A Primer on Economic Crises
Part III: Bailing Out the Financial System
George H. Blackford © 2008
In September we found ourselves in the midst of a worldwide financial crisis. (Dougherty) The only thing that kept the system from imploding at time was the fact that the Bush Administration threw the problem to Congress and asked Congress to fix it. In so doing Bush asked Congress to authorize the Secretary of the Treasury, Henry Paulson, to spend $700 billion dollars to purchase the toxic assets from financial institutions. This, Bush and Paulson argued, would reassure lenders and restore their confidence in the financial system.
At this point Congress had a choice. If they did nothing the consequences were clear: A massive reorganization of the economic system would take place. Output and employment would fall, and there would be intense pressure on wages and prices to fall as well. The prices of assets would also fall as firms and financial institutions hanging on by their teeth would be forced out of existence and their assets sold off at bargain basement prices. Many otherwise sound firms and financial institutions would be driven into insolvency and taken over by stronger firms and financial institutions (those that have managed to acquire substantial holdings of cash and Treasury securities before this crisis began) at very unfavorable terms to the owners of the otherwise sound firms and institutions. In addition, the stronger institutions would be in a position to pick up at depressed prices the assets of the firms and financial institutions that fail. The end result would be widespread unemployment and hardship accompanied by massive transfers of wealth to the owners of firms and institutions that survive from the owners of firms and institutions that fail or are taken over. So what about the Bush/Paulson proposal?
This proposal hit a brick wall in Congress when it was discovered that it gave a single individual (who at the time was George W. Bush, since the Secretary of the Treasury is responsible to, and only to the President of the United States) the ability to spend $700 billion without any congressional oversight and with complete immunity from any legal consequences. The amount of money involved here is staggering and beyond the grasp of most people. If you had $700 billion to spend you would be able to give a gift of one million dollars to 700,000 of your closest friends, or a gift of 10 million dollars to 70,000 of your closest friends, or a gift of 100 million dollars to 7,000 of your closest friends, or a gift of one billion dollars to 700 of your closest friends, or a gift of 10 billion dollars to 70 of your closest friends (that’s 10,000 million dollar bills!), or a gift of 100 billion dollars to 7 of your closest friends.
The potential for misfeasance, malfeasance, favoritism, cronyism, and outright fraud and corruption was so great with this much money that even the staunchest Bush supporters decided that this was too much temptation to put in the hands of one man. In response to these concerns Congress added oversight provisions to the bill that was eventually passed into law. How effective these provisions will be remains to be seen. There are, however, other problems with this proposal.
Wealth Transfers in A Speculative Bubble
To fully appreciate the economic implications of the Bush/Paulson bailout scheme it is instructive to begin with an examination of the kinds of wealth transfers that occurred as a result of the speculative bubble in the housing market that helped to bring us to where we are today. (Andrews)
Suppose I borrowed $100,000 and purchased a house in 2004 that I lived in until today, and you did not own a house during this period of time. What effect does the housing bubble and its bursting have on the two of us as housing prices increase to the point where my house is worth, say, $200,000 by 2007 and then the bubble bursts and housing prices fall to the point where my house is again worth only $100,000 today?
The increase in the price of my house to $200,000 in 2007 made me richer in 2007 in that I owned a house that was worth $100,000 more than I paid for it. In effect, I then owned half a house that I didn’t have to pay for. At the same time, this increase in housing prices made you poorer in that it then cost you $100,000 more to buy a house like mine than it would have if housing prices had not increased. You were poorer in terms of houses by half a house. The result of this housing boom was, in effect, a transfer of wealth from you to me, that is, from those who did not own houses to those who did own houses during that period of time. (More precisely, it transferred wealth from those who held a smaller proportion of their wealth in the form of houses to those who held a larger proportion of their wealth in the form of houses.)
The result of a housing bust is a transfer of wealth in the opposite direction. As housing prices fell to the point where my house was worth $100,000 today I became poorer than I was in 2007 in that I no longer own a house that is worth $200,000. You, on the other hand, become richer in that you can now buy a house like mine for $100,000 again. I became poorer and you became richer in terms of houses by half a house. Thus, the result of the busting bubble was a transfer of wealth from me back to you, that is, from those who owned houses to those who did not own houses. (More precisely, it transferred wealth from those who held a larger proportion of their wealth in the form of houses to those who held a smaller proportion of their wealth in the form of houses.)
