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The Bailout and Oversight.

Commentators have criticized the Paulson bill for claiming too much discretionary authority for the Bush administration, echoing a well-known complaint about Congress's authorization of the use of force against al Qaida. That authorization was a blank check, and this mistake will not be repeated, or so it is claimed, with the usual bromides about checks and balances.

It appears, though, that there are two criticisms rolled into one. One argument is that after 9/11 Congress did not deliberate enough before handing over power to the executive. The other argument is that Congress did not properly restrict the power of the executive in the course of issuing an authorization—by giving it limited powers or subjecting it to judicial or other types of review. Having learned from our mistakes after 9/11, we should insist both on democratic deliberation and enactment of meaningful oversight mechanisms.

These arguments are not so much wrong as question-begging. Congress has every incentive to deliberate; it will defend its institutional prerogatives and seek to ensure that the enacted law reflects its policy preferences. The problem is that, in the midst of a financial crisis, Congress does not have as much time as it ordinarily does. Most laws take months or years to pass. A complex optimal stopping problem arises: the longer Congress deliberates, the more that it will acquire information for making a good decision, but the greater the risk that the crisis will spin out of control. The stop-and-deliberate crowd (especially the economists among them!) need to acknowledge this problem. One suspects that their attitude merely reflects skepticism about the magnitude of the crisis or the ability of the government to solve it, not any real confidence that new information will emerge so that Congress can make better decisions. (That, or devotion to empty political forms.) How long should Congress take? A week? A month? A year? I can't see any reason to think that Congress will take any less time than it is reasonable for it to take given the urgency of action.

Meanwhile, the Dodd bill implements several oversight mechanisms -- or, more precisely, mechanisms that constrain the executive in some ways even as the bill hands over power to it in other ways. These mechanisms might be wise, but it must be acknowledged that they come at a price -- and their defenders have not shown that the price is worth paying.

1. Bankruptcy judges are given power to adjust mortgages. Democrats want to help homeowners. They give Treasury some discretionary authority to minimize foreclosures, but the sharing of power with bankruptcy judges is a crucial mechanism for limiting the power of the executive branch. Whether mortgage adjustment is good policy or not, the price of such a division of power is clear. The value of the mortgage-related securities you hold is in part a function of your prediction of how bankruptcy judges will trim the interest and principal in bankruptcy. The judicial system is highly decentralized and it will take years for common principles to develop. So it will be hard to predict how judges will act, and accordingly it will be hard to adjust the value of your assets. By contrast, if Treasury were given this power, it could issue some regulations and settle the issue. Remember that it is the valuation problem that is said to be the source of our current crisis in the first place.

2. Judicial review of "any determination of the Secretary with regard to any particular troubled asset." Determinations will be set aside if "arbitrary and capricious, an abuse of discretion," etc. The risk here is that prospective sellers of bonds will fear that a court will subsequently set aside the sale because the price or other terms seem unfair. Maybe no court would do that, but maybe some would. Are they likely to do a good job? To decide cases consistently? The result is more uncertainty with respect to the value of assets that are not selling because their value is already uncertain.

3. Reporting to Congress and an oversight committee that includes two congressional appointees, one from the majority party and one from the minority party, plus the heads of the Fed (Bernanke!), the SEC (Cox!), and the FDIC. I like the bipartisan representation of the committee, but the committee has no power. But suppose that it does. Now we must worry that Treasury will make purchasing decisions to please particular members of Congress who care about particular businesses in particular districts -- creating more uncertainty in the market, unless market participants can guess who those people are.

The benefit that is purchased is that it will be harder for Treasury to use its powers to aid political friends, and perhaps some good-faith pricing errors will be caught or avoided. But if this benefit is really substantial, why stop here? Why not make judicial review more searching or set up an independent agency to purchase assets? Why not have a bipartisan committee to make purchasing decisions? No one has a theory about how power should be divided. Dividing power makes sense in the abstract, but in the concrete it just raises, in procedural form, all the questions of policy that have not yet been answered. It reduces the ability of government officials to abuse their power but also to resolve the crisis.

