All Hail the Fed: why to be skeptical about the priciest bailout ever

By Steven E

Worst financial crisis since the Great Depression? Yes—but don’t be cowed by talk of calamity. Disasters call for prudence and circumspection, not frenzied action. Congress, in particular, must carefully consider the downsides of any bailout plan before granting the Treasury department the unprecedented, unfettered, and certainly un-American power to nationalize private assets of dubious value with $700 billion of public money—a monumental sum that eclipses even the cost of the Iraq war. For congress, waiting a few weeks to legislate a solution does mean protracting the current crisis. But there is no reason to believe that the world economy would collapse in that time. On the other hand, it is reasonable to believe that implementing the proposed bailout plan may have long-term adverse effects on capitalism. The solution congress is about to legislate will foster corruption, increase market volatility, address the effects of a problem rather than its cause, and it sets a dangerous precedent. None of these shortcomings are being discussed by the press.

  1. It will lead to corruption.
    Laws that govern securities trading are designed to prevent malfeasance and self-dealing. These regulations don’t apply to the Treasury department because the department was never intended to transact with the private sector. Having the Treasury department bid on private securities would be a mistake. The department has no checks and balances. We’ll see cronyism in the distribution of these funds. At the same time, there will be no provisions for judicial review, public contests, or appeals. The process will be secretive, undemocratic, and anticapitalist.
  2. It will not resolve market volatility, and may increase it.
    The lack of transparency that is bound to accompany the infusion of $700 billion into the economy—more specifically, into firms that took down our economy—will rally some investors sometimes and disappoint others. The point is there will be more surprises, not fewer.
  3. It addresses the effects of problems rather than their cause.
    This bailout addresses the effects of serious problems (declining house prices; defaulting mortgages; a drying credit market) but ignores the cause of those problems (regulatory missteps).

    An approach that offers the veneer of financial security without addressing the roots of instability amounts to a formula for disaster. A sudden flurry of liquidity in the credit markets can lead to a bout of foolish borrowing by distressed corporations. Financial institutions may repeat some of their earlier mistakes.

  4. It sets a precedent. This begins with $700 billion, but who knows where it ends?

The entire country is faced with an economic catastrophe. Two men—Henry Paulson and Ben Bernanke—say the solution is to have every American lend $2000 to a secretive governmental agency. This is not our only option. We can think of others. Ask yourself this: Even if all the Bush administration’s hyperbole about financial mushroom clouds is true, even if that rhetoric weren’t suffused by the administration’s ignoble history, even if Henry Paulson and Ben Bernanke were the two most capable, trustworthy men on the planet (and yes, they are capable and trustworthy, but in a few months a new administration will take office and there may be a new treasury secretary), even if a solution were absolutely necessary to avert a full-scale depression—even if all that were the case, wouldn’t it still be preferable for congress to take time to evaluate other options? This solution may prove more dangerous than the problem.

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  • Steven:

    I am not sure I agree with you.

    The downside risk of having the credit creation process being broken is that companies go under as they can’t refinance loans coming to perpetuity. Consumer spending would collapse. This would become a lot worse.

    The S&L crisis cost a few hundred billion as well, but in the end it was all cleared. The government should liquidate all the assets it obtained little by little and fix the regulation.

  • Yeah, if credit evaporates, so does small business. But note that I am not suggesting that the credit creation process shouldn’t be fixed, I am only suggesting it should be fixed a different way. Better approaches will surely emerge. Other smart economists will propose other good solutions this week. It’s a mistake to jump with the first option.

  • Warren Buffet, as always was prescient. This is an extract from his 2002 shareholder report, pages 14-15:

    “In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives. Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

    Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives
    dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

    Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed
    acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

    One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts
    up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

    Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with
    derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is
    running.

    The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to
    control, or even monitor, the risks posed by these contracts.

    Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”