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Why I Oppose the Bailout
Posted by: Dale Franks on Sunday, September 28, 2008

There are a number of reasons to oppose the bailout. Here are my top ones.

It isn't necessary.
As University of Chicago economist Casey Mulligan points out, if there is no bailout, it's Wall Street, not Main Street that will take the brunt of the punishment. This isn't 1929, folks, and the non-financial sector of the economy seems to be doing fine. Why?
In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it...

Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929...

The weak correlation between asset prices and non-financial sector performance and the strong profitability of today’s non-financial capital are two good reasons to scoff at the idea that the non-financial sector will collapse because of the recent events on Wall Street, and even better reasons to scoff at the Bernanke-Paulson-Bush idea that a massive bailout of financial firms is the key to avoiding a non-financial collapse. Wall Street’s woes are and will be largely limited to Wall Street. The Bush administration should not use the power of the IRS to force the rest of us to board Wall Street’s sinking ship.
Which brings us to reason #2.

The bailout will force us all to sign on as crewmembers of Wall Street's sinking ship.
The bailout gives SecTreas the authority to arbitrarily decide what the value of the mortgage-backed securities are. We know it isn't face value, but it certainly isn't zero. What the Treasury will do, of course, is err on the side of caution, arbitrarily giving those securities a value higher than they are actually worth. But, whatever money the Treasury pours into the MBS market is brand spanking new money. It's no different than if the Fed pumped $700 bil in cash into the economy buy buying 1-year notes from every Federal bank in the country. Such a massive increase in the money supply is wildly inflationary.

That gives rise to two problems.

First, we're intentionally inflating the money supply, which will further crush the dollar in the FOREX markets. It will expose foreign holders of government and commercial paper to increased exchange rate (currency) risk that may very well force them to sell off that paper. If they do, the glut of bond sales will cause bond prices to fall, and yields, i.e., interest rates, to rise sharply. It won't matter if the Fed lowers the Discount Rate to 0% and opens the Fed Funds window as wide as it can go. Sales of commercial and government paper can still force interest rates through the roof. The high price of money will stifle credit demand all across the economy, slowing GDP growth substantially.

Oh, and let's not forget that we import a lot of stuff. If the dollar collapses in the FOREX, all that stuff will be a lot more expensive. And since oil is denominated in dollars worldwide, well, a collapse in the dollar means that the price of oil will be going nowhere but up.

Second, even if the above wasn't true, the increase in inflation would inevitably require the Fed to ratchet up interest rates in order to get inflation back under Control. We'd be right back in 1981-82 territory again, which, for those of you who don't remember, meant 18% mortgage rates, and 11% unemployment.

Either way, the plan transmits the problems of Wall Street directly to the economy as whole. Right now, the 94% of the economy that isn't part of the financial sector is doing fairly well, and can probably weather a shock to the financial sector. This plan makes the non-financial sector pay for the financial sector's woes, penalizing everyone, not just the 4% of the economy that makes up the financial sector.

It doesn't avoid the pain.
The Congressional leaders are making the case that this will prevent the pain caused by the credit crisis. It doesn't. The Bad Things have already happened, and the pain is inevitable. We are, as Bruce said in the podcast today, now in the pain management business.

The only question now is who feels the pain. And, as my previous point indicates, the Government is on the verge of spreading that pain around, and we may all feel it sharply.

The Japanese government attempted something similar back in 1990 or so, when the horrendously inflated real estate market in Japan collapsed. Banks ended up carrying mountains of bad mortgage paper, and Japanese accounting rules allowed them to hide those non-performing loans, because they had an excessively generous definition of "performing". If a guy sent in ¥5 per month on a ¥3.5 million loan for a condo in Tokyo, that loan was "performing".

Bad accounting rules, that.

And they did something very similar to what the Congress is attempting today. The end result was that rather than letting the banks fail, then making the depositors whole, they poured cash into the banks, and created 15 years of sub-par economic performance.

