Commentary: Bankruptcy, not bailout, is the right answer
CAMBRIDGE, Massachusetts (CNN) -- Congress has balked at the Bush administration's proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the "troubled assets" of financial institutions in an attempt to avoid economic meltdown.
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.
Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.
Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.
Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.
The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.
If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.
The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.
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.
Source
I mostly agree with this assesement except that for a capitalist system to work there needs to be inherent risk and the author seems to have missed this point. I think some of the argument for a bailout (though no one would dare admit it) is that, once upon a time, limited liability for corporations created a worthwhile bubble. So why couldn't other aspects of the economy also have limited liability?
The problem is that the LLC is a method of protecting investors personally from companies they own, that is, protecting their personal assets while their company folds. What this in effect does is externalize the cost of businesses failing onto the community instead of the investor. I don't mean just their shares in the company but their houses, yachts, cars etc...
Why the LLC worked is simple: it lowered the cost and risk of doing buisness by passing them onto the community. This did stimulate the economy in tremendous ways (added liquidity by luring scared money) and I believe the cost to society was justifiable but that was when these corporations were relatively small.
In todays world where we have huge central banks, international banks and mega corporations, which make the South Sea company look like a ma and pa opperation, it is unacceptable to ask society to absorb that risk. Where once limited liability freed money today it traps it. To further this argument I would put forward that these huge companies are owned
internationally so any limiting of liability is of no sole benefit to any single country but the cost is born entirely by one!
So, for example, if there is no bailout today in the USA all the stocks around the world fail! The only incentive the USA has to offer limited liability with taxpayers money is to preserve their economic stability, however, in terms of real world money that would stay in its boarders, there is next to no advantage. For this reason using public money for such insurance is an outrage!
The solution, therefore IMO, is to limit the size of a company which can offer limited liability. At some point the owners of a company should become liable for that company and in particular when it becomes a certain size. The way it sits now the taxpayers are liable and with companies of this size that is completely ridiculous!
CAMBRIDGE, Massachusetts (CNN) -- Congress has balked at the Bush administration's proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the "troubled assets" of financial institutions in an attempt to avoid economic meltdown.
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.
Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.
Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.
Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.
The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.
If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.
The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.
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.
Source
I mostly agree with this assesement except that for a capitalist system to work there needs to be inherent risk and the author seems to have missed this point. I think some of the argument for a bailout (though no one would dare admit it) is that, once upon a time, limited liability for corporations created a worthwhile bubble. So why couldn't other aspects of the economy also have limited liability?
The problem is that the LLC is a method of protecting investors personally from companies they own, that is, protecting their personal assets while their company folds. What this in effect does is externalize the cost of businesses failing onto the community instead of the investor. I don't mean just their shares in the company but their houses, yachts, cars etc...
Why the LLC worked is simple: it lowered the cost and risk of doing buisness by passing them onto the community. This did stimulate the economy in tremendous ways (added liquidity by luring scared money) and I believe the cost to society was justifiable but that was when these corporations were relatively small.
In todays world where we have huge central banks, international banks and mega corporations, which make the South Sea company look like a ma and pa opperation, it is unacceptable to ask society to absorb that risk. Where once limited liability freed money today it traps it. To further this argument I would put forward that these huge companies are owned
internationally so any limiting of liability is of no sole benefit to any single country but the cost is born entirely by one!
So, for example, if there is no bailout today in the USA all the stocks around the world fail! The only incentive the USA has to offer limited liability with taxpayers money is to preserve their economic stability, however, in terms of real world money that would stay in its boarders, there is next to no advantage. For this reason using public money for such insurance is an outrage!
The solution, therefore IMO, is to limit the size of a company which can offer limited liability. At some point the owners of a company should become liable for that company and in particular when it becomes a certain size. The way it sits now the taxpayers are liable and with companies of this size that is completely ridiculous!