As I have noted before, the oversight mechanisms that have received serious attention are pretty trivial, which suggests that Congress and probably most experts, believe, rightly or wrongly, that the executive needs a free hand.

Order of the Coif:
After 40 years as a "corporate lawyer," I doubt that any amount of oversight will get in the way of the excess greed of business managers. I know, I've been devising end-arounds since my first day as a Summer Associate.

You have to remove the "pot of gold" and replace it with a fair compensation scheme.

No "bailout" of Wall Street financial community (who knew or should have known either the risk they were taking or that they were acting in ignorance of the risk) UNLESS:

[b]Public corporations and all affiliates have executive compensation capped at $5 million (from all entities within the affiliated group).[/b]

[i]No[/i] bonuses until all debt to/guaranteed by taxpayers is paid, then no greater % of base comp than annual increase in lower of corporate net earnings (honestly calculated? - is that possible?) or shareholders stock price. [i]No[/i] "golden parachutes," golden handcuffs," or "golden retirement" plans (however disguised).

If the executives want to [i]purchase[/i] shares, then they can get all the capital gains that any other shareholder receives, no more.

[i]No[/i] "personal" use of corporate assets (limos, planes, apartments, ski lodges, etc.). [i]No[/i] "personal" use of corporate personnel) to pick up dry cleaning, walk dog, etc. "[i]No[/i]" means "no," not merely that it is treated as extra income. CEO's have to live like regular people.

[b]There are hundreds of thousands of MBA's, J.D.'s and Ph.D.'s who will work all day for $5 million per year.[/b] There is [u]no need[/u] to pay any human being any more.
9.24.2008 11:58pm
frankcross (mail):
On #1. I understand the judiciary already has this power for second homes (which seems very odd). So there may be a basis for prediction. I also don't think that Treasury has any chance whatsoever of resolving this with general "regulations." It's got to be discretionary.

Dems are pushing this provision, obviously, to help the little guy. But the justification, I think is externalities. Very little in this bailout actually does anything about the housing market, which is the root of the problem. Keeping people in their houses (and houses off the market) does make some contribution to this problem.
9.25.2008 12:03am
Frank M Howland (mail):
Eric:

Regarding 1., Treasury may not have the power to adjust mortgages. They will be buying securities which are fragmented; if someone else still owns parts of the mortgages, Treasury may not be able to take away that other party's rights. And, paradoxically, all the security owners might be better off if some entity (e.g. bankruptcy judges) prevents lots of foreclosures and instead negotiates a lower payment level thereby keeping some value in the reduced mortgage payments and maintaining higher property values. Your point about lack of certainty due to a decentralized system of course has some force here.
9.25.2008 12:04am
nick:
Dodd's proposal: 1. Bankruptcy judges are given power to adjust mortgages.

And we wonder why mortgage paper has such a low value? Traders in mortgage paper have been increasingly anticipating since the start of the decline in that paper (and the resulting decline in the finance industry) that government would encourage debtors to get out of their mortgages, at the expense of those holding mortgage paper. One very good way to boost the value of mortgage paper, and thus restore financial stability, would be to disprove this expectation, but instead we see that as usual market expectations are being fulfilled. The Dodd version will do the exact opposite of what is needed, it will generate more finance industry losses and instability.

As for #3, there is no political solution that will come anywhere close to preventing most of the money from being wasted, but trying to stave off the worst temptations for corruption that come from arbitrary power is much better than giving the money with no protections at all.
9.25.2008 12:09am
gerbilsbite (mail):
Not to quibble with such an eminent legal thinker as yourself, but when the two options presented for fast action are allowing judicial review under a loose standard, or completely removing the ability of the judiciary to conduct any oversight whatever of the administrator of $700 billion in taxpayer assets, I tend to think the latter camp has the heavier burden when it comes to justifying their position.

