Finance

UPDATE: below

Blogger bobn, in two comments on an unrelated post yesterday, wants me to condemn "the Paulson Bailout of Swindlers." I mostly decline the offer. Here's what I do know:

• The trigger: Subprime and low down-payment mortgages likely triggered the crisis. And that's mostly, though not totally, bad risk assessment, i.e., bad management, by lenders--and I'm not convinced that any alternative set of regulatory policies would have prevented that. (In particular, I'm mystified by McCain's critique of SEC Chair Chris Cox--the SEC being mainly designed to ensure transparency, as opposed to substantive regulation.) Still, borrowers seem to have had "a belief that central banks and governments will always rescue them if things go wrong"--a moral hazard seemingly validated by recent policy.



• The flaw: I don't know what went wrong. Many Dems, along with bobn, blame it on Gramm-Leach-Bliley and similar deregulation, a narrative that is false to the facts:

  GLB had nothing to do with either lending standards at commercial banks, or leverage ratios at broker-dealers, the two most plausible candidates for regulatory failure here.
  
  Most importantly, commercial banks are not the main problems. If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk. Instead we see the exact opposite: the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks. It is the diversified financial institutions that are riding to the rescue.

  Indeed, by allowing bank consolidation, GLB likely will speed recovery. And regulation still exists--the OCC still regulates national banks, which have lower failure rates than other financial institutions.
  
  On the other hand, I do agree with bobn that the Community Reinvestment Act isn't THE problem. Though the CRA is one of the most misguided statutes on the books--by pushing loans to low-wealth borrowers, it tends to misalign risk and interest rates--that law did not itself cause the current meltdown. Neither did mark-to-market valuation, as even the Wall Street Journal has suggested--book valuation seems totally disconnected from economics. Nor am I willing to blame high CEO salaries--which would be a purely private decision if risks were properly assessed--or short-selling, which can be beneficial.
  
  In sum, I'm not smart enough to know what, if anything, is responsible for the current crunch (I'm not even sure I understand MaxedOutMama's explanation), and what, if anything should be done to right the ship. With one exception. . .



• Good riddance, Fannie and Freddie: Given their importance to the economy--"this year they have financed four out of five mortgages"--and given the government backing implicit in their structure, the Administration was right to, in effect, guarantee the two lenders. But it should never happen again: in particular, we should never again create lenders perceived as backstopped by the Treasury.



• The free market: I'm still a fan; I still believe in the invisible hand, and the minimum necessary regulation. But the financial sector grew too large as compared with other industries:

  Lehman’s bankruptcy and AIG’s failure suggest Wall Street has too much leverage and too much capital devoted to products of questionable economic utility. The bail-outs will facilitate a deleveraging. The Fed expects AIG to repay its loan by selling off its healthy businesses, while winding down its derivatives book. Mr Paulson wants Fannie and Freddie to reduce much of their mortgage portfolios.

  Further, years of government handouts have left the American economy with a significant flaw--bloated entitlements, which can only result in an entitlements crash.



• The proposed bailout: Assisting AIG was doubly logical--whole sectors, such as airframe purchase and leasing, would have died with AIG, and the Treasury likely will profit from the bailout in the long run. But what about prospective failures? Narrowly tailored legislation is needed--but I've no idea what it should cover.
  
  The current bill would anoint the Secretary of the Treasury as a virtually unreviewable finance Czar. This is worrisome--how could I be comfortable with such authority in a Democrat Administration? More transparency and accountability is needed, and I predict will be added to the bill before passage.
  
  Still, something must be done--as even bobn admits, failure to bail "could cause a global depression." I'm not such a free market purist to be willing to risk that.

Reader suggestions welcomed.

MORE:

Gateway Pundit lists 17 times Bush tried to avert the Fannie Mae crisis and was stopped by the Democratic Congress. And Ben Stein says:

The crisis occurred (to greatly oversimplify) because the financial system allowed entities to place bets on whether or not those mortgages would ever be paid. You didn't have to own a mortgage to make the bets. These bets, called Credit Default Swaps, are complex. But in a nutshell, they allow someone to profit immensely - staggeringly - if large numbers of subprime mortgages are not paid off and go into default.

The profit can be wildly out of proportion to the real amount of defaults, because speculators can push down the price of instruments tied to the subprime mortgages far beyond what the real rates of loss have been. As I said, the profits here can be beyond imagining. (In fact, they can be so large that one might well wonder if the whole subprime fiasco was not set up just to allow speculators to profit wildly on its collapse...)

These Credit Default Swaps have been written (as insurance is written) as private contracts. There is nil government regulation of them. Who writes these policies? Banks. Investment banks. Insurance companies. They now owe the buyers of these Credit Default Swaps on junk mortgage debt trillions of dollars. It is this liability that is the bottomless pit of liability for the financial institutions of America.

(via AVI, reader Bob C.)