and comments
- The taking over of these bad assets and the eventual calculation of losses/gains associated with them do not answer why the government should be in the real estate business in the first place. Philosophically speaking, the government is playing with the tax payers' money. And I disagree with that action.
- There is little reason to believe that the entire process of valuing these assets, holding them and then eventually disposing them off will be efficient in the government's hands.
- If a profit is indeed made, where will those profits go ? Will that money be spent on earmarks and pork belly projects ?
- Much has been made of a potential crisis if these (the rescued) institutions failed without adequate explanation of what exactly would happen and why that is an undesirable thing in the long run. I would rather let the system collapse, purge itself out, have the general economy bear the brunt of it and then emerge as a more prudent society.
- I am not sure that regulation approved in a rush adequately weighs out all possible outcomes and risk-weighs them. It is highly likely that unintended and negative consequences of regulations will show up several years down the road leading to more problems as yet to be defined. Solutions to financial crisis do not have to entail increasing regulation. Financial markets will largely regulate themselves if allowed to face the consequences of their actions.

bc

I believe there is a serious flaw in Bankruptcy law as well. The standard two year look-back provision is inadequate. Smart managers are gaming the system by taking out huge bonuses in real time, then backing up the long term consequences to shareholders in the end game. This is part of life in capitalism, and intentional abuse is only possible if there is fraud, but fraud should be generously defined in favor of shareholders, and any hint of it should be greatly punished.

Andrew Hamilton

How will Treasury price what it buys? Are the assets worthless? Is there moral hazard in the Treasury scheme? Should Congress/Treasury set CEO compensation?

It seems to me that some commentators misunderstand the nature of the Treasury proposal. Subject to correction, I believe it is quite simple. The Treasury will make a market for securities that currently are not trading. Because there is no market for these securities at the present time, they must be carried on the owning institution's books as of zero value, under the "mark to market" accounting rule.

However, the securities have some real residual value to the extent that they pay income
to securities owners based on mortgage payments by property owners.

I think the Treasury would buy these currently illiquid assets at the lowest price offered. Institutions seeking to unload them would compete with each other to sell. Meanwhile, I would anticipate that once trading begins, there will be other buyers looking for bargains. In short, the Treasury intervention would unfeeze a now frozen market. Once a market price is established for currently illiquid assets, accounting rules will permit that value to be reflected positively on balance sheets. Eventually, perhaps quite soon if a recession does not intervene,, the Treasury could stop buying this paper and begin selling off its holdings, probably at a profit.

If there is moral hazard here, I fail to see it. Some of the moral hazard underlying the current market failure was created when Freddie and Fannie were allowed to go public but also pushed to fulfill a federal government objective of increasing home ownership, with an implicit government guarantee as an incentive. Some was created by a regulatory breakdown at the state and federal levels when essentially unregulated mortgage brokers and mortgage lending institutions competed to sell subprime mortgages without any institution, private or public, performing due diligence on their products. In other words, with the exceptions noted by Professor Becker, I see the moral hazard in this crisis as a product of past actions and inactions.

I see no reasonable argument for giving Congress or the Secretary of the Treasury the power to set salaries in the private sector. I am sure that they wouldn't get it right. Not that boards always do, of course, but at least boards are responding to market signals about the value of a CEO. It seems to me that Congress has already demonstrated its inability to set physicians' salaries without distorting the incentives for engaging in different types of medical practice. Why should it be trusted when it seeks to extend its power to the financial sector? If there is reason to believe that CEOs have defreauded anyone, they should be prosecuted, of course.

Michael

Predictably the defense of global capitalism is perpetrated here. If the global economy is as resilient as argued, if the forces of market capitalism, and supply-demands from a global/geopolitical formulation are so ample, then why the need for a bailout? This is a bailout. Nothing less, but a good deal more, in fact.

Rather than echo tired old aphorisms about the indestructibility of the market, why don't we confess and say: the market failed because of greed, and, well more greed, coupled with short-term philosophies. A few speculators undoubtedly ended up well off, and a good deal of less fortunate, less financially backed individuals -- traders, marketers; the back-bone, smaller fish of a massive infrastructure, did not.

What we have is the government bailing out capitalism. The creation of an agency, which I am certain will cost towards (perhaps, upwards) of a trillion dollars, to buy failed companies is sort of like a backward socialism. I'm not even sure what to make it of, especially with a politically, ideologically conservative government driving the call for its creation. --Using taxpayer money to buy companies in a market system? To pick and choose, to in effect, be a stock-marketer, again with public resources? If we have such collective confidence in the strength of the market(s) -- and I, for one, am all for such an approach, then let's see what happens when the failures accumulate, and large corporations (which, really, should have known better) fare less than well. It might result in a leaner, tighter, more savvy market, and then again, it just might spook some old revolutionary ghosts out of the closet, and make our country a better place.

