How Chicken Little Is Making the Sky Fall (Updated 9/30/08; 10/1/08; 10/3/08)

I think even the most diehard anti-bailout partisans, both left and right, would agree that there have been increasing problems in the financial markets, and that those problems seem to be coming to a head.  Although I have a degree in economics, it has been almost two decades since I have used much of that knowledge, so most of it has slipped away.  So I do not claim to be an expert; just, maybe, a well-informed lay person.

In my opinion, though, the blame for transforming a troubled sector of the economy into an ‘emergency’ and ‘crisis’ that requires immediate attention (or else the “US stock market could suffer a devastating crash with shares losing a third of their value“) lies at the feet of Secretary of the Treasury Henry M. Paulson, Jr., with some left over for the congressional leaders that let his panic infect them.  It has hardly been a shining moment for President Bush either.

For some good background on what is happening and why, I recommend this article from the Cato Insitute, and this blog post at Big Lizards (h/t Ace).  From the Cato article:

The background to our current financial problems is that the United States as a whole is over-leveraged. There is too much debt and too little saving.

Low interest rates fueled the housing bubble by making real estate purchases more attractive (on top of the policies favoring loans to risky prospects), thereby raising prices drastically (big demand, limited supply, etc.).  The market inevitably became overheated, and the bubble popped.

In the meantime, financial insitutions started selling securities backed by bundles of mortgages with similar interest rates.  Because mortgages were ultimately backed by the government (via Fannie Mae and Freddie Mac), these mortgage-backed securities (MBSs) were considered as solid as government bonds.  There are a lot of arcane rules governing MBSs, but the most significant one is that they are ‘marked to market.’  What this means is that if one person sells an MBS of a certain class at a certain price, all the MBSs of that class, held by everyone, are valued at that price.

The problem now is that the mortgage defaults, combined with the takeover of Fannie and Freddie, have made the value of the MBSs unclear, and nobody can sell them.  So these large financial institutions have a large chunk of their assets tied up in these MBSs.  Previously, they were extremely liquid, meaning that they were as good as having cash on hand (better, because they brought a return).  Now, however, they are almost completely illiquid.  It is kind of like having all your savings in dollars stuffed under your mattress, and suddenly nobody takes dollars anymore — but they will again sometime in the future, you just don’t know when.

That is a good analogy to the position these financial institutions are in.  The MBSs are not worthless; the problem is that no one knows what they are worth.  Someday they will be able to sell the MBSs again, even if it is at a loss, but right now they are effectively frozen.  The potential losses are not really the problem:  the problem is that these institutions have big chunks of their money tied up in MBSs and cannot use it.

Under the ‘bailout’ plan, the government would set a price for these MBSs, buying them at a slight premium.  This would both allow banks to directly liquify their assets tied up in MBSs, and also restore the liquidity of MBSs in general because there would be a guaranteed price floor and thus people would be willing to buy and sell them again.

To wander a bit further afield before trying to tie this up, I have yet to see a convincing argument that explains the need for the Paulson plan — even if you assume that a bailout is necessary.  As the Cato article I link above points out, the Treasury Department has other means of restoring banks’ liquidity, and in fact is already doing so.  This takes the form of loans to these institutions, taking the MBSs as collateral rather than buying them outright. This seems like a superior solution to me, because the institution remains liable for the full amount of the loan regardless of how the price of the MBS behaves.  The government is then not subsidizing the poor business choices of these institutions.  Further, the government avoids taking possession of the mortgages backing the MBS unless the institution defaults, instead of getting into the mortgage business wholesale the way it would under Paulson’s plan.

I also have yet to see a convincing argument — one that actually connects the dots — as to how doing nothing will result in utter catastrophe.  Yes, the stockmarket will take a hit, but (1) any value ‘lost’ was probable inflated to begin with; (2) any value lost will eventually be regained, even if not in the short term; and (3) the stocks that are going to suffer worst are either the institutions that caused this mess or are businesses that are overly reliant on easy credit.  There will also be a contraction of the money supply (I won’t get into the nuts and bolts) which could cause or deepen a recession.  Banks will fail, but banks are already failing, and the bailout won’t stop that.  The losers from bank failures are employees, stockholders, and depositors with deposits over the current FDIC $100,000 insurance limit — and it is only really the last that has much effect on the economy as a whole, by further reducing the money supply.

Under a worst case scenario, yes, a meltdown in the financial sector could result in a deep recession or even depression.  Should the government do something to prevent that?  Sure, but then the government already is.

Is the bailout necessary?  Unfortunately, it probably is now — at least in some form.  And the blame for that rests, as I mentioned at the beginning of this article, at the feet of Secretary of the Treasury Henry M. Paulson, Jr., and the congressional leaders that let his panic infect them.  The financial sector was struggling, and rockier times were ahead, but there was no impending doomsday.  Paulson’s screaming and running around in circles bumping into things had two effects:  (1) it convinced the stockmarket that there was a reason to panic if something did not happen right now; and (2) it actually made the MDS market worse.  Only an idiot would risk selling an MDS at a loss now if it looks like the government is going to buy it at a higher price later.

Paulson’s doom and gloom may or may not have been based in reality, but unfortunately for the world markets (not just America), he has both directly and indirectly worked to make his prophecies self fulfilling.  Congressional leaders (mostly on the left side of the aisle, but not exclusively) made it worse by buying into the hysteria and even amplifying it.

So now we are in a position where I think the government has to do something visible.  I think the Paulson plan was bad, and a wholesale buyout unecessary.  But there has to be some gesture, even if it’s mostly symbolic, to restore investor confidence and at least get us back to the position we were in before Paulson began his Chicken Little dance.

Update:

Apparently the Senate vote is scheduled for tomorrow at 9 pm.

Apparently they have added ’sweetners’ to the deal to make it more palatable to Republicans.

(Michelle Malkin translates for us:  sweeteners = earmarks to buy votes.)

Ug.

Apparently Senator Chris Dodd (D – Conn.) has added an amendment.

I think ‘ug’ is too optimistic for that.  Oh, and the text is apparently not available in advance.  Lovely.

CORRECTION – Apparently I can’t read.  I originally wrote that the vote was scheduled for 9 am rather than pm.

MORE THOUGHTS:

Lots of politicians, lots of bureaucrats, and lots of bankers are saying we need this bailout and we need it now, or the world will come to an end.  But a Harvard economist, who presumably has no personal stake in this, says that we should let it ride.  Hmm.

UPDATE (October 1, 2008 at 11:54):

Another economist, this one a winner of the 2006 Nobel Prize in economics, says that some action is need but the Paulson plan is not the way to go.

UPDATE (October 3, 2008 at 9:46):

Michelle Malkin’s latest column is on the Crap Sandwich 2.0.  In it she calls out Sec. Paulson for his Chicken-Little antics.