Will the Bailout Help You?
One question that was scarcely taken up in the debate over the bailout was whether it would even work in the first place -- that is, would banks, freed from the consequences of their poor decisions, resume lending to each other and to the nation's consumers and businesses? At the time, there was no consensus that this intervention, in which the Treasury could spend up to $700 billion to buy bad assets based on home mortgages, would actually loosen up credit. And even now, there is no way to know. If taking these assets off the banks' books restores confidence and liquidity, then the benefits of the bailout will trickle down to small firms and everyone else in the economy. If it doesn't, it won't. The Treasury Department is weeks away from actually purchasing anything, but so far, the prospects look grim.
So how did we get stuck with this bill? What changed in the four days between when the House of Representatives first considered -- and rejected -- the bailout bill, and last Friday, when it finally passed? Frantic supporters marshaled increasingly alarming anecdotal evidence that consumer and commercial loans are more expensive and harder to get, but it's hard to believe that the facts on the ground could have changed so drastically so quickly.1 In any event, there was no way to know for certain what precisely was happening on Main Street -- and the numbers, when they're finally available, often contradict the prevailing sentiment.
What we do know for sure is that the bailout generated its own momentum, like a boulder rolling down hill. Wall Street was expecting the help -- if it hadn't come, the markets seemed ready to will confidence away. "You've had the president go on TV and say, 'The world is coming to an end.' You've had both houses of Congress over the weekend promise they're going to do something," economist Anil Kashyap told the radio program To The Point in the middle of last week. "To not act at this point would be pretty irresponsible."
Kashyap was something of a bellwether because he was one of the 200 or so economists who had initially signed an open letter to Congress opposing the bailout. But by last week the University of Chicago professor had come around to supporting it because, he said, his concerns about the lack of specificity and oversight were addressed in the legislation Congress drafted. Although the letter raised other issues, including fairness and the long-term effects of the bailout, which do not seem to have been clearly resolved, Kashyap believes that "a huge fraction" of the other signatories likewise changed their mind.2
Now the bailout is law, and markets around the world are bleeding confidence anyway. So far this week, the Dow Jones Industrial Average has closed down 1,067 points, dropping below 10,000 for the first time since 2004. The Federal Reserve has stepped in to loan money directly to companies, and on Tuesday cut interest rates by half a point.
It's possible, then, that Congress will have to revisit the bailout with new legislation. In the interregnum, legislators have an opportunity to get the bailout right. The next iteration of the bailout should include provisions that make it both more effective and fairer.
The next round of legislation should be straightforward in its intent. When it comes to intervening in the economy, in ways large and small, Washington likes to pretend that it is not doing what it is, in fact, doing. Tax credits are the perennial example. They're often meant to encourage new industries -- like, for example, renewable fuels -- but by nature they are an inefficient way to deliver the benefits. In many cases a direct subsidy is a more efficient to accomplish the same goal, but subsidies are ideologically suspect.
This obfuscation is why the present bailout is structured as an asset sale, and not as a simple capital injection, which is what the banks really need. The government would take equity in exchange for the cash. "With this approach, the government would not need to determine the appropriate prices and quantities of individual mortgage-related securities, it would not be providing a greater reward to companies that have made the worst investments, and it would gain the opportunity for taxpayers to receive a higher return if the financial system recovers more strongly," writes Brookings Institution economist Douglas Elmendorf. Some University of Chicago economists, including Kashyap, have suggested that government could simply mandate that banks go to the private sector for equity infusions, though the Treasury Department might still have to provide "partial support."
The bailout should acknowledge that in the 21st century, "the free market" is a fiction, or at best a theory. We should reject the hypocrisy that demands government "get out of the way and let the private sector and our families grow and thrive and prosper" (as Sarah Palin put it when she debated Joe Biden) until times get tough. Congress should tie further outlays to passing a comprehensive regulatory reform that puts most investment activity under some kind of oversight.
There's also an antitrust dimension: we need to be thinking about market-share limits in banking and finance that define just how big "too big to fail" really is. One thing that has been scarcely acknowledged is that the failures so far have consolidated market share at a handful of very large, yet fragile, institutions -- like, say, Bank of America. On Monday, Bank of America reported that its third-quarter income fell 68 percent over last year. But at least it's still a profit. (Also on Monday, coincidentally, Bank of America agreed to settle claims by customers of BofA acquisition Countrywide Financial, with measures that could keep nearly 400,000 borrowers in their homes.)