These wealth transfers may seem ethereal, but they are very real as anyone knows who lived through the housing boom of the seventies: Those who owned a house during that period found it very easy to sell their old house and move into a larger one because they could finance the down payment for the larger house with the equity that had accumulated in their old house due to the inflation. Those who did not own a house during that period found it very difficult to come up with the down payment for a large house and had to settle for a much smaller one.
Now let’s see what the situation would look like if I had sold my house to you in 2007 for the $200,000 it was worth at that time, paid off my bank loan, and invested my $100,000 gain in a Treasury bill or just held it in the form of cash. Now the house that I owned as its price rose from $100,000 to $200,000 you owned as its price fell from $200,000 to $100,000. How does this fall in housing prices affect wealth?
I have clearly gained by half a house as a result of the fall in the price of houses in that it now costs me half as much to repurchase my house than I sold if for. How does this fall in the price affect you? That depends on a number of things:
If you paid in cash, you are clearly a loser. You now own a house that you paid $200,000 for that is now worth only $100,000. As a result, you have lost $100,000 on this transaction and are now worth $100,000 less than you were before. The result of this housing bust is a transfer of wealth from you to me, that is, from those who own (hold a larger proportion of their wealth in) houses to those who do not own (do not hold a larger proportion of their wealth in) houses during this period of time.
How does this situation change if you had financed your purchase by borrowing from a bank? This doesn’t change my situation at all since nothing has changed for me, but what it means for you, again, depends on a number of things:
If you have a secure job and have not been the victim of a predatory lender who has talked you into a mortgage that you will not be able to afford when the interest rate resets, you still lose. You still own a house that is only worth $100,000 and you are now obligated to pay $200,000 for it. Your net worth as a result of this transaction has fallen by $100,000 and you are $100,000 poorer than you were before.
Suppose, however, you do lose your job or have been the victim of a predatory lender who talked you into a mortgage you will not be able to afford when the interest rate resets. Again, this doesn’t change my situation, but now whoever holds your mortgage (or insured your mortgage) is on the hook.
In this situation the mortgage holder can foreclose on the mortgage, force you out of your home, and resell your house for $100,000, and write off the $100,000 loss. You have lost your home, which is a horrible tragedy for you, but your wealth is unchanged (except, of course, for the loss of your down payment). You lost a house you borrowed $200,000 to purchase, but this debt has been canceled. In this situation the transfer of wealth is from the mortgage (or insurance) company to me. The mortgage (insurance) company is now $100,000 poorer than it was before, and I have still gained half a house.
What happens if you default on the mortgage and the government steps in and purchases the bad mortgage from the bank in accordance with the bailout proposal passed by Congress? The answer to this question depends on the price the government pays for the mortgage.
If the government pays the market value of the mortgage ($100,000 in our example) virtually nothing has changed in our example. You still lose your down payment, the mortgage holder or insurer still loses $100,000, and I still gain half a house. The only difference is the government now holds the mortgage it paid market value for.
This brings us to the crux of the issue at hand: What are the implications for this kind of transaction for the system as a whole?
Paying Market Value for Toxic Assets
When it comes to the financial system as a whole there is a major problem in trying to implement the asset purchase scheme in trying to bail out financial institutions. The individual mortgages are buried as collateral for Mortgage Backed Securities (MBSs) on the books of financial institutions, and it is the MBSs that are held by financial institutions. Because of the lack of transparency in creating these assets and in insuring them in a non-regulated Credit Default Swap (CDS) market no one knows status of the mortgages that make up collateral for the Mortgage Backed Securities (MBSs). This is true not only for MBSs, but for all of the Asset Backed Securities (ABSs) held by financial institutions. Hence, there is great deal of risk associated with purchasing these assets. As a result, no one is willing to purchase them except at a substantial discount below their face value. (Lindsey)
Many, if not all, financial institutions keep these assets on their books at prices above their market values. If these institutions are to sell these assets they must accept prices below the book values on their balance sheets. This means that if they sell these assets at their market values they will have to accept a loss on these assets, and in today's world this loss will make many, if not most of these institutions insolvent. Since no one is willing to purchase these assets at prices that will keep financial institutions solvent, financial institutions are unwilling to sell these assets at their market values, and there is no market for these assets. As a result, there is no market price by which to determine their values, and the actual prices the government pays can only be a guess at the market values of these assets. For the moment we will ignore this problem and just assume the government is able to pay the market price for these assets whatever that price may be.
