Friday, September 26, 2008

And this is what you want? 

Most U.S. stocks fell, dragging the Standard & Poor's 500 Index to its worst weekly retreat since February, as the government's $700 billion financial rescue plan stalled in Congress and Washington Mutual Inc. collapsed.

Wachovia Corp. tumbled as much as 31 percent and National City Corp. as much as 60 percent after a group of House Republicans said they wouldn't support the bailout as outlined by Treasury Secretary Henry Paulson and regulators deemed WaMu ``unsound.''
Source. OpinionJournal's Political Diary (subscription) is reporting that Eric Cantor and other House Republicans who have balked at the Paulson plan say "there is no way there isn't a vote" and that they have an alternative.
Essentially, the alternative being drawn up by Messrs. Cantor, Ryan and Hensarling aims to free up private capital to buy distressed securities by pushing through a series of tax and regulatory reforms, and by creating government insurance for mortgage-backed securities that are now burning holes in financial firms' balance sheets. Washington has more experience running guarantee programs, they note, than running a hedge fund (the Paulson plan). Their proposal would avoid committing hundreds of billions of taxpayer dollars to the discretion of the Treasury Department to "save" the financial system. And it doesn't turn the U.S. government into a giant (and conflicted) owner of U.S. financial institutions.
Details of the amended (by Congressional bargaining) Paulson plan (called Troubled Asset Relief Plan or TARP) are here. There are parts I don't like in that plan -- particularly the phase-in of the money and the uncertainty for financial markets that creates, as well as poison pills for banks that use the facility (you do want banks to use the facility, don't you?) -- but it's better than what Paulson sent them on Monday, and I prefer it to the GOP alternative.

Last year Willem Buiter and Anne Sibert argued that the central bank should take on a more modern role as a market maker of last resort. The Fed has the power to deal in a crisis with a large variety of companies in whatever type of securities it wishes (under the Federal Reserve Act of 1913.) Its decision to work only in Treasury or agency securities, and then only maturities under a year, is the result of agreements and custom. Over the last year the Fed has adopted more of a role as MMLR by allowing banks and some other financial houses to deal in other assets, including some mortgage-backed securities (MBS). The Fed's portfolio, however, now has a lot of this other paper on it, to the point where it may run out of Treasury securities with which it can conduct open market operations. In other words, they may run out of bullets.

TARP would have Treasury working as MMLR for the more illiquid assets. Buiter argues separately that this is no function for the Fed; the Treasury, and therefore the taxpayer, has to bear the credit risk. It is this risk that House GOPers are fighting. Given that there aren't a thousand Warren Buffetts in the world, and that foreign sources are probably not forthcoming (and may not be politically palatable to some), it can cure the banks' insolvency problem with either forced debt-to-equity swaps for banks and their creditors, or by having government purchase preferred stock. The amended TARP has such a provision -- while Buiter would rather see those two items separated, and I would too, the forced provision of warrants to government and government's exercise of them might get it done. Neither of these options will appeal to conservatives, but banks need capital, not just liquidity.

Why do they need capital? Because, as Ed Morrissey pointed out yesterday, they have been incentivized by our regulatory and tax systems, on which many of us profited:
When prices fell, an entire class of overextended borrowers could no longer refinance their ARMs to get affordable mortgage payments, and they began to default. As I wrote earlier, it was similar to the margin calls in 1929, only in slower motion. The bottom fell out of the housing market, and thanks to the massive sale over the previous decade of MBSs based on marginal loans, the collapse didn�t just get limited to the lenders or the borrowers, but investors around the world.

I�ve written this a couple of times, but this LA Times article from 1999 makes the case clearly � and maybe even more credibly, since it praises all of the stupidity and government intervention that created the bubble and the collapse. Clearly, this was not the fault of a free market out of control. Congress and the executive created this problem by extorting banks into poorly-considered lending practices under the threat of prosecution as �unfair lenders�. They compounded that extortion with an artificial mechanism to incentivize lenders by having GSEs buy the paper and resell it, with government imprimatur as its guarantee.

Normally, I�d say let the lenders drown. Unfortunately, this isn�t completely their fault, and we should have known better. Not too many of us complained about the rapid escalation of our own equity that came from this housing/lending bubble, and in the end most of us will still benefit from it, if not quite as much as it seemed a year ago. Three years ago, Alan Greenspan tried to get Congress to act, and only John McCain, Chuck Hagel, John Sununu, and Elizabeth Dole responded � while politicians of both parties made sure to keep the Ponzi scheme in full swing. And those MBSs were minted at the behest of Congress, the people�s branch of government. We broke it, and we own it.

Who will be the politician that says the hard truth of that italicized line? Between now and Election Day, don't hold your breath.

Unfortunately, the government guarantee program offered by the House GOPers is no more helpful than the Paulson plan at solving this mess, and it does not help provide relief for the Fed as a MMLR. TARP at least takes care of one of these. We might have time to deal with recapitalization later, but not as much time as you think.

P.S. Tim Duy is very wise:
My hope is that a bailout is coming. But it will not change the path the economy is already on, it will only prevent activity from shifting to a new, less desirable path. I don�t quite see how the billions of dollars plowed into this program will be funneled to households. I see instead it will only cushion the process of deleveraging, and thus minimize the quantity of resources stripped from the economy. This is important and necessary, but will not provide a miracle cure for the economy�s travails.
It's that or Mellon. Congress chooses this weekend.

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