Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

30 September 2008

How the Dow’s Drop May Save Us

The bailout blowout and the Jewish Holidays have given us all a couple of days to think things over. One of the things we need to rethink is whether the sky is really falling and, if so, how fast.

If you look at some rough numbers, you can make yourself really afraid. The bailout plan that just fell through asked for $ 700 billion. That’s a lot of money. But I’ve read in two places that the total amount of credit default swaps now outstanding is $ 62 trillion. If only ten percent of them are irredeemably bad, then even the bailout plan that failed to pass may be too small by an order of magnitude.

On the other hand, our immediate problem is the freezing of credit. There’s not enough capital in sound enough financial institutions, we are told, to serve our economy’s needs for bank loans and “commercial paper”—the means by which business finances day-to-day operations.

But wait a minute. Isn’t commercial paper what money market funds buy and hold? Don’t they also hold huge bank certificates of deposit, which also provide money for loans? And didn’t Secretary Paulson stabilize the money-market-fund industry with a mere $ 50 billion and a new voluntary insurance scheme?

Now think a minute about yesterday’s 778-point Dow drop. According to two estimates (1 and 2), that drop reflected a loss of between $ 1.1 and 1.2 trillion in market value. But the Dow itself dropped only about 6 percent, so the people who sold out must have received about sixteen times that much in cash. (If a stock worth $ 100 drops six percent in value, and you sell it for $ 94, the cash you get is about sixteen times the drop.) So there now should be over $16 trillion of loose cash floating around the economy that, as of Sunday, had been tied up in stocks.

Where did all that money go? Stock sellers could have put it in gold bars, but they take time to purchase, are heavy and can be stolen. Sellers could have bought foreign currency or commodities, but they’re risky. A significant part of the proceeds of sale no doubt went into retirement and other tax-advantaged accounts. It takes days or weeks, and a lot of paperwork, to transfer those accounts into gold, commodities or foreign currency. So if I had to bet, I’d bet that nearly all of that $16 trillion is sitting in insured bank accounts, CDs, or money-market funds—the very things we thought we might have to rescue last week.

If this analysis is right, then the fall in the Dow might be our salvation. As frightened consumers and institutions sell stock and put the money in liquid financial instruments, banks will have more money to lend. They will also have more money to buy up weak institutions, just as Citigroup bought Wachovia yesterday. And the credit freeze will thaw.

One thing is certain. Yesterday’s drop in the Dow appears to have generated over twenty times as much free cash as Paulson is demanding from the Treasury for his entire bailout plan. Maybe markets really can help.

Both these numbers and common sense bid us all to take a deep breath. A graph of the 1929 crash shows that stocks took three years to hit bottom from their peak. As almost every expert has remarked, houses trade much more slowly than stocks. So it may take most of a decade for housing prices to hit bottom. Things may indeed get bad if nothing is done, but they probably won’t get that bad that fast, at least if infusions of new cash from a declining stock market continue.

Equally important, there are political reasons not to hurry. The bailout blowout sent a very clear message that every pollster and politician should heed: the American people do not trust their leaders.

And with good reason. We were told that we had to invade Iraq so quickly that we couldn’t wait for arms inspectors to finish their jobs, let alone for diplomacy. We were told that we had to let our Executive spy on us secretly by electronic means—that we didn’t even have time to get approval by a secret court. This Administration has lied to us at least twice, saying that the sky was falling when it was not. Now we won’t buy that line anymore, notwithstanding Secretary Paulson’s and Fed Chief Bernanke’s self-evident expertise.

Whatever public bailout plan we adopt will be risky. It will risk taxpayers losing money and adding substantially to the national debt. It will risk letting undeserving private financiers get rich. Worst of all, it will have nonzero risk of simply not working or of making things worse.

In any of these undesirable outcomes, public confidence in our government may utterly disappear. The nation may become ungovernable, as it was during the farm mortgage rebellions and labor unrest of the Great Depression. We may see real social upheaval of the type banished from our land for nearly a century.

Under these circumstances, doesn’t it make sense to wait? In 120 days, we will have a new administration and a new Congress. Fresh leaders always get a honeymoon. Unless and until they screw up as badly as this administration and this Congress has, they will enjoy the people’s confidence and hope. Doesn’t it make sense to temporize as long as possible and let the new team do the heavy lifting?

To be sure, this analysis relies heavily on where all that money from the sale of stock is going. But if it’s going where I think it is, we may have more time than we think. We at least ought to have enough time to get past the election, perhaps with some more matchmaking and individual bailouts by Paulson at Treasury.

The prospect that we now have before us is absurd. An utterly discredited and exhausted administration and an utterly discredited and exhausted Congress, in which the people have zero confidence, is trying to solve the greatest financial crisis in a century, in a few days, under the pressure of the highest-stakes election in decades. That is one of the most frightening political, social, and economic prospects that I have ever seen, and I’m in my sixties. The Dow’s drop and the free cash it produces may save us from that catastrophic managerial and political mistake, which now looks as if it might produce a catastrophic economic blunder.


There are two reasons why the Paulson bailout plan is a bad idea. First, it makes the wrong people bear the pain. The people who were stupid enough to have made loans that borrowers can’t repay, who were unscrupulous enough to package those loans as securities, who were dumb enough to buy those securities, and who were dumb enough to insure them against default should bear the pain. Second, in bearing the pain, those people—not the taxpayers or the government—should help resolve the crisis they created. If we pull their feet from the fire they will have no incentive to clean up the mess they made.

There is a just and proper solution to the mortgage crisis and the mortgage valuation dilemma. Redraw the bad loans as if they had been made prudently, and reduce the borrowers’ payments accordingly. In exchange for the lower payments, make borrowers share future home appreciation with their lenders. With payments that are then sustainable, put the borrowers back in their homes, saving people and their neighborhoods.

This plan will help stabilize home prices and real-estate values. It will also give the mortgages and the securities that bundle them the value that they should have had if their issuers had not been stupid, greedy, unscrupulous, or all three. That’s better than the value of a mortgage on an empty house in a decaying neighborhood, and it provides an upside to encourage market formation. The exposure of default insurers will be correspondingly valued.

The biggest problem with this solution is that it takes time. (Doing it all through bankruptcy court, as some Democrats have proposed, would take even more time.) But the stock-market decline and the enormous sums of free cash that it generates appear to have given us some time. If we take that time, we can do it right, force the bad loans to be redrawn according to prudent lending standards based on borrowers’ ability to pay, put people back in their homes, save our blasted neighborhoods, and, in the process, stop or retard our housing meltdown.

Paulson’s plan (and his panic) derive from the assumption that the bad paper is inextricably linked with our real economy. That may be true, but recent events suggest otherwise. Apart from AIG, which was rescued before it could sell its sound and valuable assets, the only failed firms are those on Wall Street that helped bring us this crisis. Strong financial institutions like Bank of America, JPMorgan Chase, and Citigroup have flourished by bottom fishing and are getting stronger by the minute.

It is unclear whether the financial system is nearing collapse or is simply undergoing a rapid restructuring and consolidation, albeit a somewhat chaotic one. Most of our trading partners have only a handful of great banks to serve their economies; maybe we don’t need any more. I see no evidence that financial collapse is imminent, especially with an injection of $ 16 trillion in cash from Monday’s sale of stock.


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  • At Tue Sep 30, 04:01:00 PM EDT, Blogger Shay said…

    I really like your solution. Here's hoping our lawmakers either adopt something like it now or decide to wait and let the new administration and Congress sort it out.


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