Tuesday, September 30, 2008

If the market is allowed to work it will sort things out

James Calhoun offers some badly needed perspective:

Last week Goldman Sachs raised $10 billion in new capital in one day. They sold $5 billion in preferred stock and warrants to Berkshire Hathaway and also completed a secondary offering of common stock that raised another $5 billion. Friday, JP Morgan raised $10 billion in a secondary offering to help pay for the Washington Mutual takeunder. Both of these offerings were oversubscribed, meaning that the companies could have raised more capital if they wanted. There is not a shortage of capital for well run financial companies. There is, however, a shortage of capital for companies that have acted irresponsibly with investor capital in the recent past. For some reason, our political leaders believe this is a failure of the market, but isn’t this what should be expected from rational investors? ...

The biggest bank failure in the history of the United States happened last Thursday night and by Friday morning, it was business as usual. The only difference was the name on the door and the losses suffered by those unfortunate enough to invest in Washington Mutual bonds or stock. The taxpayers didn’t lose anything and depositors didn’t lose anything, only investors. That is how capitalism works in case everyone has forgotten.

In a free market situations like this are dealt with by badly run businesses going under and their assets being taken over by better run businesses. Bad debt is written off, investors take a hit (investors reap the largest rewards of success but they assume the risk and sometimes lose their money if you can't deal with that don't invest) and the economy begins to grow again.

This 700 billion (which will quickly swell to at least a trillion) dollar bailout was a gigantic ream job which the left (Treasury Secretary Paulson is a liberal Democrat) was attempting to foist on the American taxpayers. The propose of the bailout was to generate a huge pile of cash which congressional liberals could divert to their buddies (like B. Hussein Obama's associates at ACORN) knowing that a substantial cut would be returned to them as campaign contributions and that these entities would have lucrative jobs waiting for Democrats retiring from "public service".

Equally important, to the left, was the fact that the bailout would have moved the federal government into the nation's financial markets in a way which has never been done before. This move would have represented a government takeover of a significant part of the American economy almost on a par with Hillary Clinton's attempt to bring about socialized medicine in the 90's.

The failure of this "deal" is a good thing. Harvard economist Jeffrey Miron puts it this way:

This bailout was a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

[. . .]

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

It is time NOW just weeks before a presidential election for the American public to take a long hard look at exactly who caused this mess and exactly what needs to be done to fix it.

As Mr. Miron said the answer to bad government is not more government.