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Sunday, July 12, 2009

A World Without TARP: A Thought Experiment II

Jeffrey Miron has an excellent piece on this subject that I also recommend reading.

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Most people think we started stimuli and bailouts back in September with TARP. I go back even further. I go back to May of last year when the government bailed out Bear Stearns. Bear Stearns was days away from filing for bankruptcy when the Federal Reserve, in one weekend, stepped in and brokered a deal in which JP Morgan Chase would buy them out. Such a deal would normally take months to work out. Yet, this was worked out all in one weekend. You could say, as Michael Corleone would say, the Federal Reserve gave each an offer they couldn't refuse. Since Bear Stearns was on the verge of collapse, they had no room for bargain. The mere fact they would get bought out was good enough. As for JP Morgan Chase, the Federal Reserve sweetened the deal so much that they simply couldn't refuse. In other words, the Federal Reserve structured the deal so that it was so undervalued that Chase had to accept. They even backed it up with loans and equity.

When I first heard about this, I was shocked. Here was our central banker also acting as rainmaker, investment banker, and debt backer. This appeared to me to be a massive usurption of power. The story got its due of publicity but not nearly enough. Furthermore, while most business folks acknoweldged the troubling aspects of the Fed's power grab, they also justified it by saying the financial system would collapse without this deal. (Doesn't that sound familiar) No one, at the time, seemed to ask what sort of a system we had that one company, Bear Stearns, could bring it down. Of course, only months later Lehman Brothers failed and the system came down anyway.

I bring this up because the Bear Stearns fiasco was about thirteen months ago. Yet, things haven't gotten better but worse. Those that defend the bailouts clam, as the president did, that our financial system has come back from the brink. What exactly does this mean?

After all, lending has only tightened since Bear Streans, Lehman, and TARP. We've spent more than a trillion dollars to prop up the financial system and it's harder today to get a loan than it was before we spent all this money. Commercial mortgage lending is nearly non existent. Meanwhile, residential lending continues to get more and more difficult. In the months since TARP, Lehman, and Bear Stearns, things have only gotten worse in the credit markets.

When folks that defend the bailouts say we have come back from the brink, what they really mean is that things have gotten slowly worse since then. That's sort of like a .400 hitter who suddenly starts hitting .200. Then, you tell people that you brought him back from the brink because he's now only hitting .195.

Sure the financial companies are healthier. Of course, they are. We pumped two trillion dollars into the system. The Federal Reserve let's them borrowe for free (through a fed funds rate that is currently at ZERO). Of course, they've gotten healthier. We've spent trillions to make that happen. The problem is that their health hasn't filtered into the rest of the economy. Sure, their investment banking operations are making money. Sure, they make more margins on their own loans. (since they borrow for free) None of it makes its way into the rest of the system. So, when the feds say we brought the financial system back from the brink, what they really mean is that they made sure that bankers could continue enjoying profits. There's no evidence, however, that those profits were actually shared.

Mr. Miron makes an excellent point about the fundamental fallacy of bailouts.

By doing nothing, I mean we could have done nothing new. Existing policies were available, which means bankruptcy or, in the case of banks, Federal Deposit Insurance Corporation receivership. Some sort of orderly, temporary control of a failing institution for the purpose of either selling off the assets and liquidating them, or, preferably, zeroing out the equity holders, giving the creditors a haircut and making them the new equity holders. Similarly, a bankruptcy or receivership proceeding might sell the institution to some player in the private sector willing to own it for some price.

With that method, taxpayer funds are generally unneeded, or at least needed to a much smaller extent than with the bailout approach. In weighing bankruptcy vs. bailouts, it's useful to look at the problem from three perspectives: in terms of income distribution, long-run efficiency, and short-term efficiency.

As a nation, we set up a sophisticated system for dealing with companies that failed, banks included. Yet, those that favored trillions in bailouts would have us believe that these systems weren't equipped to deal with the failures such companies as Bear Stearns and Lehman Brothers. Why not? When Bear Stearns went under our unemployment rate was in the fives, it's now nearly ten percent. The sort of doomsday scenarios that were floated to justify its bailout are occurring. The only difference is that it took over a year to get there, whereas without it we would have gotten there much faster.

The problem with bailouts is that it subverts some very important characteristics of markets. Markets are supposed to reward the strong and punish the weak. They reward risk but punish excessive risk. None of that is happening now. The folks that didn't dip too far into sub prime and other risky mortgages are the ones that are supposed to be benefitting from the failure of all those that did. Instead, those weak companies are propped up with endless amounts of government money. The reality is that if AIG had simply been allowed to fail, someone would have stepped in to buy it for pennies on the dollar and gladly taken on their debt obligations if the price was small enough. Instead, the federal government has pumped nearly two hundred billion into a company worth $1.5 billion. How does that make sense?

