Markets & Finance

The Bailout: Back from the Dead


Ronald Reagan once noted, "I'm from the government and I'm here to help," are the nine most terrifying words in the English language

From Standard & Poor's Equity ResearchAfter the U.S. House of Representatives' stunning rejection of a rescue plan for the financial services sector on September 29, the Bush Administration's revised bailout bill passed the Senate 74-25 on October 1. And on October 3, the House finally concurred.

Along the way, the Emergency Economic Stabilization Act of 2008 ("EESA") bulked up to $800 billion from $700 billion and to 451 pages from 2.5. Pages 113 to 451 offer a cornucopia of items — $150 billion of public funds, the Wall Street Journal estimated, for everything from credits for new qualified plug-in electric drive motor vehicles to an exemption of excise tax for "certain wooden arrows designed for use by children."

Washington is nothing if not baffling. But given the levels of terror from Wall to Main –– its desire to "do something" is understandable. And given the subarctic temp of the credit freeze, it is necessary.

The hope of EESA is that the U.S. government's purchase of up to $700 billion worth of "toxic assets" from troubled firms will cleanse balance sheets and thus motivate loan officers to cut checks to businesses and consumer alike. Knock on wood — the stern record of history testifies that big fixes can sometimes deliver consequences more unpleasant than not.

EESA will turn the U.S. government into the largest hedge-fund in history — with taxpayers liable for an Everest of paper that nobody but nobody has been interested in buying. But that's not the least of it.

The Manhattan Institute's Nicole Gelinas thinks Henry Paulson has misdiagnosed the problem. It's not "toxic assets" — $600 billion worth of which has been written down already, according to figures compiled by Bloomberg. Nor is it a fundamental lack of liquidity: yields on 3-month Treasuries are at lows not seen since the Fifties, indicating a flight to safety.

The problem is a lack of trust between financial institutions, as evidenced by the historic spread between 3-month Treasuries and LIBOR. And at the root of that mistrust is not the failure of free-market capitalism, as gleefully asserted by pundits. Instead, Gelinas says, it's the failure of Wall Street's basic business model.

For the last several decades, Gelinas says, Wall Street has operated under the assumption that anything – a house, a mortgage, an auto loan, credit-card receivables — could be transformed by the magic of securitization into a security tradeable in real time, like common stocks or U.S. Treasuries.

This assumption has proven spectacularly incorrect. There is no market for those securities. And now, a new financial system must be created, more or less from scratch.

This is of course entirely possible — smaller institutions can rise and replace the ones that failed. But Gelinas is concerned about the quality of management at institutions that take advantage of EESA's $700 billion. Will they be able to admit that the old model has failed, and adapt to reconstruct a New Model financial system?

And Gelinas doesn't much care that under EESA, good institutions will be required to compete with firms left to hobble along after selling their bad assets. She would also prefer bondholders take a haircut for losses on bad assets. (Thus far, Gelinas notes, losses have been selective – WaMu debtholders lost money, Wachovia's did not.) Otherwise the moral hazard will continue to haunt Wall and Main Streets alike.

"First, do no harm," was the counsel of Hippocrates. Applied to public policy, this often means choosing the least bad option. As EESA stood on October 3, is it the "least bad" option?

Dr. Charles Calomiris, a visiting scholar at the American Enterprise Institute, suggests government purchases of preferred stock in distressed firms — an approach resembling that of the Depression-era Reconstruction Finance Corp. Sweden undertook such a program, with considerable success, in the 1990s.

Preferred stock investments, Calomiris says, would avoid the headaches associated with pricing subprime assets for government purchase. Under EESA, assets will be acquired at "ill-defined, 'above fire sale' prices, an approach that positively invites errors and abuse in execution."

Preferred stock purchases, on the other hand, would leave valuation and liquidation decisions in the hands of the private sector — but provide financial firms with much-needed recapitalization. However, the U.S. government decided to take another tack.

Economic historian John Steele Gordon, at a round table on the crisis sponsored by the Manhattan Institute, says the current environment resembles 1929. Bad regulation, however, could turn it into 1932.

Holloway is Vice President, SP Editorial .

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