Similarly, today, someone is going to feel the pain. The only question is who feels it. Right now, it looks like the answer to who feels the pain is, thanks to the government, "All of us."

I don't think I'm gonna like that answer any more than the Japanese did in the '90s.

It props up the guys who are the biggest problem children.
Banks that made bad mortgage choices get a buttload of money for their bad MBS paper. Banks that charted a more reasonable course—and yes, there are quite a few—get no reward.

In a real free market, of course, the banks that made bad decision would have to take the hit. They'd auction them off at whatever price the market would bear, and they'd have to suck up the losses on the difference between face value and sale value, even if that meant driving them out of business. Meanwhile, the more rational banks would be able to pick up the MBS paper at a discount, and make some cash off of the distress sale from the incompetent banks.

And, of course, the incompetent banks would probably be driven out of business. Which, after all, is how it is supposed to work. But, the government seems entirely uninterested in letting the market work this out, which brings me to my next point.

The market actually works.
Everybody in Washington is running around like Chicken Little, screaming "The sky is falling!" Nobody's even trying to take a look at how to let the markets work this out.

I keep hearing over and over again—and I've even said it—that no one knows what these mortgage backed securities are worth. But let's be clear here: the reason we don't isn't because the price is mystifyingly unknowable. It's because they haven't even tried to sell them off yet. We already know it's possible to find out what the price is, simply by offering them up for sale. Indeed, we did it in July when Merril Lynch sold off its entire MBS portfolio.

The reason we're not doing it now is because the holders of MBS paper expect a government bailout, and they expect to receive through it a price significantly higher than they would in the secondary market. If it were otherwise, they'd already be auctioning them off.

After all, we're talking about securities based on the value of mortgage repayments. We already know that the default rate on most of the MBS paper will be around 5%, with a maximum of probably no more than 10%. Everybody already knows this. Now, just to turn the screw, a buyer might want a discount of over—perhaps well over—50%. after all, it's a fire sale, and everybody wants a bargain, right.

But there is a market-clearing price for these securities, and everybody on the street knows it. What they also know is that they have an excellent chance of receiving a much better price from the Feds, and that waiting for the bailout gives them a better chance to stay in business, even if the Treasury is a large shareholder in the company. And, after all, if the Treasury is a shareholder, how likely is it that the government will let them fail, losing all that equity?

The bailout doesn't solve the problem. It keeps the bad banks in business, lets them escape the worst consequences of their malfeasance, and prevents the better run banks from taking up the reins that would be otherwise dropped when the bad banks went out of business.

Which is kind of the next problem I have with the bailout, which is...

This isn't "reform" in any meaningful way at all.
Everyone is shrieking about how the root cause of all this is a "failure of deregulation". Well, it's only partly true that there was a failure of deregulation. There was a failure, such as relaxing the leverage ratios of the investment banks from 12:1 to 30:1. That was simply a bad idea.

But let's be clear about one thing: The root cause of all this is that the Federal Government urged—and then mandated—that bank loan portfolios included an increasing number of loans to politically favored groups, more or less irrespective of the loan recipient's creditworthiness or ability to pay.

This is not a Democratic or Republican thing. It's gone on for thirty years, through both Republican and Democratic presidencies, and through both Democratic and Republican Congressional majorities.

In doing so, the government set up perverse incentives. Failure to provide loans to politically favored groups resulted in stiff regulatory action and fines. Ah, but comply with the mandates, and write bad loans, and if things got tough, there was Freddie and Fanny, who were keen to buy those bad loans off you.

Well, people respond to incentives, and so the banks responded to the incentives the government provided. They wrote bad loans, to avoid trouble with the regulators, and secure in the knowledge that Fannie and Freddy would take up the slack if things went south.

So we're in the middle of this crisis because the Government of the United States created the incentives that caused it.

