Here are points made by the CEO of a healthy bank in the Southeast arguing against the Paulson plan.
1. Freddie Mac and Fannie Mae are the primary cause of the mortgage crisis. These government supported enterprises distorted normal market risk mechanisms. While individual private financial institutions have made serious mistakes, the problems in the financial system have been caused by government policies including, affordable housing (now sub-prime), combined with the market disruptions caused by the Federal Reserve holding interest rates too low and then raising interest rates too high.
Again “affordable housing.” I’m now starting to think the federal affordable housing policies which mandated banks make sub-prime loans were an important piece of the problem.
2. There is no panic on Main Street and in sound financial institutions. The problems are in high-risk financial institutions and on Wall Street.
3. While all financial intermediaries are being impacted by liquidity issues, this is primarily a bailout of poorly run financial institutions. It is extremely important that the bailout not damage well run companies.
4. Corrections are not all bad. The market correction process eliminates irrational competitors. There were a number of poorly managed institutions and poorly made financial decisions during the real estate boom. It is important that any rules post “rescue” punish the poorly run institutions and not punish the well run companies.
The physician’s mandate is to “do no harm.” If the Paulson plan would hurt healthy companies, we’ve got a huge problem.
6. This is a housing value crisis. It does not make economic sense to purchase credit card loans, automobile loans, etc. The government should directly purchase housing assets, not real estate bonds. This would include lots and houses under construction.
My position is that this crisis is caused by dramatically falling housing values and the crisis won’t start to improve until housing prices start to bottom out. Once house prices start to bottom out, then even a government program couldn’t stop the housing industry from improving.
7. The guaranty of money funds by the U.S. Treasury creates enormous risk for the banking industry. Banks have been paying into the FDIC insurance fund since 1933. The fund has a limit of $100,000 per client. An arbitrary, “out of the blue” guarantee of money funds creates risk for the taxpayers and significantly distorts financial markets.
8. Protecting the banking system, which is fundamentally controlled by the Federal Reserve, is an established government function. It is completely unclear why the government needs to or should bailout insurance companies, investment banks, hedge funds and foreign companies.
Good points.
9. It is extremely unclear how the government will price the problem real estate assets. Priced too low, the real estate markets will be worse off than if the bail out did not exist. Priced too high, the taxpayers will take huge losses. Without a market price, how can you rationally determine value?
This is a great point I hadn’t thought of!
13. The primary beneficiaries of the proposed rescue are Goldman Sachs and Morgan Stanley. The Treasury has a number of smart individuals, including Hank Paulson. However, Treasury is totally dominated by Wall Street investment bankers. They do not have knowledge of the commercial banking industry. Therefore, they can not be relied on to objectively assess all the implications of government policy on all financial intermediaries. The decision to protect the money funds is a clear example of a material lack of insight into the risk to the total financial system.
So the Paulson plan is a Wall Street bailout that may create a Main Street problem.
{ 13 comments… read them below or add one }
Brian 09.27.08 at 2:16 pm
John, Yes, Yes Yes!!! You hit it on the head. I argue this point with my liberal friends all the time. They want to somehow blame President Bush for the this financial crisis, but the blame falls squarely on the shoulders of Congress.
Fannie and Freddie, and Sallie for that matter, are instruments of the Dems for providing affordable finance to “level the playing field” for the underclass. They are subsidized institutions and are run by members of the Washington “GOBN” (good old boy network). Certain Republicans, like John McCain, have long fought against the GSEs as being conflicted and out of control. But they were strongly defended by an increasingly liberal Congress.
The problem of the GSEs’ mandate for “affordable housing” was compounded by efforts of the Republicans (Congress and White House) to reduce or eliminate regulations, from the mid 90s to today. As an example, the Glass-Steagall Act, regulations in place since the early 1930s to protect against banking mis-adventure, was repealed in 1999.
Artificially low interest rates as a result of the Tech Bust and then 9/11, also encouraged over investment in housing and poor lending standards.
When loose lending standards meet low interest rates and reduction or elimination of regulation and oversight, it spells very big problems for our financial system.
I also want to comment on this banker’s take on the financial rescue plan (let’s stop calling it a bailout, which is perjorative). He doesn’t have this right in my mind, except for his own benefit:
2. No panic on Main Street: so this guy wants to wait until there is a physical run on the banks, riots in the streets, 20% of the population out of a job, before we act? If this ball really gets rolling, it will be very hard to stop. Think 1930s on steroids.