When we're talking about a massive bit of quasi-socialist economic engineering, it might be a good idea to park the formalism for a spell.
9.25.2008 12:45am
Gilbert (mail):
Regarding #3 - If you assume, instead, that the oversight committee has no power, your concerns do not follow. Meanwhile, the committee has the power to report to Congress which has all the power in the world to address abuses in the system, and does not suffer from the personal interests problem that you identified.
9.25.2008 12:51am
Visitor Again:
Nearly all U.S. voters have had enough of the vicious greed mongers of the capitalist class and the obeisance of their running dog government lackeys, including McCain and Obama. Screw bailouts, and to hell with the election. It's time for revolution before our whole country goes to hell. It's time to pick up the gun.

Sorry, just blowing off steam before bedtime.
9.25.2008 12:52am
Elliot123 (mail):
Traders often make offsetting trades very quickly. I can buy an instrument, and sell it five minutes later. Or I can buy it and sell a different one to offset it. What happens when some judge decides to change my initial purchase price? By the time the court action is taken and the lawyers all set their schedules, the instrument may have been traded fifty times.

(I think the proposed judicial review only applies where the gov is a party, but they might be a party to a great many trades.)

How about spreads? (simultaneous buy of one instrument, and sale of a similar) Is some judge going to rule that one leg of the spread is priced wrong?

How about hedgers who are trying to pass off risk? Judicial review artificially adds risk to the market.

If we want liquidity and volume in the markets, judicial review will thwart it. I believe the ultimate goal of the plan is to eventually pass the securities back into the private markets. Traders are going to be very reluctant to do participate if judges can change price after the trade has cleared.
9.25.2008 1:12am
Alan Gailes:
Congress does not have as much time as it ordinarily does.


But from White House Deputy Press Secretary Tony Fratto, we learn that this plan was put together over several months:
Defending the package, White House spokesman Tony Fratto said Tuesday that the bailout had been "months" in the making but insisted that lawmakers should pass it "this week."

"This was not a program that was conceived of, or put together, hastily. There was an enormous amount of analysis and debate and discussion before we came forward with this program," said spokesman Tony Fratto.

"Some of the policy staff have had months to think about what a program like this would be like and how it would work. Others have had at least weeks to think about it," he told reporters on a conference call.


If everything's on the up and up, then the high-pressure, used-car salesman tactics just weren't necessary. And real, hard details of the plan could be divulged. But this administration has chosen instead to sell a vague, hand-wavy program to the taxpayers, voters and the Congress with a campaign of sudden fear.

It's a scam.

Posner, looting the treasury is not good public policy.

I don't think I really despise you for insisting that a complete lack of oversight is desirable. But you're a fool to advocate it, unless you've been guaranteed your cut. In writing.
9.25.2008 1:50am
Edmund Unneland (mail) (www):
If the oversight committee had authority, would not the presence of congressionally-appointed members violate the appointments clause?
9.25.2008 1:56am
Public_Defender (mail):
Given my title, I'm obviously not a finance guru, but don't bankruptcy judges already have a set of rules for adjusting debt (even mortgage debt for second homes)? And why wouldn't those rules be easily transferable to first home mortgages? Of course, there would be questions at the margins, but what real problems would there be?

As to oversight, there is a price to pay for repeated dishonesty, incompetence, and defensive secrecy. I'm not sure that the price we'd pay for giving unchecked power to a band of secretive, incompetent liars (Bush Administration) is worse than the price of inhibiting executive action.

Posner, make an argument that supports your point about the need for executive action that assumes (correctly) that many of your readers don't trust the integrity or competence of the people you want to give the power to.
9.25.2008 6:18am
PersonFromPorlock:

Congress has every incentive to deliberate; it will defend its institutional prerogatives....

But its "instutional perogative" is to enjoy the perks of office while avoiding responsibility; thus, the AUMF 'authorizing' the president to go to war if he wants to and other ingenious dodges. "No time" is the perfect excuse for passing the dirty details off onto somebody else.
9.25.2008 8:04am
PersonFromPorlock:
Gaah. "perogative" = "prerogative"
9.25.2008 8:08am
A. Zarkov (mail):
Order of the Coif:

I like your reforms, but I think you're missing a big one: the CEO and Chairman of the Board should always be separate people.
9.25.2008 8:09am
Patrick22 (mail):
I think Congress would love to set up an independent agency to do this along the lines of the RTC. However, creating a new agency and staffing it and getting it into action will take months, if not years. It seems what Dodd is trying to do is create the same thing out of the Treasury Dept.