And with all this current talk of making the bad actors pay for their sins, you'll notice that no one is talking about changing the government's policies that caused this. It's never the government's fault, apparently. They only create the incentives. And hold a gun to the banks head to comply with them. But they don't actually, you know, sign the mortgage papers, so they're in the clear. They can just point at the bankers and say, "It's the greedy capitalists, man!"

Ownership warrants are death to capitalism
No way. No how. Once you open the door to government ownership of private firms, you can toss the free market right out the window.

The whole idea of government ownership of private firms is, in my view, blatantly unconstitutional. But, beyond that there is no chance at all that the government will resist the temptation to override rational business decisions with decisions made on the basis of some nebulous social or political goal.

And the government is one shareholder you can't afford to upset. Unlike other shareholders, the government doesn't have to sell the shares in your company if they don't like the way you run it. it can simply send in men with guns to chasten you if you don't give in to its demands. And don't for a second think the government won't do it if they want something bad enough.

Shareholder value will go right out the window if government ownership becomes widespread, and investment will simply dry up. I can think of no better way to make Hong Kong the financial center of the world overnight than government ownership of private firms.


So, where does that leave us?

Well, a bailout just isn't the way to go. Aside from the panicky declarations from Secretary Paulson—the former number one at Goldman Sachs, a company which was one of the bad players in our little drama—I see no real evidence that the non-financial economy is in serious trouble. But the bailout threatens to bring Wall Street's troubles to Main Street. So what, then, do we do?

Clear the market.
Call up the banks and tell them, "Start holding MBS auctions, boys. Take what you can get, and hope it's enough." Let the banks and other institutions that didn't go too far out on a limb buy the securities, and make some money off of them. Let's find out what the market clearing price for this MBS paper is.

Protect the depositors
Ramp up the FDIC, and give them lots of cash to ensure that the depositors in the banks that will inevitably fail are made whole. In fact, temporarily kill the per-account deposit limit, and ensure that the depositors are made whole.

Most banks, of course, will have their deposit assets bought by commercial banks who didn't play fast and loose. Those depositors will be OK. But for the outright failures, let's ensure the depositors don't get screwed. The banks' managers and shareholders can suck wind, as they should, but the depositors are innocent bystanders here.

Coordinated central bank activity
Lest we forget, there are a number of European institutions that are at least hip deep—or neck deep—in this MBS paper, too. Some central bank money-supply expansion is going to be necessary, but there's no reason that the US should suck up the inevitable inflation all by itself. Let's get the Bank of England and the European Central Bank involved in this, too. First, US inflation hurts the Europeans, because a collapse in the dollar makes European exports far less affordable. And the price of oil hurts them, too. Let's get them involved in coordinated central bank activity, buying dollars in the FOREX, and injecting cash into their money supplies as necessary. They don't want an American financial cold to turn into a European flu, after all.

To the extent that there are inflationary implications for an increase in money supply in excess of demand, let's spread it around a bit. That way, we minimize the currency risk for US investment, and avoid a huge repatriation of money to Europe, where there are, frankly, not enough investments to cover that repatriation. They don't want to see yields crashing to zero any more than we want to see them at 25%. Let's work together here.

Re-examine the CRA
Let's face it: The Community Reinvestment Act is about as pure an example of fascism as you're likely to find. Its sole purpose is to require private firms to advance government aims. They might as well have called it the "Strength Through Joy Act".

We really need to have debate about CRA. If the government wants to ensure that non-credit-worthy people receive home loans, even if their ability to pay for them is questionable, then the government, not private-sector companies, should be footing the bill. The government should be honest about what they're really doing, and make it clear that if you can get a loan, you get one from a bank, based on your creditworthiness. If you can't then you get a loan from the government.

Let's see the government go out and convince the voters that they need to pay taxes in order to provide bad loans. So let's be honest about it. Tell the taxpayers that the government is gonna take their money, and pour it down a rathole, and then...hope for repayment. Then we'll see how that flies with the taxpayers.