3. This is no “Bailout” once again. The bad actors (WaMu, IndyMac, Lehman, AIG) are getting taking out of business. The American public is who is getting bailed out, not some financial elites.
4. “Corrections are not all Bad”…and how much more correction would this guy like to see? Home prices are already down 25% around the country, and more in some places like Phoenix. We have already lost several major banks. Unemployment is already up past 6% and headed higher. It is the job of Treasury and the Fed to soften the blow of financial cycles and crises.
6. This is patently unrealistic. How would the government go around buying up all the millions of individual foreclosed or defaulted homes? Sounds like a huge and non-existent bureaucracy. The mortgage backed securities are already huge bundles of house assets and are much easier to evaluate and process. If those securities are taken off the market, into Fed hands, and the banking system (not individual broken banks) are infused with the capital that buys those securities, and then encouraged to lend, housing prices will stabilize.
7. Jim Cramer had a very good suggestion on Friday: Raise the limit on FDIC insurance to $2.5M. That would really help confidence in bank deposits. Money markets should be covered by the same insurance. That would prevent runs on Money Market funds. For any amount above $2.5M there should be an option to purchase additional insurance from the FDIC. This will help institutional investors.
8. Have a little imagination Dude! The problem with many of our financial institutions and regulations is they were created in the early 1900s and are outdated.
9. Has this guy ever visited EBay? That is how it is done. You put out a minimum price, publish the specs on what it is you are selling, and then advertise to the world. That is how prices are set on junk (which to someone else might be a jewel).
13. This guy is a real cynic and/or scratching his own back. GS and MS are NOT the big beneficiaries of this deal. We don’t even know what kind of assets they have on their books. Who is to say they have any RMBSs. The beneficiaries are you and me, if we want to be able to make a living and pay our bills tomorrow.
John Wake - Real Estate 09.27.08 at 2:28 pm
“Jim Cramer had a very good suggestion on Friday: Raise the limit on FDIC insurance to $2.5M. ”
Interesting option! I don’t think you need to go all the way to $2.5M to have a big impact, though.
In the small banks the FDIC has taken over recently, the vast majority of depositors were covered by the $100,000.
A substantial increase for those regulated banks is a good idea.
Brian 09.27.08 at 2:46 pm
I think Cramer was trying to extend the indea of deposit insurance to institutional investors who are behind the run on Money Markets and as a result depressed safe 3 month T-Bills to 0.05% interest last week. The pros are panicking, which gives some indication of the seriousness of this crisis.
Concerned citizen 09.27.08 at 3:24 pm
So it might start with $700 billion, but I’ve read some economists are estimating the bailout could reach over a trillion.
From Forbes: “It’s not based on any particular data point,” a Treasury spokeswoman told Forbes.com Tuesday. “We just wanted to choose a really large number.”
http://www.forbes.com/home/2008/09/23/bailout-paulson-congress-biz-beltway-cx_jz_bw_0923bailout.html
Focusing on just the value of houses is shortsighted; hardly anyone talks about the value of the dollar itself. Where is this bailout money coming from? We’re not going to get it as a loan from other countries and we can’t be taxed for this money. The Fed will have to supply the credit, essentially create more money out of thin air. Credit got us into this problem in the first place, so how does adding more credit solve the problem? Ultimately the value of the dollar will fall as a result and if the value of the dollar falls far then we’re way worse off.
The housing bubble has to deflate and passing this bailout will keep housing values artificially inflated. This is price fixing…the government is trying to assign value to something worthless. The economy will then have to catch up to the over inflated house values. Combine stagflation into the mix and recovery will be extremely slow.
So, I agree with point #9. And we’re not talking about someone’s old record collection they’re trying to sell on eBay (which the other poster mentioned), we’re talking about trillions of dollars of bad debt. Who’s going to want to buy that? And from what I understand the problem isn’t just due to the toxic mortgages that are still on the books at these financial intuitions, but also with the bad loans that have already been packaged with other debts and absorbed into the market. They are beyond the reach of this bailout.