The legislation should make those who profited from this fiasco pay for it. Let's be honest: this effort to limit executive compensation misses the point. For one thing, it's certain not to work. The legislation's compensation provisions are only in effect while the company participates in the program; there appears to be nothing that prohibits a firm from leaving the program, rehabilitated with taxpayer investment, and then renegotiating sweetheart employment contracts with its executives. The bigger problem, as conservative economist Gary Becker points out, "there develops a war between the government's closing of loopholes, and the ingenuity of accountants and lawyers in finding new ones." Besides, these guys are not the ones who steered these firms into the ditch in the first place; those folks have long gone.
The solution, then, is not to place limits on executive pay. Rather, Congress should craft a retroactive "robber baron" tax, designed to punish -- yes, punish -- Wall Street financiers and CEOs who made tens of millions of dollars in salaries and stock options and now stand with their hats in hand. As Tom Peters noted at the Inc. 500 conference. The severance, though, was just the beginning: it came on top of $140 million in cashed out stock options, $12 million in salary from 2003 to 2007, and $57 million in bonuses from 2003. (Mercifully, the bonuses stopped after 2005.) All told, that's at least $319 million. The robber baron tax should be steeply progressive, perhaps starting at $2 million -- someone who made $10 million should be paying a higher rate than someone who made $5 million, and someone who made $50 million should be paying a bigger share still. For someone making $319 million, an effective tax rate of, say, 90 percent seems almost about fair.
The retroactive tax should be finely enough tuned so that not everyone who made outrageous sums of money in the last five years should be liable for it -- there are ways to target specific kinds of income. It ought not target Inc.'s readers (though I'm guessing very few would qualify for this retribution) or our most popular celebrities, for example. But in general, everyone in the capital class should shoulder some of the obligation here. That some can insist in one breath on shoring up the markets with taxpayer money and in the next breath insist on maintaining low tax rates on the very wealthy is not quite as offensive as Angelo Mozilo's payout, but it's offensive enough. (And it is not likely to win the day in 2010, when the Bush tax cuts expire.)
The legislation should more closely balance the interests of homeowners and banking institutions. It could, for example, follow a cue from John McCain. In the debate Tuesday night, the Republican presidential hopeful proposed that the Treasury spend $300 billion to buy home loans directly and renegotiate with the borrowers. The current legislation makes a feint in that direction, but it's nothing more than that. Here's the passage that relates to "Foreclosure Mitigation Efforts:"
To the extent that the Secretary acquires mortgages, mortgage backed securities, and other assets secured by residential real estate, including multifamily housing, the Secretary shall implement a plan that seeks to maximize assistance for homeowners and use the authority of the Secretary to encourage the servicers of the underlying mortgages, considering net present value to the taxpayer, to take advantage of the HOPE for Homeowners Program ... or other available programs to minimize foreclosures. In addition, the Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures.
The Secretary will "encourage" and "may use" -- Congress isn't exactly aiming the big guns here. The HOPE for Homeowners Program was included in the bill that granted the government authority to rescue Fannie Mae and Freddie Mac, but it is strictly voluntary on the part of lenders and servicers, and likely to help at most just 400,000 of the millions of homeowners likely to lose their homes. Those who argue that it's a mistake to encourage inflated home prices have a point, but it is surely possible to devise a plan that keeps homeowners in homes with values that have been adjusted downward. If taxpayers are ultimately going to have to write a check to someone, maybe it should be for the difference in the book value of mortgages that would otherwise go into foreclosure and the market value of those houses today.
Last week our elected leaders failed us. Not because they didn't immediately pass the bailout -- as some commentators would have it -- but because they didn't use the two weeks they had to come up with something more meaningful. We can only hope they do not make that mistake again.
1One somewhat abstracted indicator did take a turn for the worse. The so-called TED Spread, which measures the difference between the interest rate of short-term U.S. Treasury Bills and the rate for short-term interbank loans, is often used as a benchmark for perceived credit risk in the economy. (T-Bills are considered risk-free.) For the last several years, until September 2007, the TED Spread never reached one percent (and seldom topped 50 basis points). It spiked in mid-September 2008, and reached a new high of 3.5 percent the day the House voted down the bailout bill. It fell slightly the next day, but then began coursing upward, and on Friday, after the House reconsidered, closed at almost 3.9 percent, an all-time record.
2It didn't hurt that the Senate larded the bailout with tax breaks. Only 113 of the bill's 451 pages are taken up by the bailout. The remainder detail giveaways for "motorsports racing track facilities," Hollywood producers, and makers of toy wooden arrows, among many others -- $100 billion that in the context of the current environment simply adds insult to injury. And I say this as someone sympathetic to the renewed renewable energy incentives that are included.