Here’s the two-bit tour of the current financial crisis: In an attempt to cure the woes that led to the Great Depression, the banking industry was regulated. These regulations were designed to rein in unchecked greed from running us, lemming-like, off a financial precipice. Over the past thirty years, the Republican philosophy of de-regulation — championed by conservative leaders like Reagan, Bush, and McCain — systematically dismantled these protections. The warning flags were raised with the S&L crisis in the late ’80s (which included significant scandals including George W. Bush’s brother and John McCain himself). But, after the S&L bailout was paid, these warning signs were largely ignored and the Republicans continued on their de-regulating crusade.
Which brings us to today. With a significantly deregulated mortgage market, lenders issued riskier and riskier mortgages in the pursuit of more and more money. And because the banking industry had been deregulated, they were able to package these risky mortgages into unregulated securities… which could be sold to give them more money to make even riskier mortgages. In many ways it resembled a pyramid scheme and eventually, like all pyramid schemes, it collapsed as the risky mortgages started failing.
Today the value of these securities has completely flat-lined. They’re worthless paper because nobody has any confidence in the value of the risky mortgages on which they’re based. But our entire deregulated financial system is so heavily invested in these worthless mortgages as a result of the unregulated securities they were packaged into that the entire system is in danger of eminent collapse.
(Warning: The previous paragraphs contains gross over-simplification of a complex issue.)
So, enter the bailout: The government will buy up these bad mortgages (although no one is sure exactly what they’re worth), which will hopefully save the financial institutions which foolishly invested in them. If you think of the bad mortgages as a thug with his foot on the windpipe of the financial institutions, we’re grabbing the thug and giving the financial institutions a chance to get back on their feet.
But there’s a problem with this analogy: There is no thug and no innocent victim here. The financial institutions we’re trying to help get back on their feet were the ones putting their feet on their own windpipes.
What’s needed here is not a rescue. It’s an intervention.
Here’s a better analogy: Our financial institutions are cutters. They like to hurt themselves. It’s not really their fault. It’s just that, collectively, they’re incapable of controlling their own greed. We need to get them help. And an important part of that help will be putting them in a straitjacket so that they can’t keep hurting themselves.
The name of that straitjacket? Regulation.
And this is my primary objection to the Bush bailout plan: It throws money at a symptom without actually curing the disease. The fact that the symptom itself (the dead weight of these sub-prime mortgage securities) is bad enough that it needs to be addressed doesn’t mean we should be ignoring the disease. And that means that part of this bailout needs to be a re-institution of the post-Depression regulations that were put in place to stop exactly this kind of disaster from happening again.
But there’s also another problem to be addressed here: The bad mortgages.
The bailout is designed to buy up those bad mortgages, wave a magic wand over them, and make them disappear. (This looks like another analogy, but it isn’t. The Treasury Department really has no idea what they’re going to do with these mortgages once they buy them.)
But, again, that’s just a crude attempt at treating the symptom. The problem is that these are bad mortgages. Just transferring ownership to the public isn’t going to change that fact.
So why are these bad mortgages? Because (a) the people who borrowed money under these mortgages are likely to default on their payments and (b) the value of the property itself has been devalued so that foreclosure won’t recoup the lender’s investment.
And why are these people likely to default on their payments? It’s not as if anyone wakes up one day and says, “You know what would be fun? Getting foreclosed and ruining my credit!”
Well, there are two primary reasons:
(1) They have lost the income that allowed them to make the payments on the mortgage. (They may have lost their job or the other costs of living may have risen to a point where they can no longer afford the payments.)
(2) The size of the payment has increased to the point where they can no longer afford the payment. (The result of an adjustable rate mortgage, a balloon payment mortgage, or similar “teaser rate” schemes.)
There’s little that can be done about the former (short of strengthening our economy in general), but the latter is — once again — the direct result of deregulating the mortgage industry. The types of mortgages are predatory in nature, irresponsible for both lender and borrower, and (as we have seen) extremely dangerous for our economy.
It should be obvious to anyone looking at this crisis objectively that these types of loans need to be regulated out of existence. Like usury interest rates, there is no reason for them to exist.
But I would go one step further. We shouldn’t just be getting rid of these loans going forward, we should be figuring out a way of retrofitting the existing loans so that the people currently holding these loans can continue making their monthly payments.
I’m not a mortgage expert, so I don’t know the best way of accomplishing that. But we know that the homeowners with these mortgages were (and probably are) capable of making a reasonable monthly payment. The goal is to find a way to restructure these mortgages to lock in this reasonable monthly payment. And that may be offering a lower interest rate; extending the term of the loan; or any number of other things.
For the loans that we end up purchasing as part of this bailout, this type of retrofitting should be relatively easy to carry out under the auspices of a properly formulated agency. For other loans of this nature out on the market, we can probably offer incentives to encourage/bailout the financial institutions needing to restructure these “assets” on less favorable terms.