While buying up the bad assets of financial institutions at market values does increase the liquidity of financial institutions by providing them with cash, neither the total assets as measured at market prices nor the total liabilities of these institutions are affected by this kind of transaction. As a result, neither the true value of their net worth (assets – liabilities as measured by the market) or leverage (liabilities/net worth as measured by the market) are affected by this purchase. Thus, it does nothing to reduce their leverage or to improve their solvency or to induce them lend more or for investors to invest more in banks. All it does is force insolvent banks out of business since they will no longer be able to hide the fact that they are insolvent from lenders or investors by carrying the toxic assets on their books at above market value.
This brings to the core of the problem. The financial crisis was brought into being by a speculative boom in the housing market that bid up the prices of houses to the point where housing prices are out of line with the incomes of homeowners. (Ohlemacher Kaviat) This boom was the direct result of deregulation in the financial sector that made a number of formally illegal practices legal (e.g., allowing commercial banks to become investment banks (Lipton)), a refusal to regulate hedge funds and the Credit Default Swap (CDS) market, and a failure of the government to enforce regulations that were left in place (e.g., not cracking down on predatory lending practices or enforcing capital requirement on financial institutions (Andrews)). The end result was an explosion in predatory lending practices in the housing market and a huge expansion of the financial sector that financed the toxic assets created in the process of this expansion. The result is not only that housing prices are out of line with the incomes of homeowners, and housing prices must fall; the entire financial sector of the economy is out of line with the real sector of the economy, and the size of the financial sector must fall as well. (Crises Gudmundsson Hearings)
There’s the rub, for the expansion in the financial sector was brought about primarily through a huge increase in leverage on the part of bank holding companies, investment banks, hedge funds, and other financial institutions that participated in financing the housing boom. This increase in leverage in the financial sector made it a house of cards that is threatening to collapse. As the market value of their assets fall in response to the housing bubble bursting financial institutions are being driven into insolvency as their net worth as measured by the market is being wiped out. Purchasing the toxic assets of financial institutions at their market value ($100,000 in our example) does nothing to increase asset prices or decrease liabilities, thus, does nothing to restore net worth. All it does is cause the house of cards to fall faster as insolvent banks are forced to sell off their toxic assets in the face of a collapsing housing market.
Paying Face Value for Toxic Assets
What if the government were to pay the face value for these assets ($200,000 in our example)? This would increase the net worth of financial institutions directly by restoring the total value of their assets as they exchange their toxic assets at face value for cash. It would also provide the liquidity (cash) necessary to reduce their leverage by paying off their liabilities as the financial sector contracts to get back in line with the real sector. Financial institutions would be off the hook and the entire loss in wealth, to the extent assets are purchased at their face value, would be shifted to the society as a whole.
This scheme could be utilized to provide an orderly contraction of the financial sector of the economy to bring it back into line with the real sector by concentrating on those institutions that are otherwise financially sound or have the greatest impact on the economy while allowing those that are beyond redemption to go out of existence. The added liquidity combined with the increase in real equity (as opposed to the equity created by carrying toxic assets on their books above market value) could be used to keep sound and teetering financial institutions from going under.
This also could, in principle, restore confidence in the financial sector and give financial institutions an incentive to increase their lending and give private investors an incentive to increase their investment in the financial sector, but it is highly unlikely it would do this unless the government purchased virtually all of the toxic assets out there. In principle the government could do this. The problem is this would be very expensive, especially as the developing recession worsens.