Brian 09.27.08 at 3:34 pm
Two points: one, the money that comes out of thin air comes from the same place where the money was lost on the decline in home prices. Printing money offsets the deflation caused by credit contraction. There is little risk of inflation according to many experts, including economist Richard Bernstein of Merrill Lynch:
“Everybody is asking about inflation. Everybody is sure that we are printing money, that the United States has quickly become an Argentina, that the dollar is going down and that inflation is going up….I just don’t think that’s the right approach. That scenario could happen. If the economy quickly turns, yes, we have a big problem on our hands. But if the economy continues to slow and credit creation continues to contract, it’s going to be very hard to get sustained inflation.”
http://online.barrons.com/article/SB122246744271480397.html?mod=9_0031_b_this_weeks_magazine_main&page=sp
Second, the noted Bond King, Bill Gross, endorses the plan. No one knows more about the value of bonds than Gross. From today’s Barons: “He estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries.”
http://online.barrons.com/article/SB122246748703380411.html?mod=9_0031_b_this_weeks_magazine_main&page=sp
Brian 09.27.08 at 3:40 pm
I think we are talking about an old record collection. The debt on financial company books is not moving.
BTW…”we’re talking about trillions of dollars of bad debt. Who’s going to want to buy that?” Warren Buffet wants to buy those bad loans. He stated on CNBC the same day he invested in Goldman Sachs, that if he could borrow $700B on the same terms as the Treasury, that he would buy up all the bad debt under the terms of the “bailout” as it is incorrectly called. He thinks all that debt is a steal at current value.
Concerned citizen 09.27.08 at 6:42 pm
Explain how the debt on the books isn’t moving. The plan is to buy the bad debt, so why would it stay on the books?
I can understand where Warren Buffet is coming from if this stuff was worth something, but it might not be worth anything. So how can he say it’s a good investment when they hold no value currently? These bad loans have to go somewhere in the end and it seems that our government will be stuck with them for awhile, if not indefinitely.
Richard Bernstein’s comment only makes partial sense and even he says the dollar could go down. He’s saying “if the economy continues to slow and credit creation continues to contract, it’s going to be very hard to get sustained inflation”. Right, but the reason behind the bailout (and it is a bailout*, I’m really not sure why you say it isn’t), is to jump start our economy and to get credit flowing again. And I don’t doubt it won’t, but it will take years for the “true” price of homes to meet up with the inflated values this bailout will maintain. By pumping more money into the economy, the value of the dollar has to fall.
http://mises.org/story/908
People couldn’t afford the houses at the 2006 peak prices (obviously) so they used dangerous loans. They lost the houses and that gap left over between the true (market) value of the house and what the loan is for is what we’re talking about here. If the market itself says that number is meaningless, then it has no value; it’s money lost through foolish lending. The $700 billion bailout is a desperate attempt to justify those inflated prices.
They are trying to maintain the inflation, excuse me, the over-inflation of the credit market. You say the money comes from the decline in housing prices, but that number was artificially inflated to begin with. There was no money there in the first place, so no, this money they’re printing (technically not really printing) isn’t from the decline in housing values. Again, there was no real money there to begin with.
*From Wikipedia: Bailout in economics and finance is a term used to describe a situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations. Often bailouts are by governments, or by consortia of investors who demand control over the entity as the price for injecting funds.
Brian McMorris 09.27.08 at 9:02 pm
The problem of the bad loans is one of scale. There is no bank with a big enough and strong enough balance sheet to get the ball rolling the other way.
Potential buyers wait because many will buy on leverage and a further 10% decline in the value of the purchased mortgage security could wipe out the investment. No good investor wants to be a sucker and those left with money are by definition, shrewd. But all these debt securities do have siginficant value, well above zero.
Take any mortgage security, even one based on sub-prime loans, and it has plenty of intrinsic value. Even if 100% of the loans default, the housing collateral backing the mortgage still has plenty of value. Let’s say that we experience 50% housing price depreciation on a security built around sub-prime loans with 100% defaults on loans with no money down (I think everyone would agree, this is beyond a worst case scenario). In this case, the security is still worth 50% of face value, based on the underlying collateral of mortgaged homes.
Private money is waiting in the wings for the banks holding these mortgage securities to blow up. Then they swoop in and buy up the securities held by the blown up bank for pennies on the dollar. Why should a bunch of rich investors, many foreign, buy up these assets leaving American taxpayers on the hook for our destroyed financial system? Much better that our Treasury buys the securities and holds them for resale when the market is stabilized.
Only the US Treasury has the resources to buy up enough securities to put in a floor on the market for those securities and get the momentum turned. And, when the Treasury sells the securities at a big profit, which Warren Buffet and others say they it will, it becomes a profit generating effort for the American taxpayer, so in no way can be called a “bailout”.
Regarding the falling of the dollar: you are wrong here. The value of the dollar, which is right now the world’s Reserve Currency, is based on global confidence in the American economy which underwrites the dollar, not on number of dollars in circulation. How else to explain how the dollar continued to strengthen against other currencies and gold during a money expansionary period like the late 90s?