REHABILITATION PLAN
So instead of talking about a “bailout”, let’s instead talk about a Rehabilitation Plan based on three pillars:
(1) We will treat the immediate symptom of this crisis by buying up these bad loans, giving our financial institutions some breathing room.
(2) We will re-institute proper regulation of our financial system to insure our economic security in the future.
(3) We will retrofit existing ARMs and similar mortgages to reduce the foreclosure rate. This will benefit homeowners, help to stabilize these rocky segments of our financial markets, and reduce foreclosures (which will also help the real estate market recover and further stabilize the market).
ARCHIVED HALOSCAN COMMENTS
Charles
I still don’t understand why a bailout is needed. If you have 700B to get the credits flowing again, shouldn’t you make new loans instead of sinking the money into old loans? That is, instead of bailing out the old banks, shouldn’t the government set up a new bank?
Tuesday, September 30, 2008, 3:38:45 AM
Pandora
The big problem about the current crashes and the reason why the governments need to help the companies is that there are innocent people in there somewhere. Many businesses are connected and with VAST sums of money. If you dont help out one you will condemn more than that one company to bankruptcy.
That said I dont think it should be necessary for the governments to do this, but the big question is: What are they doing to prevent it from happening again? NOTHING! We had quite a few crashes on the stock market in maybe 15 years now, starting with Nick Leeson, who single-handedly crashed a really big bank through speculation and continuing with the E-business-bubble and now the current crisis.
How could the governments stop this? Easy. Just declare “spculative trades with stocks” as “gambling” and do not allow it to continue. The original purpose of stocks was good – giving a company money so it can expand and getting a small dividend in return each year if they are successful. Greed has changed that and I cant say that I consider greed to be a good human characteristic. So to get back on the right track the ownership of stocks should be legal, just day-to-day-trading should have a tough “fine” (500% tax if youre selling within 1 year of buying, 400% if youre selling within 2 years and so on until the 5th year when its free of charge).
How likely is it that soemthing like this will get passed? About as likely as a snowball in hell I would say.
Monday, September 29, 2008, 2:10:07 AM
Tetsubo
One of my main issues with this whole mess is the nature of business people and politicians. Many business people go into politics and successfully get elected. They enter their political lives already heavily tied to the business world. They are more than willing to accept bribes (campaign contributions) from fellow business people. Once their political careers end they often return to the business world.
It’s one huge ball of conflicted interests. They don’t care at all about the people they actually represent, so long as those people keep electing them.
I actually have a solution: Hold politicians to the same standards as we do judges. If a judge takes a bribe he doesn’t get to be a judge any more. A judge can’t adjudicate a case where he has a personal interest. Make politicians accountable.
I also support regulating the crap out of the banking and finance industry. I’d have them filling out triplicate forms to wipe their own asses.
The Rep. party has done more damage to the American nation then all the foreign powers that have attacked us, combined. How anyone can vote for these boobs is beyond me.
I am literally praying that Obama wins.
Friday, September 26, 2008, 3:00:00 PM
Stargate525
My logic is that it is not the government’s job to protect businesses from failing because they screwed up. Once the government gets its fingers into the regulation and ‘protection’ of that aspect of the private sector, what’s stopping them from ‘protecting’ other aspects of the private sectors?
The first major test of these ‘safeguards,’ as you put it, was in 1980s and still cost the taxpayers millions of dollars. Sure. It works. Right.
I also find it interesting that you blame the republicans solely for the de-regulation. As far as I can find, de-regulation measures occured in 80, 87, and 99. 80 was a completely democratic government, 87 had the democrats still in the representatives, and 99 was the only one that wasn’t democratically controlled. You can’t put this all on the Republicans, as much as you might like.
Your entire analogy to the Great depression is flawed in any case. The great depression was a global phenomenon ended by world war II. Current trends in trade and commerce make this possibility somewhat moot, especially with China in the mix. Secondly, the great depression was a sudden, abrupt collapse of confidence and panic on Wall Street. Things like that can no longer happen, as the market automatically shuts down in such occasions.
Friday, September 26, 2008, 2:07:23 PM
Justin Alexander
James Galbraith makes a pretty compelling case for a better approach to the rehabilitation plan.
Friday, September 26, 2008, 6:41:03 AM
Justin Alexander
@Lior: While it’s true that the FDIC is partially funded with premiums paid by the banks, those premiums aren’t actually sufficient in a major financial meltdown like the one we’re currently experiencing. And when that happens the American taxpayer is left on the hook for it.
And that’s why, when the FDIC was instituted it was instituted hand-in-hand with regulation designed to help protect the American taxpayer. The Republicans got rid of the protections offered by regulation, but left us all on the hook.
Friday, September 26, 2008, 1:50:46 AM
Justin Alexander
I’m not entirely clear on how you’re jumping from “financial markets failing” to “anyone who disagrees with the government”. Would you care to explain your “logic” there?
I mean, this isn’t a complex issue. On the one hand, you have the Great Depression. On the other hand you have the financial regulations with a proven record of preventing that kind of economic meltdown.