The cost would, undoubtedly, be in the trillions of dollars. Choosing this option would lead to a significant increase in the National Debt that will have to be serviced, and as the real economy goes into a significant downturn it is not at all clear how disruptive this increase in the National Debt will be to the economy and to the proper functioning of government. This increase in the National Debt could necessitate huge increases in taxes and reductions in government services that could further destabilize the real sector of the economy and hamstring the government when it comes to dealing with the economic hardships that develop as the recession worsens. (Reinhart N Klein)
In addition, this scheme provides a pure gift from the taxpayers to those institutions that are able to sell their toxic assets to the government. It is unlikely that taxpayers will stand for this solution once they grasp the size of the bill they will have to pay. After all, the government will be providing this gift, at taxpayers’ expense, to the very people whose poor judgment, recklessness, and overall incompetence are responsible for the mess we find ourselves in today, and these people are among the wealthiest people in the world. Not even the most optimistic financial institution or investor believes the government will be able to pull this off without creating a powerful backlash from the electorate as we head into a worldwide recession.
There is one other, somewhat ironic, aspect of the government paying face value for the toxic assets rather than market value that is worth noting. Suppose the government pays face value for the mortgage in our example ($200,000). Now the mortgage holder is off the hook, and the entire $100,000 loss in wealth is shifted to the society as a whole. There is now a transfer of wealth from taxpayers to people who do not own houses. In this situation it is the taxpayer that must write off the loss of $100,000 (half a house) suffered by their government either through increases in taxes or cut backs in government services.
This means my $100,000 gain is now at risk to the extent my taxes go up or I lose the government services cut as a result of the government taking this loss. (More precisely, this means the speculative gains of those who profited from the speculative bubble in the housing market are now at risk to the extent their taxes go up or they lose the government services cut as a result of the government taking the loss.)
This is not a reason to favor this option, however. In the end it boils down to who is going to pay the costs of bailing out financial institutions by paying the higher taxes and suffering the loss of government services that result from the government paying above market values for the toxic assets. Chances are, if financial institutions have the political clout necessary to receive this kind of favorable treatment from the government, they also have the political clout necessary to avoid having to pay the increased taxes or suffer the loss of government services that result.
Insurance Bailout Option
There are two other ways in which the government can intervene in this situation that were not in the original Bush/Paulson proposal but were added by Congress. The first was added by congressional Republicans, namely, instead of buying the toxic assets of financial institutions the government can insure these assets.
This option has almost the same effects as the government buying the toxic assets at face value, $200,000 in our example. It would restore equity to financial institutions indirectly by increasing the value of their assets to their face values by way of the government guarantee, but it would not provide liquidity directly to these institutions. This scheme could be utilized to provide an orderly contraction of the financial sector of the economy to bring it back into line with the real sector by concentrating on those institutions that are otherwise financially sound or have the greatest impact on the economy while allowing those beyond redemption to go out of existence. Financial institutions would be off the hook and the entire loss in wealth, to the extent assets are insured, would be shifted to the society as a whole. My $100,000 (speculative) gain would still be at risk depending on how the government losses are financed.
The extent to which it would restore confidence or give private investors an incentive to invest in these institutions would depend on the extent of the insurance. Virtually all assets would have to be insured to have these effects. As a result, the cost is still prohibitive, and it is still not clear how disruptive the resulting increase in the National Debt would be to the economy and to the proper functioning of government. In addition, we would still be providing a pure gift to those who are responsible for the mess we are in today. When the bill comes due it is still unlikely taxpayers are going to be willing to pay it graciously.
Preferred Stock Bailout Option
The second option for government intervention not in the original Bush/Paulson proposal but added by congressional Democrats is the government purchasing preferred stock from these institutions. This proposal gives the government an ownership interest in the financial institutions from which it purchases stock.
Such purchases would add to, and thereby increase the assets and liquidity of financial institutions directly by the amount of cash paid for the stock without changing the value of their liabilities. Thus, it would increase the capital (net worth) of financial institutions as well. As a result, it would address their solvency (net worth = assets – liabilities) and leverage (liabilities/net worth) problems directly.
One important difference of the preferred stock purchase option is that even though the government must put the money up front, and the taxpayer must suffer an initial loss, there is a possibility the government can recoup this loss, and possibly even make a gain. This can happen if the program is used wisely and the institutions the government invests in survive so they can repurchase the preferred stock issued to the government or if the government is able to sell this stock on the open market for what the government paid for it.
