Friday, April 24, 2009

Bailout Blues

Wow, I haven’t posted anything in over two months. Maybe I should try and get those blogging juices flowing again with one of my ever popular political rants. The topic I want to address today is the financial crisis and the bailout.

Lately I’ve been following a lot of links to articles about how the economic recovery is coming along and the general consensus seems to be “not so good.” I’m not talking about the politicians and pundits on the right whose attacks on the Obama administration’s actions are mostly motivated by blatant partisanship – Obama bailing out the banks is SOCIALISM!, never mind that Bush was gearing up to do the exact same thing back when he was president – I’m talking about economists who know what they’re talking about. Here’s my synthesis on what I’ve gleamed the problem is…

The Problem

Over the last sixth months our financial sector has fallen apart due to systemic problems. The crisis goes deeper than just the fallout from the real estate bubble bursting and housing prices going down: it’s about letting banks, brokers, hedge funds and other operators in the financial market engage in shady activities, it’s about not enough oversight from the government institutions that are supposed to be safeguarding the market (like the SEC); and it’s about rules and accounting principles that allowed for the overvaluation of what turned out to be very risky assets.

For decades, profits had been soaring for financial institutions and everyone wanted to believe that they could go on like that forever. When crises like Enron popped up (which today seem like historical footnotes, nothing more than portents foreshadowing the much bigger meltdown that was to come) the system managed and contained the fallout and this created the illusion that the system was strong and could handle any problems that might arise in the future. This was the legacy of Alan Greenspan. And as for all those derivative financial assets that people had invented in order to raise money in creative new ways, and which most people never really understood (or understand), nobody wanted to listen to the few naysayers and Cassandras who suggested that they might carry more risk than everyone was assuming and that they were thus overvalued.

What do we do?

So now the house of cards has come crashing down. A systemic failure like this seems to demand big change. I don’t know a whole lot about the world of finance, but I know enough that I can say there need to be stricter rules regarding what different types of institutions can and cannot do, more and better monitoring by oversight authorities, and there need to be tougher accounting principles telling companies what value to assign to these mysterious derivative assets.

The other side of this big change is that we must accept that when the storm clouds clear the financial sector should look very different. First, there needs to be a shift in attitude: financial operators should be chastened after this, and they should get used to taking less risks and, in turn, accepting lower (some would say "more reasonable") profits. That's the easy part. The hard part is deciding what to do with these big name institutions that are failing. One option is maybe put them into receivership (the company goes bankrupt, shareholders are wiped out, a new entity is formed with all the creditors as shareholders, the new entity tries to pick up the pieces and become profitable again). Another option: if the government is going to bail out institutions that can’t fail, it can assume more control over the recipient institutions. The obvious (and extreme) move would be for the government to call the bailout money an equity investment and for it to get shares of common stock in return. In a lot of cases this would result in the US government becoming the majority shareholder (or at least the largest plurality shareholder) in which case it could (and probably should?) use its voting rights to tell the institution exactly what it should do. Of course, this would create an interesting conflict of interest for the government (protecting the taxpayers’ equity investment in the bank vs. the interests of the financial industry as a whole) as well as putting taxpayers’ investment at risk (if the value of the stock goes down, the government will lose money on its investment). In Europe, some banks were nationalized in the '70s and '80s and feelings are mixed about how that turned out.

So, yeah, the question of what we should actually do with the floundering big name institutions is problematic. But a wishy-washy solution such as the government simply loaning money to the banks or the government insuring or buying those toxic assets may not be enough to fix the problem. Loans don’t give the banks the capital they need, and the government isn’t doing much to control how the money is used (which might be a bad thing). Temporarily inflating the value of these crappy assets by insuring them (hoping, I guess, that the real value will someday go back up) is just putting a band aid over the crack in the dam and it basically assures there will be more problems down the line. And as far as buying the toxic assets from the banks, would this amount to “nationalizing loss” while leaving the banks to enjoy future "private gains"?

I guess that's enough to chew on for one post. Stay tuned for Part II where I'll discuss what the government is actually doing and whether it's good or bad.

Wall Street photo taken from

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