Probably the best thing to do is to fund the Treasury temporarily, come back in the new Congress, and set up an RTC-type agency that takes over. Hopefully, in the meantime, the Treasury won't screw things up too badly.

A better option would have been to give the money to the Fed. But the nasty detail they haven't been telling us about is that the Fed balance sheet is already a mess from taking this toxic waste as collateral.
9.25.2008 10:00am
Francis Marion (mail):
The issue regarding executive compensation is just plain dumb. The result will be that certain current highly paid executives in the financial industry will suddenly become highly paid "outside consultants" to circumvent the limits on executive compensation. Sometimes I really am amazed how stupid Congress truly has become. Clay, Webster, and Calhoun must be rolling over in their graves right now.
9.25.2008 10:49am
Francis Marion (mail):
The canary in the coal mine just died when the nation's largest auto dealer announced end of yesterday that it was closing due to short term credit drying up. The auto industry is extremely dependent on short term credit. If Secretary Paulson's plan isn't passed today, GM and Ford will not be able to draw on short term credit to meet payrolls. We can all kiss the domestic auto industry good bye in such event.

The markets close today at 4:00 p.m. EST. By 3:30 p.m., I will be cashing out my modest six figure portfolio if there is no deal in sight. I intend to be one among the first to exit this burning theater. The ban on shorts expires first of next week and there will be a huge pent up release of short trades as a result. Coupled with the seizing up of the short term credit markets, it will be "Good Night Gracie" for the American economy.

For this law blog, the real shame will come when law students return home for Christmas vacation to envelopes from their student loan lenders informing them that student loans will not be made available to them for the Winter Semester due to a lack of short term credit. In such event, I hope the law schools' financial aid offices will be prepared to deal with a deluge of requests for hardship loans from the schools.
9.25.2008 10:57am
PLR:
I agree with Elliot123. I definitely think there should be oversight, but to do it on an asset-by-asset basis is just loony.
9.25.2008 11:08am
Elliot123 (mail):
"And why wouldn't those rules be easily transferable to first home mortgages?"

The individual mortgage the judge is dealing with has already been packaged up and sold to investors. The investors purchased the package based on the aggregate rate of all the mortgages in the package. If the judge changes the rates on individual mortgages, the rate for the package also changes. This will lead to lower bids for the packages since there is more risk.

Given the huge number of mortgages in default, and on default watch, we are more likely to generate markets if investors do not have to accept additional risk. They already accept the risk that the home owner is a deadbeat. With judicial review they will also have the risk that a judge will change the rate on the instrument.

It's very difficult to dissect one of these things now. Judicial review will simply insure that investors now have to figure out how many lawsuits are in play, what the judge's past record has been, and what the judicial risk premium will have to be.
9.25.2008 12:34pm
Dan Weber (www):
The canary in the coal mine just died when the nation's largest auto dealer announced end of yesterday that it was closing due to short term credit drying up.

Bill Heard was a scoundrel. He's closing because the cops and GM are circling. Make a bowl of popcorn and Google "bill heard illegal".
9.25.2008 1:03pm
PersonFromPorlock:


Bill Heard was a scoundrel. He's closing because the cops and GM are circling. Make a bowl of popcorn and Google "bill heard illegal".


>"bill heard" + illegal< works better. He does seem to have had a customer satisfaction problem.
9.25.2008 3:09pm
CPT:
Whether or not there is "sufficient" time for Congress to "do something" avoids the central issue. Maybe there is enough time in a week, or a month, or a year to effectively deliberate, analyze, and solve the problem before the economy tanks. Maybe there isn't. That is not the problem.