This scheme could be utilized to provide an orderly contraction of the financial sector of the economy to bring it back into line with the real sector if the government invests in the stronger banks and allows the weaker banks to go out of existence. This option makes more sense than the other options in the modified Bush/Paulson proposal in that it 1) addresses the problems of leverage and solvency directly, 2) improves the liquidity of financial institutions directly, 3) minimizes the cost to taxpayers and, hence, minimizes the impact on the National Debt and the extent of wealth transfers that result from government actions, and 4) minimizes the extent to which the people who caused the problem are rewarded, but only to the extent that the banks the government invests in did not cause the problem.
Speculative gains are still at risk to the extent taxpayers will have to bear these losses, but, as was noted above, the losses government will incur can be minimized via this scheme. There is still no reason to believe using this option will restore confidence in the financial system, however, until the process of contraction has worked itself out. The toxic assets are still on the books of the financial institutions, and so long as they are there and recorded at above market values there is little reason for investors to have confidence in the financial system.
In addition, there is no reason to believe using this option will be cheap. The financial sector is going to have to shrink. This means some banks are going to go out of business. The deposits of those banks are insured by the government. The government will incur the costs of insuring these deposits no matter what scheme is used to bail out the banks—even if no scheme is used at all—and taxpayers will have to bear these costs to the extent taxpayers are forced to bail out the FDIC. The question is not how to avoid these costs. We can’t. The question is how can we minimize these costs and, at the same time, minimize the disruption in the real sector of the economy and distribute these costs equitably.
This seems to be the option Paulson relied on most when he was Secretary of the Treasury. (NYT) Nevertheless, there are fundamental problems with this and all of the other options in the Bush/Paulson bailout proposal.
Obama's PPIP Proposal
The fundamental problem with the Bush/Paulson bailout proposal is all of its options, save the market value purchase proposal, bailout the people who caused the problems we face today. As has been indicated above, the face value purchase and insurance proposals are the most egregious in this regard and the preferred stock purchase proposal the least, but even the preferred stock purchase proposal has this effect.
In addition, the preferred stock purchase proposal leaves the toxic asset on the books of banks. No one knows what these assets are worth, and since there is no market for these assets there is no way to assign a value to them. As long as banks hold these assets no one can have confidence in the financial statements of banks—or in the institutions these financial statements pretend to describe—and the financial crisis cannot be resolved. In recognition of this fact, the Obama Administration has proposed a complicated scheme to induce private investors to participate with the government to establish a market for toxic assets.
In the Obama/Geithner/Summers Private Public Partnership Investment Program (PPIP) private investors and the government each put up 7.15% of the purchase price and FDIC finances the balance by way of a non-recourse loan. Private lenders then bid for the assets as they are offered for sale by banks, and the government and private investors share in whatever gains there may be from the assets purchased. This scheme is designed to create a market for the toxic assets by providing a subsidy to private investors by capping their downside losses at 7.15% of the total investment, thus, making it possible to get the toxic assets off the balance sheets of banks while, at the same time, establishing market prices for these assets. The government, in turn, benefits from this program by taking 50% of the profits from the toxic assets purchased.
However, given the 7 to 1 leverage it provides investors after accounting for the government’s taking half the profits, combined with the non-recourse nature of FDIC loans which limits the potential losses of investors to 7.15% of the total investment, this scheme guarantee’s investors will offer to purchase the toxic assets above their market values. (Sachs Kotok Sachs) Thus, while this scheme may succeed at getting the toxic assets off the books of banks and provides a mechanism for pricing these assets, it will do so at the cost of inflating their prices above their market prices, and that cost is going to be paid by taxpayers.
Once again, under this scheme the government will be providing a pure gift, at taxpayers’ expense, to the very people whose poor judgment, recklessness, and overall incompetence are responsible for the mess we find ourselves in today. And we are talking about a huge transfer of wealth here from the taxpayers to some of the wealthiest people in the world. Thus, the Obama/Geithner/Summers bailout plan is little better than the face value purchase option of the Bush/Paulson bailout proposal.