The same is true for endless bailouts of troubled borrowers. Those that favor bailouts, John McCain included, would tell us that mass foreclosures hurt not only the foreclosed but those around them. After all, everyone's property value falls when there are mass foreclosures. Of course, that's only true if you sell right away. It's also only true if you are a seller at all. One third of this nation rents. All of those folks would benefit from lower real estate prices. Once again, the dynamics of markets are dismissed. Those flushed with cash now would be able to take advantage of low home prices. Instead, the government props up home prices under the misguided notion that artificially keeping them up helps all. So, borrowers that became overextended are rewarded with new better rates. Meanwhile, qualified borrowers face all sorts of new ristrictions. Just think about it. The best deals in the mortgage market right now are for loan modifications. Those can go as low as 2%.

The biggest problem with bailouts is that stops the market bottom. Markets bottom out when those that survive see opportunities and invest back in. That isn't happening either on the corporate or individual end because government intrusion is stopping those opportunities. There should be millions of homes being sold in a desperate attempt to unload foreclosures. The recipients of those deals would create the bottom. There should also be thousands of health parts of hundreds of unhealthy financial firms that would be sold right now to financial vultures looking for deals. Just think about it. If Citigroup had been allowed to fail, someone would have gotten a deal for Salomon Smith Barney. Instead, Citigroup is kept whole through about $50 billion in government money.

Here's the real problem with all of this. Despite what some may claim, there is something called an economic cycle. Economic booms are followed by economic busts. The busts bottom out but only after the excess has been removed. That's removed when those that took too much risk are punished with removal. That isn't happening and so the bottom gets dragged out longer, much longer, than it needs to be.

That's why it's important to track the beginning of these bailouts to May of last year. Had we let Bear fail, it would have created a significant but quick crater. We would have had all sorts of economic pain. Yet, our pain would now be ending and we would be starting the recovery. Not to mention that the government wouldn't have spent two trillion dollars.

5 comments:

Gail said...

None of the "solutions" worked because the problem was never correctly identified.

The real problem is the threat of socialism. The economy started having problems when Obama became a viable contender shortly after the Iowa primary. While the idiot media was pontificating on race, a non issue to about 80% of the American population, the real issue, his love of socialism started applying pressure to every weak point in the economy.

While we have been scrambling trying to address the source and causes of each weak point that sprung, the real problem, threat of socialism continues to grow with every spending action.

The question is, do we want to wait until 2010, and gamble that ACORN will not have received sufficient funds from the billions available to it in the Stimulus, Omnibus and Budget to:

1. Man up with all of the unemployed people
2. Engage in rampant voter registration fraud
3. Rig elections

To keep the liberal/socialist super-majority in both houses?

Or are we willing to act now to force Congress to repeal ALL of the spending legislation, including the budget and thereby remove the threat of socialism.

All we need to do is give the government an object lesson in NOT SPENDING. We need to engage in a consumer spending freeze.

Yes, we will suffer acutely, but briefly. All of the nations that hate us, that also depend upon our consumerism for their economies will apply the necessary pressure to the President and Congress to compel them to meet our demands.

They have already demonstrated that they do not care what we the people think or what we need or what we want. Our liberty, lives and pursuit of happiness are below their pay grade. They answer to a higher power, it is not God and it is not us. Who does that leave?

http://backyardfence.wordpress.com

Best regards,
Gail S

Anonymous said...

Wow, just wow. Gail that is the most ridiculous assertion I have ever heard. You are insinuating that the very *possibility* that Obama could become President is what caused the entire economy to collapse? Was Obama even the Democratic front runner in February?

And furthermore, if Wall Street intentionally scuttled the economy in response to an Obama *candidacy* as you claim, why are the Democrats bending over backwards to help them? A "socialist" is supposed to fix a Wall Street that wanted to see the world burn because that very same "socialist" was about to be nominated? Not elected, mind you, not even nominated, but ABOUT TO BE NOMINATED?

How can you lead when you let your hatred blind you?

I think I'll take Mike's explanation, that the economy collapsed because of too many bad loans, if that's all right with you. And even if it isn't, either.

mike volpe said...

I agree. Blaming Obama for having a terrible economy is totally ludicrous. Though, Dick Morris does believe the stock market started dropping after Obama got elected for that reason.

Also, I can't take credit for saying the economy is bad for too many bad loans. That's a fairly mainstream assertion.

Anonymous said...

Mike,

Why do you allow Gail to spam?
Would you allow a liberal to spam their website?

Her above argument shows she is slightly nutty.

mike volpe said...

I'm not sure what you mean but "spam" and certainly "nutty" however I encourage comments from everyone. Having a "nutty" comment is certainly not grounds from rejection. Swearing or name calling are the only things I try and dismiss.

If you are talking about her leaving her site at the end, I really don't care.