Brian McMorris 09.27.08 at 9:13 pm
Another point I missed, and I have been arguing this point with friends because it is not so obvious, is that the inflated value of houses did indeed create real money. The housing inflation allowed us citizens to create our own printing press and flood the market with real dollars, not pretend money.
How so? You could take your inflated appraisal to the bank and obtain a home equity loan. With this loan you could literally print money by going to the ATM. This is real money that entered our economy. It is now leaving our economy. If anyone bought a house after 2003, I bet they can’t get and HEL against that house. And the mortgage loans that have either been written off, or written down, maybe through a short sale, do indeed contract the money supply. The banks holding these loans must either cut expenses by laying off employees or shut down (IndyMac, WaMu). The reduction in salaries and other business expenses into the economy are a reduction in dollars in circulation. This financial contraction is not make believe. It is really happening before our eyes and printing more money at the Fed will help to slow down the contraction This current contraction is why Ben Bernanke always promised to figuratively drop dollars from a helicopter to stop a deflation from occuring; the $700B financial rescue is the real world way that takes place.
Concerned citizen 09.28.08 at 5:52 pm
“Only the US Treasury has the resources to buy up enough securities to put in a floor on the market for those securities and get the momentum turned.” To paraphrase “create money out of thin air”
“How else to explain how the dollar continued to strengthen against other currencies and gold during a money expansionary period like the late 90s”. I’m not sure what you are referring to here. I don’t recall the Fed inserting $700 billion dollars into our economy in the 90s. Are you talking about more currency being created or low inflation during low interest rates or…?
Dollars, or Federal Reserve notes, are meaningless if they aren’t tied to anything. I emphasize the “note” because, it’s just paper. We lost our gold standard in the 30s and since then the dollar isn’t tied to anything but the confidence in our economy (as you stated). You’re calling paper dollars real money and that’s where we differ. The cash that you pull from the bank originated from the Fed (tells the Treasury print it) and puts the paper money into circulation. Thing is, the Fed doesn’t tie that paper money to anything (the gold standard that I mentioned before), so essentially the paper money represents nothing; it represents money pulled out based on credit. And in the case of your example, in our current housing market, over inflation.
Talking about “private money is waiting in the wings”, again people will only buy what they think they are worth, and that’s yet to be determined. So let me take this a step further and say anything is only worth what someone is willing to pay for it. This is evident in a true free market. With the creation of easy credit, everyone was able to qualify for a loan, even loans [in hindsight maybe especially loans] they couldn’t afford. So now with a higher demand for housing, house prices went up. Not because the true value of the homes went up, but because people were willing (and able, thanks to the credit they should not have qualified for) to pay more for them. What I’m getting at is the easy credit artificially drove the prices of housing up way higher than they should have been and now the market is trying to stabilize.
So once the demand starting going down, the cost of living going up and people not getting paid more, everyone started to default. Housing prices are coming down because they are only worth what someone is willing and able to pay for them. And here’s our problem, if you bought your house back in 2002 for $150k and it jumped to $250k in 2006, then you cashed out the $100k (real money, right?). Let’s just say you keep it in your mattress and wait a few years. Now in 2008 your house is down to $200k (I know this isn’t really following the market trends, but it’s just a for instance). What value does that $50k left over have now? How can that be “real” money when the equity it was borrowed against isn’t there anymore? That home equity line of credit was money taken out of the bank based on credit and the “equity” was a number based on over inflation caused by the easy credit in the first place. That $50k remainder has no real value at this point.
So this $700 billion plan is our government trying to justify those bubble prices. By passing this plan they are saying “the value of houses in 2006 is the true value”. They aren’t allowing the market to make that choice and we (the market) all pretty much agree that the 2006 prices were way too high. To help prove my point about the true value of houses, people would not be able to qualify for the same mortgages that they did before the bust. The prices that homes are getting to now is starting to fall in line with what people can actually afford. So going back to my example of that $50,000 remainder…passing the $700 billion plan justifies the over inflation price and then keeps that bad debt in the system. Because in the end it has to go somewhere, either disappear by a failing bank (and if the mortgages can’t get sold, some people are getting their houses for free) or be bought by someone. And they why I’m hearing you explain it, it sounds like we’re buying the bad debt from these companies, we’ll wait a few years, and then sell it back to them (?)
Even if you don’t agree with my point of view on this matter, you have to at a least agree that the Fed failed to do its job…look where we are now.