A Suggested Way Out
All of the schemes to deal with the financial crisis put forward by the Bush and Obama administrations, save the face value purchase option, entail transferring wealth from taxpayers to the people who got us into this mess, people who are among the wealthiest people in the world. (Johnson) All of these schemes have been put forth by people who have close ties to the banking community, and none serve the public interest. They serve only the interests of bank executives and bank stockholders.
There is, however, a very straightforward solution to this problem that would serve the public interest and minimize the costs to the taxpayer. Let the FDIC do what it was setup to do, and has been doing quite successfully for seventy odd years now, namely, send their examiners into the banks and enforce the laws on the books regarding the capital requirements of banks. Any bank that cannot meet the capital requirement it is required to meet by law—after the quality of its assets have been evaluated and it has paid back any money it has received from TARP or from the AIG bailout (CNN)—should be forced to either meet that requirement or be taken over by the FDIC and put into receivership. (Bair) If this is done the stockholders will be wiped out, and the bank executives that created this mess will be out on the street without their multimillion dollar bonuses, forced to live on the hundreds of millions they have managed to accumulate over the years while they created this mess. This is, I think, a rather small price to pay to minimize the cost to the taxpayer. (FDIC Krugman)
In doing this we may find the situation is so bad there is no capital left in the banking system—that the entire banking system is insolvent as a result of the outrageous leverage the conglomerate banks have undertaken and the poor quality of the ABSs banks hold. That would mean we will have to nationalize the entire banking system. So be it. It is better to find that out today before the Federal government is driven into bankruptcy trying to save a private banking system than when it is too late to do anything about it. It may turn out the financial institutions we thought were too big to fail were actually be too big to save without bringing down the government and the rest of the economic system with them.
It makes much more sense to preserve the government’s ability to function at the cost of a private banking system, than it does to save a private banking system at the cost of bankrupting the government.
Working with the Real Sector of the Economy
There are a number of things the government should do to mitigate the effects of the developing recession and the concomitant feedback effect on the financial sector. (Mishele) The place to begin is in the housing sector. There are innumerable mortgages in this sector on the verge of foreclosure, many of which can be salvaged if Congress acts to provide a legal mechanism whereby these mortgages can be renegotiated. (CFRL) What’s more, if this isn’t done the fall in the prices of houses will be far greater than what needs to occur to bring these prices back in line with income. If this happens the ensuing recession will become much worse than it need be.
Next, the government should begin to implement programs to deal with the impending increase in human suffering that will result from increases in unemployment and the concomitant loss in health insurance that can be expected in the near future. Unemployment insurance, the food stamp program, Medicaid, and the earned income tax credit should be expanded and interest rates, fines and fees charged by credit card companies need to be severely regulated to reduce the hardship of those who are unemployed, or who are about to become unemployed. (LAS) This should be done not only because if these things are not done the ensuing recession will become much worse than need be, but because it is the right thing to do.
In addition, public works projects should be undertaken to improve our infrastructure. Long overdue maintenance of our bridges and highways and schools should be funded and implemented along with other projects that have been planned but not yet implemented. Furthermore, the private sector should be encouraged through subsidies and tax credits to expand investment in areas that reflect national priorities such as investment in alternative energy, the environment, and technology. Again, if these things are not done the ensuing recession will become much worse than need be.
Furthermore, government loans or a preferred stock bailout option should be extended to those firms in the real sector that are otherwise financially sound, have the greatest impact on the economy, or are essential to our national priorities. It makes no sense to try to save the financial sector while letting the real sector go down the drain. In the end, the financial sector cannot survive without the real sector.
Finally, there must be a wholesale reorganization of the regulatory system in the financial sector, and the regulatory system must be provided with sufficient funds to accomplish its mission. If this isn’t done history will most certainly repeat itself, as it is in fact doing today (TheHistoryBox), and it will be only a matter of time before we go through this kind of crisis again.
Most of the above suggestions were included in the economic stimulus package put forth by congressional Democrats for inclusion in the modified Bush/Paulson bailout bill. This package was blocked, however, by congressional Republicans and a threatened veto by Bush. (Faler) Congress finally passed a Recovery Bill along these lines on February 13, 2009. I fear that this bill is woefully inadequate. (Krugman)
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