The problem is that none of us has been told, in explicit terms, just exactly what this proposed $700B is buying, beyond alarmist platitudes about vague notions of saving mortgages and ethereal future credit concerns.

Give them a blank check based upon a handful of people wringing their hands and asking for the largest government intervention in history? Give it to them without any details as to what, when, where, who, how, and why? And give it to them under pressure to "act quickly"?

No way. If that results in further economic troubles, so be it. The choice always boils down to good/fast/cheap. Pick two. If it's good/fast, the sacrifice is cheap. For $700B, they can take a month to explain it. Anything else isn't gov't of the people. It's of bureaucrats.

Others can trust that equation. As for me, I was at the DMV today. Needless to say, there is no way I'll support a check that big without knowing what it's paying for.
9.25.2008 3:29pm
james messina (mail):
This is another way to bail us out
By James Messina


First let's go back to the beginning starting at bubble, although I'd rather refer it to a balloon. In the year 2000 just after post doomsday Y2K the balloon was just placed on stem of the tank of air. During that year a house, let's say in Holiday Florida would average at $50-60k. During that same year there were many types of easy loans such as HUD and Veteran (it wasn't necessary to actually be a Vet, one just got a little better rate if you were) which made it very easy for the average individual with $500 and job to obtain approval. Section 8 had a role in this also. If they had 20% of the price of the home they didn't even need a job. Actually they did, but what was referred to as a "no doc" all they had to do is just say they had an income.
Now here is where the air valve just barley inflates the balloon. Keep in mind that Holiday Florida is just a reference point and places like California and Miami holds the same principle just different prices. These loans usually carried an ARM which meant 5 years down the road Fannie Mae &Freddie Mac would be tacking on another 2.5-3% interest. These easy loans that owners had to put their signatures on, selling their souls sort of speak, compounded by falling prices.
Before they got to that point there was a "get rich quick" craze going on and everybody and his brother became an overnight realtor by "flip that house." or two or three or four, renting them or just fixing them up, and profiting by the fast rising house prices caused by the craze.
We can argue who is to blame, apparently both the home buyer and the lender is at fault. The lender acted recklessly and lent and lent and competed to lend. Mortgage and title companies were popping up all over leading the owners like sheep before the slaughter.
The balance of fault lies on the degree of greed. Could you blame the average Joe that wanted to get rich quick or the banks who should have had more sense?
Now we know how we got there lets propose how to get out. Giving 700 million to the same banks who got us here, paid for by the average Joe's taxes and not only that but, Joe must barrow the money with interest just to give it to the ones who lent Joe the money for the house that he is now foreclosed on. That's like Joe borrowing money to give to heroin dealers in order to make sure they have a steady supply of heroin that they could sell him.
We have another option but of course it will not be considered because the government thinks it is in their best interest to help the banks thinking it will save Wall Street. We have to let the air out of the balloon by getting the prices of homes closer to the year 2000. The way we can do that is instead of giving the money directly to the banks; give it to the notes that are over priced. Let's start with Joe's house and his only house for now. If he paid let's say $200,000 and he is in foreclosure, reset the value to the year 2003. That means rewriting the note. The year used adjusting the house value would be determined on until the 700 billion is allocated to first every homeowner that will occupy that house(700 billion will just an arbitrary number for now or just a limit). This will in no doubt cause values to come down all over. This plan could be implemented to the relevance of importance. The homeless first then to the struggling families aiming at the outrageously over priced homes, this will hurt the rich and humble undeserving. There are Joe's out there that flipped houses until he bestowed on half a million dollar house with an income that can't support it. He should eventually be included in this bill.
It all comes down to the basics, supply &demand. Now the supply is high. By slashing prices will create gamut of demand. New loans, transparency and credit will flow like neighborhoods at a block-party. This is the way to bailout Main Street &Wall Street.
9.25.2008 3:31pm
Reality Czech (mail):
The problem is that, in the midst of a financial crisis, Congress does not have as much time as it ordinarily does. Most laws take months or years to pass. A complex optimal stopping problem arises: the longer Congress deliberates, the more that it will acquire information for making a good decision, but the greater the risk that the crisis will spin out of control.
There is a simple solution to this.
1. Authorize the Fed to buy only good new debt for a set period, leaving the bad debt with the banks. This creates liquidity without rewarding the wrongdoers.
2. Leave the solution to the new Congress.
9.25.2008 5:52pm
Elliot123 (mail):
"Whether or not there is "sufficient" time for Congress to "do something" avoids the central issue. Maybe there is enough time in a week, or a month, or a year to effectively deliberate, analyze, and solve the problem before the economy tanks. Maybe there isn't. That is not the problem."