The CRA essentially requires banks to write bad loans, so that they stay off the government's books. It's really nothing more than a taking of the bank's money for political—or, at least social—purposes. I think that's not only wrong, but, as we're now learning, disastrous in the right circumstances.


There are other options than a bailout. Options that don't create huge moral hazards, don't allow the government to take an ownership stake in private-sector companies, and don't threaten to make the whole economy pay for the bad acts of the financial sector.

But the bailout certainly isn't one of those options.
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Previous Comments to this Post 

Thank you for the detailed explanation. Are you going to run for office so I can vote for you?

Anyway, is it the big bad investment firms that are largely at fault or the government that held a gun at their heads to give loans to people who shouldn’t have received them. It seems that the government should take 95% of the blame. This is important in discussing whether we should let those firms die. But maybe not.

Also, I hear word that the short term credit market has pretty much dried up and that we are seeing the negative effects on small to large businesses that rely on that market regularly for short term capital. Supposedly, the short term credit market is benefited by the government bailout. Maybe there is another way. Or maybe I’m hearing bad information.

(Why is this financial stuff so complicated?)
Written By: Nuclear
URL: http://

(Why is this financial stuff so complicated?)

Same reason laws and legislation is so complicated....job security. you don’t need a lawyer to explain though shall not steal.
Written By: mac
URL: http://
Just a quibble. I think people have become attached to extremely low interest rates. So I don’t think 18% mortgages rates would be required to achieve the desired effect, at least in the short term.
Written By: jpm100
URL: http://
but the depositors are innocent bystanders here.
Perhaps i’m a horrid person, but this sounds off to me in a purely market way. If i deposit my money im being paid by th bank to keep it there. Its basically a never ending loan to the bank. Shouldn’t i choose my bank more wisely? How does the depositor come out innocent? I guess the only alternative is the mattress, this notion just seems off. But i could be wrong and ethically its a downer of a notion, and im completely on board.
Written By: josh b
URL: http://
Perhaps i’m a horrid person, but this sounds off to me in a purely market way. If i deposit my money im being paid by th bank to keep it there. Its basically a never ending loan to the bank. Shouldn’t i choose my bank more wisely? How does the depositor come out innocent? I guess the only alternative is the mattress, this notion just seems off. But i could be wrong and ethically its a downer of a notion, and im completely on board.
Since these are investment banks and not retail banks, I didn’t think this would apply. There are some retail banks in trouble. But I’m hoping thats a limited issue and not another trillion dollar bailout everyone knows about but aren’t saying.

As for the ma and pa investor, I look at my 75 year old mother (who’s more like a 65 year old healthwise) and God bless her soul she’s never been too bright for financial things. She would be so screwed if there wasn’t her sons to take care of her if it was completely caveat emptor. In fact, she would probably have her money in a matress if she considered that safer than a bank.

Which is why there is some interest in providing FDIC insurance. It encourages people to actually put money in the bank as opposed to some static investment that sits idle (like gold) or the matress.
Written By: jpm100
URL: http://

Unfortunately there are lots of banks in trouble, not just the investment banks. This isn’t, and shouldn’t be, Armageddon, and I am impressed with Dale’s good sense. I have a few twists on his plan, but basically it is what I believe as well.
Written By: Lance
I keep hearing how credit is dried up, but at the same time, I keep hearing advertisements for lending tree (dot) com. The banks compete, you win bunch. If banks are not willing to lend, they wouldn’t pay the dot com site for the referrals, and the advertisements would not air. At least, that seems to me to be true.

So perhaps credit is not as dried up as claimed.
Written By: Loren
URL: http://
I am curious why we should be extending FDIC to accounts larger than the current 100,000. (is that the number?)

If we are willing to let the companies eat some losses based on risks, so should large depositors.

