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

03 October 2008

The “Rescue” Act: First Impressions

[For comment on the Fed’s October 7 entry into the commercial paper market—an encouraging development—click here.]

As readers of this blog know, I’ve not been a strong supporter of the Paulson Bailout. Now that the bill has passed into law, like most Americans I want it to work. I’m even willing to call it the “rescue” law—the new euphemism for bailout.

But my realism is fighting my hope. In this brief essay, I outline the struggle and explain why I think the rescue is just the start of a long, painful, expensive and uncertain process.

Let’s begin with the positive. To the extent our current crisis is just a crisis of confidence, the new law should help. The United States is still the world’s leading financial power. Our currency is still the primary global monetary metric. Oil—the most valuable commodity on Earth—is still priced in dollars. The baton may yet pass to China or Europe, but it hasn’t passed yet. More important, the rescue involves a lot of money—more than any financial bailout in human history. All these things should send a clear signal to financial markets that the U.S. takes the crisis seriously and that a steady hand is on the tiller. That signal alone might help calm things down a bit.

The increase of FDIC insurance from $100,000 to $250,000 per account should help a lot. Bank runs set off the Great Depression, and we don’t need them to start up again. Knowing that the full faith and credit of the United States stands behind every bank account, up to $250,000, should persuade most consumers and small businesses to keep their money in the bank, where it can be used to allay the credit crisis.

Another part of the law, added by the Senate, may be equally important in the long run. That’s the extension of existing tax credits for alternative and renewable energy. As I’ve outlined in another post, wind energy is entering its exponential growth phase. Solar and biofuels are just getting started. The smartest, most prescient and most innovative investors, inventors and entrepreneurs depend on these tax credits to bring us a world in which we don’t have to spend a billion dollars every day on foreign oil. Unless we cut them, our expenses for foreign oil will exceed the entire amount allotted to the rescue every two years.

In the long run, these tax credits may have a far bigger effect on our nation’s financial health than anything the rescue can do. For now, they take the sting out of the law’s $ 150 billion worth of pork, much of which reflects sheer corruption.

That’s the good side—at least the part of the good side that sticks in my mind. What’s the downside?

Unfortunately, the crisis of confidence is not just that. Real, serious, and huge financial problems underlie it. More important, the folks whose confidence is shaken are hardly common consumers, worried that their bank account will evaporate because they overheard a rumor while drinking in a neighborhood bar. The people now withholding credit are managers of substantial financial institutions. They are used to dealing with large sums of money and dispassionately analyzing risk. Their confidence was harder to shake. Once shaken, it will be harder to restore.

To get an idea of the problem’s magnitude, you need only know a single number. The aggregate principal amount of obligations insured by so-called “credit-default swaps” is $ 62 trillion. That’s $ 62,000 billion.

Not all those obligations are bad, but a significant part of them may be. Worse yet, no one knows how many are bad and who owns the bad ones, because nobody was keeping tabs. Still worse, there is a domino effect. Lender A, which owns $ 5 billion of questionable credit-default swaps, may have sold other kinds of debt (normally untroubled) to financial institutions B, C, and D. Worried that A may not be able to pay that debt because of its unknown store of toxic assets, B, C, and D may curtail their lending and hoard cash.

No one knows how big this sort of domino effect is, because (again) no one was keeping tabs. The tangled web is completely hidden from view. But we do know the web exists because it is causing a credit-confidence crisis. Completely healthy firms are unwilling to lend money to other healthy firms in usual amounts and under usual terms because they suspect the other firms, or still others whose debt they hold, of being trapped somehow in that opaque web.

So here is Treasury Secretary Paulson’s challenge. How do you solve a problem whose magnitude is a significant part of $ 62 trillion, when domino effects may increase that number by an order of magnitude, when you only have $ 0.7 trillion to spend, and when Congress has kept you on a short leash even for that?

One approach might be to use the money to prop up failing financial firms as they begin to fail, first come, first served, until the money runs out. That’s a sure plan for failure. The money will almost certainly run out before the credit runs stop and confidence can be restored. Paulson himself apparently has already had that epiphany.

A second approach is more intelligent. Pick only essential firms to rescue; send failing banks to the FDIC; try to force private acquisitions of the other failing firms and, if you can’t, let them die. That’s what Paulson appeared to be doing with Fannie Mae and Freddie Mac (bailed out), Bear Sterns and Wachovia (bought out), and Lehman Brothers (allowed to fail). But he must have concluded that the money would still run out before the job was done, else he wouldn’t have asked for the law just passed.