Irrespective, I think the terms of engagement in the debate have radically changed with the government's response to these failing companies, and the market economies faltering -- it is no longer illusory, or mere liberal ideology to speak of national healthcare, free university educations, or the like. In light of the substantial direction of public finds being invested in these companies which may, it is conceded, bring (although I highly doubt this; though, I might just live long enough to see it) revenues and returns, so too would national health care and free higher education create significantly equal, and arguably, better returns, and at an overall better cost to the market's health -- and maybe, in the end, to the development of our collective soul.

Michael

Predictably the defense of global capitalism is perpetrated here. If the global economy is as resilient as argued, if the forces of market capitalism, and supply-demands from a global/geopolitical formulation are so ample, then why the need for a bailout? This is a bailout. Nothing less, but a good deal more, in fact.

Rather than echo tired old aphorisms about the indestructibility of the market, why don't we confess and say: the market failed because of greed, and, well more greed, coupled with short-term philosophies. A few speculators undoubtedly ended up well off, and a good deal of less fortunate, less financially backed individuals -- traders, marketers; the back-bone, smaller fish of a massive infrastructure, did not.

What we have is the government bailing out capitalism. The creation of an agency, which I am certain will cost towards (perhaps, upwards) of a trillion dollars, to buy failed companies is sort of like a backward socialism. I'm not even sure what to make it of, especially with a politically, ideologically conservative government driving the call for its creation. --Using taxpayer money to buy companies in a market system? To pick and choose, to in effect, be a stock-marketer, again with public resources? If we have such collective confidence in the strength of the market(s) -- and I, for one, am all for such an approach, then let's see what happens when the failures accumulate, and large corporations (which, really, should have known better) fare less than well. It might result in a leaner, tighter, more savvy market, and then again, it just might spook some old revolutionary ghosts out of the closet, and make our country a better place.

Irrespective, I think the terms of engagement in the debate have radically changed with the government's response to these failing companies, and the market economies faltering -- it is no longer illusory, or mere liberal ideology to speak of national healthcare, free university educations, or the like. In light of the substantial direction of public finds being invested in these companies which may, it is conceded, bring (although I highly doubt this; though, I might just live long enough to see it) revenues and returns, so too would national health care and free higher education create significantly equal, and arguably, better returns, and at an overall better cost to the market's health -- and maybe, in the end, to the development of our collective soul.

Jack Okie

A few questions from the ill-informed:

Do Fannie Mae and Freddy Mac have anything resembling a board of directors?

If so, what is their exposure from the chicanery of Raines, Johnson et al? I thought after the Enron debacle the boards got some serious exposure to being asleep at the switch.

Is there any indication that these CEOs with the golden parachute have kicked back part of their bonuses to a compliant board?

PlanetRalph

My political slogan for the aftermath of this crisis is:

Any financial institution too big to fail must be too well regulated and too transparent to fail.

We now have quite a few big players that may find it advantageous to break themselves back up if we instituted enough regulations to protect tax payers against bailouts of "too big to fail" enterprises.

craig

Once a corporation throws itself upon bankruptcy court to stanch the bleeding of corporate assets, why should the court not be empowered to consider the fact of bankruptcy itself as overwhelming evidence that management bonuses could only be paid out of an intent to defraud the creditors? There would obviously have to be some kind of proration of claims against already-paid bonuses from previous years, but I don't see anything wrong with the court seizing, say, three years of bonuses retroactively.

Brian Davis

Great little pieces from both of you. I hope members of Congress are paying attention.

How much and how to finance? Those are the gut-check issues. Let's get that $700 Billion guesstimate whittled down by every means possible. If that means assessing a huge tab back to Wall St so be it. The commercial banks took such a hit in '90-'91. Congress could create a fiction like the Resolution Funding Corporation of the '89 Act and authorize it to issue "off-budget" bonds, to the public - anybody who wants to buy them, to finance working capital. That's a better approach (not to mention more constitutionally-defensible) than giving the Treasury Secy authority to write a staggering blank check.

I believe we all know what really has to happen - figure out 1) who/what actually owns/holds the legal right to foreclose the defaulted/defaulting loans and 2) how to get it done at least cost to ultimate resolution. That's tough love but anything less will cripple global confidence in our financial system and what's left of respect for our rule of law.

James Strom

Ignoring Fannie and Freddie, because that involves an examination of an additional question of possible corruption, causation for the crisis involves on the one hand pressures by the Federal government to make unsafe loans (as in the Community Reinvestment Act), aided by the Federal Reserve providing easy money, and on the other hand stringent regulation, particularly in the form of the mark-to-market rules for reporting on bank capital. One is tempted to think of this scenario as a trap set out for the banking system. Given the underlying situation it is superfluous to worry about whether the solution undermines the free market nature of the economy. Government is deeply involved in both creating and resolving the problem.

....

But of the possible solutions discussed here and elsewhere, a government purchase of troubled assets seems to be one of the least intrusive--certainly less intrusive than acquiring stock in and onership of a lot of banks. These assets can be held serenely by the Treasury and sold back into the markets as they recover value. Treasury will not trouble itself with a mark-to-market rule. Very likely the taxpayers will have a profit.

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