(sarcasm on)

Heck, let’s get rid of FDIC altogether, THEN we will see some real capitalism!

(sarcasm off)

FDIC is designed to stop bank runs and prevent systemic risk. Sort of like this bail out plan.

So, I guess my question is whether or not we are truly seeing serious systemic risk or not. That’s where it gets dicey for me...I sure wouldn’t want to bet the farm that everything will work out fine.
Written By: Harun
URL: http://
Here is why I am against it.

I had nothing to do with the problem. I am responsible for myself and make good decisions. I did not lie about how much money I made when purchasing my first home 4 years ago. I bought a house that cost a fraction of the amount for which I was approved. I put my money down after saving for a long time. I have driven two different cars in 15 years. I don’t trade them as soon as I have equity. I have very little other debt other than my mortgage, and the little debt that I do have, I have a very low fixed rate that is not subject to changing. I have enough money in the bank to pay my bills for a long time should I or my wife become unemployed, and in our professions, that is not going to happen, even in a Depression.

After being cautious, not living beyond my means, and doing everything right, I get swallow hard and take the necessary step from the presidential candidates. F*ck them. F*ck this bailout. I am sick and godd@mn tired of being bent over and robbed by politicians.

I believe in capitalism and want to live in a country that actually practices it. Welcome to the Union of Socialist States of America.

Congratulations John McCain. You just lost the election.
Written By: Is
URL: http://
All well stated, Dale.

But there’s one over-riding issue in my view; This is a governmentally created problem. They forced this number of failures by means of governmental power. Specifically, the expansion of the CRA and by means of hiding corruption within the agency they ran that expansion through. (If there was a lack of governmental oversight, it was at F&F, where Democrat cronies walked away with millions of taxpayer money.!) …they broke it, they need to pay to get it fixed. On that basis, I support the concept of a payment, if not, perhaps, under these specific conditions.

The way I described the morality involved here, the other day is this:

Let’s imagine that someone drives a truck through your house. Thank God, nobody gets hurt, but your house is now a large pile of kindling. Would you not want the people responsible for the accident… the driver and the company he’s driving for, for example, to pay for the damages and to set things right?

This situation was caused because government misrepresented itself to the companies that failed, and forced them into bad business practices, and gave them implicit assurances that they’d be backed by the government.

The government, of course, lied. to extend the metaphor, they broke it, they should pay for it, and going forward should keep their hands the hell away from it.

Yes, unquestionably, this bailout will mean a growth of government, but given my understanding of our situation,(Indeed, they’re already doing it when they lay the blame for this current crisis at the feet of private enterprise and try to attach ACORN funding to it, for example)... I see a larger growth occurring without it, as they will without question try to deal with the repercussions of the collapse.

Understand me clearly; I’m not happy about this either. Yet, given the basic morality of ‘you broke it you fix it’ and particularly given the dire consequences we see absent such a bailout process, I fail to see a moral alternative.

The stuff that will get added on is the nature of politics, I’m afraid, at the moment. We’re going to have to deal with the financial consequences and the initial problem as separate issues. Those added items, and those misdirections need to be fought, tooth and nail, I think.

The difference to be made, here I think, is how the lesson this crisis teaches, gets absorbed into our national consciousness. I accept, very grudgingly, that the government paying to fix the problem is the only first step that can be taken. However, the lesson needs to go out that government needs to keep their hands off private enterprise… including CEO pay, including lending policy, and so on, going forward.

There is a lot of blame to be placed at the feet of both parties for our current condition; The Democrats for pushing us in this direction and the Republicans for their ‘go along to get along’ and “we’re all Americans” BS, in allowing this nonsense to get as far as it has, instead of fighting this stuff tooth and nail as they should have been. But we’re here now, and there’s nothing for it, but this, I’m afraid.