It's a mistake to think there is a single problem that can be rolled into a neat soundbite. Time certainly is a problem, but it is one of several serious problems.

Suppose line of credit from a bank to a small business is due to be rolled over today, but the bank has curtailed lending and cuts off the business. That is a very serious time problem.
9.25.2008 6:12pm
PersonFromPorlock:

Suppose line of credit from a bank to a small business is due to be rolled over today, but the bank has curtailed lending and cuts off the business. That is a very serious time problem.

This only happens if the bank has no money to lend. So far, there haven't been any bank runs that would make that the case.
9.25.2008 6:59pm
Elliot123 (mail):
I agree a run will prevent lending. However, banks will cut off credit when they are acting to maintain a healthy balance sheet so there is no run on the bank. No bank will keep lending until it has no money left.

We recently saw that banks curtailed overnight lending to each other. It was real; it happened, and continues. That is just one thing that can cause a bank to curtail credit to commercial borrowers as it seeks to strengthen its position.
9.25.2008 8:14pm
Thomas Vega-Byrnes, Lecturer in Law, U Chgo Law School (mail) (www):
One aspect of the current crisis that has received some attention but not nearly enough is the role of the accounting profession in allowing the abuse of off-balance sheet structures to deceive investors. Auditor's letters routinely state that financial statements give true and accurate picture of a legal entity's finances, yet the FASB has tolerated for years the abuse of off-balance sheet structures. I know these plays intimately, having been counsel to major banks in setting up synthetic lease financings for Enron and other electric power plant financings. The revisions to the accounting rules in the wake of Enron (rules on "variable interest entities") are quite inadequate. The off-balance sheet concept is what enables securitization, and is at the root of the current troubles. Poorly underwritten loans (e.g., the famous "no doc" mortgages in which the borrower simply "swears" to his/her income without any supporting documentation) could be generated and re-sold in the secondary markets and sliced and diced in securitization trusts, in large part because the accounting rules allow (still allow) the major financial institutions that created these structures to keep them off their balance sheets and thus not bear the weight of the contingent liabilities on their balance sheets. Off balance sheet structures should be outlawed by act of Congress. The FASB has proven to be a failure at policing the accounting profession when it comes to writing accounting rules that achieve the ostensible purpose of protecting investors from deceit and fraud. The PCAOB (Public Company Accounting Oversight Board) is a joke. It is a private sector non-profit with no direct authority over the actual writing of accounting rules. The SEC has said that US companies will have to adopt IFRS but that is still a way off, and I don't know if off-balance sheet structures are also allowed under IFRS. The bottom line is that if audited financial statements are allowed to still hide the ball by permitting off-balance sheet treatment of a firm's activities, then the accounting profession has failed the investing public.

A second problem is over-leverage, by which financial institutions that are functioning like banks, by holding the public's savings, e.g., in money markets, and so-called "low risk" mutual funds, were allowed to avoid the prudential regulations imposed on traditional banks, to maintain sufficient capital adequacy. High leverage (high debt to capital ratios) in a falling market are what have plunged us into this crisis. If we had modern financial regulation that looked at substance over form, i.e., if an institution functions like a deposit-taking institution, it should be regulated like one. The fact that extremely low yields on savings accounts have driven millions of Americans to effectively save via money markets and mutual funds is a development that has been ignored by the outmoded (mid-20th century) financial regulatory structure we have in this country.
9.28.2008 8:47pm

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