After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

President Bush, Treasury Secretary Paulson, and Congress seem to think there’s no time to hold hearings on the proposed $700-billion bailout plan to buy bad assets from victimized financial institutions. But surely they’ve all got an hour or two to answer a few questions. Here are six, in fact, each easily answerable in 10 minutes or less. How about it, guys?

One. Will this bailout plan actively delay recovery? It may discourage private vulture investors from swooping in to snap up mortgage-backed assets at “cheap” prices. Over the past few months, some buyers have come in to buy the most suspect mortgage-backed securities from institutions like Merrill Lynch at less than a quarter of their face value. Such investors have to do the difficult work of assessing the securities’ possible value and assigning the level of annual return they should demand for the risk of buying them. But the government’s intervention gives them a new task: assessing political risk. Potential investors might wonder: What will happen to the price after two years, when government support for the program ends, as the current plan stipulates? The bailout could also delay recovery if potential investors in financial institutions worry about the prospect of successful court challenges to the bailout. Would financial institutions then have to pay back any benefits they receive?

Two. Isn’t Treasury worried about the dead-weight loss to the economy that the bailout could represent? If a box of pencils is worth $3, but Congress mandates that taxpayers spend $10 each on 70 billion boxes of pencils, all of that extra money goes to waste. That money—a significant sum—could have gone toward productive investments in the economy. (And even if we get some of it back, it’s still wasted for now.) Are the decision-makers in Washington certain that the projected benefits of this plan outweigh the more certain costs?

Three. How will this plan restart the now-moribund credit markets? Secretary Paulson figures that by taking bad assets off financial institutions’ books and giving them cash equivalents instead, the government can entice them to start lending again while encouraging private investors to put new money into those institutions. But the bailout can’t change the fact that the primary infrastructure through which America has exported its private debt to the world—securitization—is now severely weakened. Nor can the bailout change the fact that many potential investors in financial institutions may now believe that these firms’ business model is broken. It will take more to fix that perception than erasing bad debt—the defining symptom of that broken business model. Lending institutions likely need time—months, maybe years—to figure out what went wrong, before private capital can replenish the banks’ coffers. Plus, lenders must reassess the credit risk behind all manner of potential borrowers, and they need to re-price that risk as well, charging some borrowers much higher rates than in the past and refusing credit to some applicants altogether. These tasks, too, will take time, and unavoidably reduce access to credit.

Four. When the Treasury prices mortgage-related assets under its program, what criteria will it use in assessing current values? Fed chief Ben Bernanke has suggested—though he hasn’t said so outright—that it would be better to price the assets at their “long-term” value, not their “fire-sale” value. But would that long-term value take into account only today’s default rates, which already put more than 9 percent of American mortgage borrowers at least a month behind on their payments? Or would Treasury’s assessment include the very real risk that many more homeowners will default on the mortgages for still-dangerously overvalued homes? If you had bought a house in the New York metro region (not just Manhattan or the outer boroughs) for $300,000 in 2000, you could have sold it in 2006 for $640,350. Can those prices possibly hold up? What could severe devaluations do to the default rate?

Five. Will the Treasury buy derivative securities like credit-default swaps under this program? Current language gives officials much discretion in the purchase of assets. But such derivatives are long-term contracts for one party to make payments to another party if, say, the value of a particular institution or security declines. If Treasury buys them, it could be on the hook for making payouts over time to the financial institutions—including hedge funds—that took the other side of those transactions. Potentially, the Treasury, in this manner, could magnify the exposure it already has to the still-imploding housing market through the government’s new guarantee of Fannie Mae and Freddie Mac debt.

Bonus Question: The proposed bailout plan means that many creditors to financial institutions would be effectively off the hook for mistakes made by the firms to which those creditors lent money. (Injecting government capital into flailing banks, which some have proposed, could carry the same risk.) But in Thursday’s FDIC-engineered failure of Washington Mutual, the nation’s sixth-largest commercial bank, uninsured creditors will suffer losses made through similar management and investor miscalculations. Why is it acceptable for WaMu creditors to suffer, but not the creditors of the institutions that will be able to sell their bad assets to the taxpayer? Aren’t we setting ourselves up for worse problems in the future, by encouraging future lenders to big financial institutions not to worry too much about the toxic assets those companies may be amassing?

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.