What needs to happen now, as a part of this process, is problem identification, without shrinking from what we find. Solving a problem after all, involves identification of the cause, and arranging things so it doesn’t happen again. Given our situation with the election as the backdrop, that means McCain, and the Congressional Democrats are going to have to start attacking the Democrats on their history in this thing.

Written By: Bithead
I’m against it too, just like Democracy is the WORST form of government, except for all the others, I’m against this bail out...I say let the market plunge to 9,500; let unemployment rise to 7-10%, let GDP fall 5-10% it’s all necessary and eventually libertarianism will rise to mighty about 80 years after this debacle is forgotten...

So yes sirree keep standing on them principles...We have to take our medicine, by which Dale means YOU have to take your medicine, because Dale, having done nothing wrong and painting the blood of the Pass Over Lamb on his door lintel, will see the Angel of Financial Death pass he and his by...
Written By: Joe
URL: http://
Yeah, because it couldn’t at all be that he’s against it for all the actual good sense reasons he listed, could it Joe?

There’s going to be pain because of this, there’s no getting around it - we’re just in the middle of determining how long its going to last, not how we can avoid it.

You obviously prefer chronic pain management with few lessons learned over the more brutal but short pain of letting a correction take its course and learning valuable lessons from it (as in "never again").

Interestingly, given the House vote, it appears, at least at this point, more agree with Dale than you.`
Written By: McQ

What makes you think that any of what you predict will not happen anyway?

Why is this going to actually help?

Also, who cares about the stock market? Especially considering the stock market is too high. At present levels you cannot make decent long term returns in stocks, even if the economy blows the door off. See returns since 1998.

The reason the crisis is here is not that banks are going under. We can handle that, see WAMU. No problem. It is the commercial paper markets which have freezed up. How does this plan help that? Especially in the short run?

At best this plan helps marginally at potential great long term cost. Since this plan would not have helped anything in the short run, we can now debate better ideas, and ideas which could help much faster, though I am not sanguine. Go back and read my piece on Glass Steagle. Note my comment about hoping Europe doesn’t drag us down, because they are in even worse shape. I think this weekend kind of makes that point for me. The pittance of help that under the best of circumstances this plan would have provided just got overwhelmed.

Want something even more scary, nowhere are banks worse off than in Chna, talk about a time bomb which could explode at any moment.

Our goal should have nothing to do with the stock market, nor helping institutions survive. It should be to help healthy, or at least healthier, institutions take over for the ones who have failed. These banks and institutions have far more assets than are necessary to cover for depositors and counterparties.

Stockholders may take a hit, bond holders need to as well, but counterparties and depositors can be covered by existing assets. That was true in Lehman’s case and Bear’s (though our government pretended it wasn’t in Bear’s case) it is true for all these others as well.

Government action is necessary, this isn’t the way to do it.
Written By: Lance
We really need to have debate about CRA. If the government wants to ensure that non-credit-worthy people receive home loans, even if their ability to pay for them is questionable, then the government, not private-sector companies, should be footing the bill. [...]

Let’s see the government go out and convince the voters that they need to pay taxes in order to provide bad loans. So let’s be honest about it. Tell the taxpayers that the government is gonna take their money, and pour it down a rathole, and then...hope for repayment. Then we’ll see how that flies with the taxpayers.
A central problem for all of us who oppose this bailout — and all the other wasteful and harmful outrages that government perpetrates day-in, day-out — is that so many voters are not net taxpayers. And many who do pay in to Uncle Sam more than they receive back in direct benefits are constantly trying — and voting — hard to change their status to net beneficiary.

How the idea of direct government mortgage loans to unqualified home buyers "flies with taxpayers" is unfortunately not as important as how it flies with voters. And that would depend on how many could, or thought they could, get and/or otherwise profit from one of those loans.

How long before access to government loans for home-buying became a right?

That nit picked, this is a great post.
Written By: Linda Morgan
URL: http://
This "Big" problem is why 20% down used to be the standard for buying a house.
Written By: Mark Bishop
URL: http://

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