How anyone could possibly be pro-Depression fascinates me and I’m eager to hear your explanation.
Friday, September 26, 2008, 1:46:03 AM
Lior
It seems my comment was cut short by the system.
In any case, as a lesson from the bank run of the 30s, there already is a safeguard against bank runs: the FDIC. As I already explained above, this serves to protect depositors in banks who made bad loans.
The banks themselves should not be saved. New banks will be created which will be more prudent in their loan policies.
For the future, the main regulation that is needed is one that will ensure that banks are conservative enough with the capital they got from low-risk accounts link checking and CDs. In other words, one should separate investment banks and savings-and-loan banks into distinct businesses.
Friday, September 26, 2008, 1:45:31 AM
Stargate525
“Our financial institutions are cutters…. putting them in a straitjacket so that they can’t keep hurting themselves.”
that’s a very, very dangerous statement. So where does it stop? The unions are cutters? What about Airlines? Newspapers? Rights Activists? In fact, anyone who disagrees with the government are cutters, and we just need to help them!
Down this road lieth 1984. If they screwed up, there is no reason we should bail them out at all. Look at Taiwan; no bailout procedures, and they’re turning a profit. Investments are insured for a reason; let the banks fail, people will lose a little money, and hopefully the next generation of lenders will be a little less moronic.
Friday, September 26, 2008, 12:24:40 AM
Justin Alexander
Have you ever seen It’s a Wonderful Life? You know the bit with the bank run where everyone comes to George Bailey and demand their money and he has to dip into his honeymoon fund to pay them?
That was because the Building & Loan had taken the deposits and invested them in loans made to other people.
Hollywood dramatization (and decades out of date), but there’s a basic truth in that: Our financial system is increasingly a house-of-cards propped up on interlocking layers of debt.
The problem today is not just that a few banks are failing… it’s that we are in danger of reaching the critical point where failing banks start triggering other banks to fail.
Friday, September 26, 2008, 12:00:35 AM
Lior
I still don’t understand who it is that needs to be “bailed out” in this situations.
Some people decided to gamble on the real estate market. If you take a 100% mortgage on a house, and but the house will go up in value 20% over the year, you can sell the house at the end of the year and (since there was no down payment, only monthly payments) get a tremendous rate of return on your investment. You can also keep the house and refinance, since once the mortgage is for less than the value of the house the rate will be lower. Of course, if the value of the house does not go up you might not be able to afford the payments long-term. This is in the nature of gambles. There is no need at all to assist those who gambled and lost.
The banks also participated in the gamble: if the scheme works, the bank gets a pretty good rate of return on its investment too. If it doesn’t, the bank can foreclose and recover some of its investment back. This is a knowing gamble on the side of the bank. Again, there is no need to rescue them due to their losses here. (more on this later).
Finally, there are businesses who bought “mortgage-backed securities”. They also knowingly gambled and lost, mostly because they failed to correctly evaluate the true risk in their investment. That’s their problem and there is no need to bail them out.
In all cases, the gamblers would not have paid a “windfall tax” had their gamble panned out. Thus, there is zero reason to bail them out when now when we know that their gamble failed. There should be no insurance without premiums.
If an investor, whether an individual or a corporation, makes a bad gamble on the real-estate market, the stock market or any other market, and they lose out, they can always declare bankruptcy. Bailing them out is not only wrong, but it’s bad policy: it will only encourage them to take greater risks next time, knowing that the general public in its infinite benevolence is underwriting all risks, without asking for a share of the potential rewards associated with the risks.
Since the US economy is currently growing, unemployment is low, and there is no shortage of capital or ways to connect lenders and borrowers, letting some banks collapse is much better than increasing the national debt by $30K/person.
The only people who might deserve to be bailed out, are those who lent banks money (by making deposits, taking out CDs etc), if the banks they lent the money to collapse. When a bank only offers low interest on a deposit, it should correspondingly offer very low risk. Banks didn’t honor this by gambling on the real estate market and this is the only place where a bailout makes sense.
Note, however, that this is a much more limited issue. If an when a bank collapses, there can be consideration about the extent to which depositors should be helped (say by the FDIC). There’s no need for the government to buy bad loans.
It’s true that some regulation is needed
Thursday, September 25, 2008, 8:20:37 PM
Regulation is not the solution. In fact, regulation was the cause of the financial meltdown. The Community Reinvestment forced banks into giving dangerous loans. Here’s a timeline: http://www.freedomworks.org/crisis
But don’t stop there. I’d recommend reading up on the CRA and government subsidized banking, as well as Angelo Mozilo. There is an incredible amount of disinformation and lies about banks preying on the unfortunate. Use common sense. No lender wants to give loans to people they know can’t pay when the ARM explodes. This doesn’t make any logical sense, unless you understand that banks have been strong-armed into giving bad loans by profiteering politicians. You accuse banks of graft, but there is no end to the graft once the government gets involved and tampers with the market. I love your gaming articles but you are absolutely ignorant about how the housing market unravelled. Do some homework.