Will the bailout enacted last week do the job? The Emergency Economic Stabilization Act of 2008 1 vests in the Treasury Secretary liberal freedom to essentially run a $700 billion hedge fund. Consider the following,
- The act “establish[s] the Troubled Asset Relief Program … to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary”.
- “The Secretary may, at any time, upon terms and conditions and at a price determined by the Secretary, sell, or enter into securities loans, repurchase transactions, or other financial transactions in regard to, any troubled asset purchased.”
- Although the pricing mechanism of the marketplace is “encouraged”, it is not obligatory.
- As a concession to Republicans who originally proposed it as an alternative to the bailout, the Act includes a weak provision for the Secretary, at his discretion, to start an insurance fund for troubled assets, the premiums for which will be charged to the financial institutions who opt to participate.
- Whereas the Act includes a provision to “prevent unjust enrichment” of financial institutions, this is left to the Secretary, who hails from that industry and may have a distorted view of the term “unjust”.
Aside from the financial dimensions, this bill clearly transfers a massive amount of power to the Executive branch. It does establish the Financial Stability Oversight Board, though incomprehensibly, the membership comprises the same bunch who brought us to this point in the crisis: Federal Reserve Chairman, Treasury Secretary, Director of the Federal Housing Finance Agency (the conservator of Freddie Mac and Fannie Mae), the SEC Chairman, and the Secretary of Housing and Urban Development. This is the equivalent of allowing the top poker players in Vegas to form the Gambling Commission.
In return for purchasing troubled assets, the Secretary will receive warrants on non-voting common stock or preferred stock or debt, depending on the type of financial institution involved. Thus, Congress has precipitously institutionalized government ownership of companies that began with the nationalization of Freddie and Fannie. The alternative might have been to take options on a portion of future bank income without a transfer of ownership.
The money for the program will come from the sale of government securities and the total debt of the United States is increased by $1 trillion to $11.3 trillion. $1 trillion is more than the GDP of all but 12 countries2. However, after five years, the President may submit legislation that recoups from the financial industry an amount equal to any shortfall in the program in order to ensure that it “does not add to the deficit or national debt.” If that liability hangs over the banks’ heads, is this then an effective and necessary bailout?
One salutary provision is the emergency authority given the SEC to suspend mark-to-market accounting. William Isaac, chairman of the FDIC, 1981-1985 calls mark-to-market “the biggest culprit” of the crisis saying it makes no sense to "mark the assets to market even though there is no meaningful market." 3 The resulting depreciated value of the assets forces banks to cover capital requirements with increased borrowing, which puts further pressure on them and the financial system. Even before passage of this bill, the SEC finally relaxed these accounting rules 4.
The much touted increase in FDIC insurance to $250,000 from $100,000, designed to build confidence in the banking system, expires at the end of 2009. It may thus not have the intended effect because of depositors’ expectations of that expiration.
The Act includes many other provisions not having to do with the financial crisis directly—energy, taxes, and the usual Congressional pork (my favorite is a break for manufacturers of wooden toy arrows).
Let’s analyze the funds flow and the possible effect on the economy:
a) Money is drawn from US economy or from overseas creditors through the sale of government securities. This temporarily contracts money supply and increases US debt, a dangerous thing in a recession.
b) Money is drawn from the banks if they participate in the insurance fund, precisely when they need it most.
c) Funds from (a) are diverted into the ‘toxic assets’ no other investor would buy.
d) Premiums from (b) are placed in a fund to insure assets no one else will insure.
e) In exchange for these operations, the government (taxpayer) gets warrants in companies in which few others are investing.
There must be a better way.
Anna Schwartz, an economist at National Bureau of Economic Research, wrote a paper in 1992 whose underlying message is still valid: “Discount window accommodation [by the Fed] to insolvent institutions, whether banks or nonbanks, misallocates resources.”
And she was talking about lending, not wholesale acquisition of bad assets in return for government ownership. In our haste to react, have we forgotten basic economic principles?
1- H.R. 1424, Division A, http://online.wsj.com/public/resources/documents/senatebillAYO08C32_xml.pdf
2- International Monetary Fund, World Bank, CIA World FactBook
3- Isaac, William: “How To Save The Financial System”, The Wall Street Journal , 19 September 2008. http://online.wsj.com/article/SB122178603685354943.html
4- John, David C. Gattuso, James L. Gattuso: “ SEC Makes Mark-to-Market Accounting Markedly Better ”, The Heritage Foundation, http://www.heritage.org/Research/Economy/wm2095.cfm
5- Schwartz, Anna J.: “The Misuse of the Fed’s Discount Window”