There appear to be only two other rational ways to solve the problem. The first is to hit the problem at its roots, in bad mortgage loans, by revising the loans and mortgages themselves and making payments under them sustainable.

There are two problems with this solution: (1) finding and fairly revising all the bad mortgages will take time (maybe a year or two) because there are so many of them; and (2) this solution requires government-mandated revision of private contracts (even many not yet in default), which is anathema to business and conservatives.

The credit/confidence crisis might tank the economy utterly in the time needed to work through this solution. That, apparently, is what the many experts who supported the rescue act concluded. At this point, no one can assert with any confidence that they were wrong.

The second way to solve the problem is to unravel the hidden web. Maybe only a handful of firms in the web are centers of a significant number of questionable obligations. Acquire them or their assets, guarantee their debt, and you may be able to unravel the whole web of failed confidence.

There are two problems with this solution, too. First, the web is completely hidden because no one was keeping tabs. You can’t untangle it until you can see it. Second, once you can see the web, you may find that it doesn’t untangle easily. If the toxic assets and debt relationships in the web are widely and evenly distributed, then the rescue money may run out before you can restore confidence. No one knows whether this will happen—or even the risk of it happening—until we start to unmask and untangle the web.

Apparently that’s precisely what Paulson intends to do. He intends to use the government’s investigatory powers, all the experts he can hire, and his own intuition, contacts and judgment (born of a lifetime in finance), to untangle the web as quickly and cheaply as possible.

Godspeed. But unforeseeable events, such as multiple simultaneous failures or the need for more money than Congress appropriated, could derail that effort.

If that effort fails, what then? Well, the economy will start to tank, and with it the stock market. Last Monday’s 778-point Dow meltdown produced an interesting number: for every 6% drop in the Dow, the falling stock market generates about $16 trillion of free cash. In theory, a drop of 24% would generate enough free cash to cover all $ 62 trillion of the obligations underlying outstanding credit-default swaps, even if every single one of them were bad (an unlikely prospect).

If that happened, investors fleeing the stock market would seek security and safety above all. The government could corner their money by offering short-term notes with very low interest rates, as just happened last week. It could then loan the money to banks, at higher interest rates, on condition that they use it to make further loans, and not sit on it. The government could even loan money directly to business firms.

In other words, the government could use the huge hoard of free cash generated by the stock market’s collapse to take over (temporarily) the commercial paper market. It could probably even make a profit for the taxpayers. As it restored the credit markets, money would flow back into stocks, sales of T-bills would return to normal levels, and the commercial paper market could revert to the private sector. [On October 7, 2008, the Fed began to take this approach.]

Of course this approach would involve an horrendous administrative nightmare. But the government could appoint sound private banks as “agents” to act in its name and so get the credit ball rolling again.

While that effort would resolve the crisis of confidence and credit, it still wouldn’t solve the housing crisis. Homes with foreclosed mortgages would still stand empty. Homeowners hanging on to ridiculous loans by their fingernails would still face new foreclosures, the more so as they lost jobs in the downturn. Home prices would stay in free fall, neighborhoods would continue to rot, and lenders would still face the prospect of worthless collateral.

Only revising the ridiculous loans that can’t be repaid will solve these problems. So if we want to kill this monster once and for all—and not have it thrash about for a decade like Japan’s post-bubble financial Godzilla—we had better start thinking about those foreclosed and precarious mortgages.

We can put off those issues while we address the immediate credit crisis. We can’t put them off forever—especially not in a deep economic downturn that will drive a new wave of foreclosures. Only a single clause in the huge rescue law gives the government authority to undertake this process. But it’s a start.

UPDATE (10/7/08): FED ENTERS COMMERCIAL PAPER MARKET. As the New York Times reported today, the Federal Reserve Bank has entered the commercial paper market, buying short-term obligations of financial institutions and other businesses. That’s an approach I recommended above, although my verb “take over” was a bit exuberant.

This approach offers real hope for the reasons I stated: as global stock markets tank, plenty of money (far more than the rescue plan’s $700 billion) will find its way into short-term T-bills, from which the Fed can recycle it into commercial paper, alleviating the credit freeze. The sole reason for caution is that commercial paper, too, entails risk. But it’s very short-term risk, and anyway that risk is far lower than the risk of total global financial meltdown that we face if credit markets don’t thaw. So the Fed indeed looks as if it’s on the job.


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