Brian 09.28.08 at 6:58 pm
Some of what you say makes sense to me, in terms of how easy money leads to higher prices. That is consistent with economic theory: inflation results from too much money chasing too few goods (John Maynard Keynes - http://en.wikipedia.org/wiki/Demand_pull_inflation).
But otherwise, you lose me. If you are arguing for a gold standard, it doesn’t work. Its already been tried. Gold artficially limits the options of the financial system to soften economic cycles. Don’t you think it is arbitrary to tie the world economy to something that is mined from the ground. It introduces all types of political issues as it might be mined in unfriendly countries. Like oil, the higher the price, the more will be mined. There is no direct relationship to economic value or gross national product. It causes extremes in economic cycles as more gold is mined at the end of an economic cycle when it issn’t needed and less at the beginning of a new cycle when it is needed to finance expansion. As a result of its inefficiency, it creates hardships for many people at the worst possible times and exacerbates a boom to bust cycle. This is why we went off the gold standard (really, in 1972 with Bretton Wood 2, not the 30s).
If you are saying that we should just let the market do whatever it will do, explain the benefit of that approach. It sounds good ideologically, but there are really no compelling benefits. A “free market” will swing to great extremes from greed to fear, with no regulation or control. People will be hurt and no one will trust the economic system, limiting trade and growth that would benefit all peoples of the world. A gold standard is not the way to “grow the economy” to the benefit of all citizens.
A Reserve Currency like the dollar (maybe someday will be the Remnibi) makes much more sense. It represents the total productive capacity of an economy, and an important one the world believes will keep on ticking through thick and thin. This is why the Dollar is a Reserve Currency. Other sovereign currencies are indexed against it, so other countries will hold dollars in Reserve.
This global Reserve status is what anchors the dollar and we express it by the phrase: “backed by the full faith and credit of the United States”, meaning all of us. A dollar represents a small slice of America. As America grows, proportionately, so must the dollar supply.
Without getting into an argument about “what is the optimum rate of money supply growth”?, let me just say that in a way you are right. This $700B plan can be seen as locking in the aggregate price of American housing at a point a few years ago, though more like 2003 or 2004 than 2006, the peak. We have already bankrupted several banks and lost several hundred billion in the process. The losses of those banks is gone into thin air, so we are already well back before 2006.
I think from this perspective, if we are at 2004 levels today, and that is what the data show for Phoenix, that we will be lucky if this $700B program arrests the price decline at 2003 levels.
Maybe a free market is efficient, if not very fair, and maybe all those people buying homes after 2003 deserve to lose everything to pay for their greed. But we have a little kinder society in America, I like to think. So, yes, the $700B does let people (on Main Street, not Wall Street) off the hook, and that is as it should be in America. And that matter, for the rest of the world, as our Dollar currency is the “gold standard” that all other economies index.
Remember: Economically, what happens in America, does NOT stay in America, it affects the entire world and how we are perceived.
Brian 09.28.08 at 7:14 pm
Oh, and regarding the Fed failing to do its job, let me say that I DO agree with you on this point. Alan Greenspan did not tap the accelerator lightly / responsibly, as he should as Fed Chairman. He and the Treasury were much too aggressive expanding money supply and easing interest rates at the end of the 90s and after 9/11.
Bernanke has been trying to pick up the pieces ever since his appointment, so he is less to blame. Few Fed Chairmen have been willing to precipitate a recession to rein in money supply. Paul Volcker is one of the few (in the 1980-81 period).
Other effects were out of the Fed’s control, like the “carry trade” which resulted from Japan’s anti-deflation policy of keeping its interest rates very low. Asia / China were flooding our economy with dollars, investing in mortgage securities and other debt, as a result of their huge trade surplus with America, as they used our consumers to improve their own economies.
All of these interactions will be studied by economists and central banks and we hopefully will get better at managing global currency flows.
Concerned citizen 09.29.08 at 1:39 am
To be honest I don’t know enough about the gold standard in history to make a case for it or against it. But it’s easier for my head to get around the concept of having our paper money associated with something physical. You say the gold standard didn’t work and I’ll take your word for it. But it doesn’t seem like we’re too well off now without it.
Either way, gold standard or not, we’re in a bad situation. And I think we’re talking around the same conclusion. In simple terms, overextension and greed lead to bad things. Not moving forward with this plan or moving forward with this plan; they will both have their negative effects. I just hope for all our sakes our leaders know what they’re doing.