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Continuity We Shouldn't Believe In - Moral Hazard and the Geithner Bailout Plan:

Nobel Prize-winning liberal economist Joseph Stiglitz points out that the Treasury Secretary Tim Geithner's plan to have the government subsidize investments in "toxic assets" creates a serious moral hazard: Private investors will pocket any gains, while the federal government promises to cover virtually all potential losses:

Professor [Joseph] Stiglitz on Tuesday led a list of well-known economists and high-profile industry figures who have said Treasury Secretary Tim Geithner's toxic asset plan may not be as successful as it first seems.

The plan involves ensuring up to $100bn of government funding is matched by private investors, with the monies combined and leveraged up, in some cases to by as much as 20:1, with the help of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), to buy pools of unwanted assets.

Professor Stiglitz, speaking at a conference in Hong Kong, said that the US government is essentially using the taxpayer to guarantee the downside risks, namely that these assets will fall further in value, while the upside risks, in terms of future profits, are being handed to private investors such as insurance companies, bond investors and private equity funds.

"Quite frankly, this amounts to robbery of the American people. I don't think it's going to work because I think there'll be a lot of anger about putting the losses so much on the shoulder of the American taxpayer."

As Stiglitz suggests, this privatization of profits combined with socialization of losses is likely to incentivize overly risky investments that taxpayers will be left holding the bag for. It may also lead to misallocation of resources, as investors transfer funds from more economically efficient uses in order to take advantage of Uncle Sam's blank check for investing in "toxic assets." Jeffrey Sachs, another prominent liberal economist, makes a similar point in this Financial Times piece (free registration required).

Ironically, the moral hazard created by the Geithner plan is similar to the incentivizing of risky mortgage investments by the government's backing of Fannie Mae and Freddie Mac, which played a major role in causing the financial crisis in the first place, as economists Peter Wallison and Charles Calomiris describe in this paper. Wallison deserves some credit for warning about this danger back in 2005.

Both parties deserve blame for the policy of federal backing for dubious mortgages and investments. Certainly, President Bush didn't help matters when he, in his own words, "use[d] the mighty muscle of the federal government" to promote the issuing of risky mortgages.

Barack Obama, however, promised to break with the failed policies of the past, and often criticizes those who he claims advocate "the same failed ideas that got us into this mess in the first place." Ironically, he has now embraced some of the worst of those ideas himself.

martinned (mail) (www):
Just a nitpick: imho, economics is actual science. So rather than describing Stiglitz and Sachs as "liberal economists", it would be fairer to describe them as economists who are liberals, or liberals who are economists, or something along those lines.
3.31.2009 6:53pm
common sense (www):
I have heard some novel plans presented, but they were more concepts than fully developed. The fact that we keep coming back to the same bad conclusions makes me wonder if there really isn't a better plan that makes sense once it has been fully developed. I want to believe that there is a better solution by any of several metrics, but I wonder why no one has seriously presented one. The incentive is surely there. A Republican congressman who could present a plan as a bill, with the full backing of a respected group of economists would make huge gains politically. So, it is a given that the current plan is bad. Is there a better, legitimate alternative bouncing around?
3.31.2009 7:03pm
gab:
Or we can let Citibank, B of A, Fifth Third, Wells and a bunch of other banks go broke, wipe out trillions of dollars of debt- and equity-holders money, and start fresh.

Sound like a plan?
3.31.2009 7:06pm
Ilya Somin:
So, it is a given that the current plan is bad. Is there a better, legitimate alternative bouncing around?

For a start, we can get government out of the business of subsidizing dubious private investments. Even if we can't think of a way for the government to make the situation better, we can at least prevent it from doing things (like the Geithner plan) that make it worse.
3.31.2009 7:07pm
Thoughtful (mail):
Geithner is a lawyer. I can't understand how this happened?
3.31.2009 7:11pm
ShelbyC:

imho, economics is actual science.


It's a social science, FWIW
3.31.2009 7:22pm
common sense (www):
Prof Somin,
Is that a legitimate plan in the current economic climate? With all apologies to Mr. Rumsfeld, we make laws with the electorate we have, not the one we wish we had. And that still leaves the question unanswered that I have seen debated by people with a much stronger background in economics than I have: is the long term cost of this kind of moral hazard worse that the short term implications of bank collapse? Instinctively, I'm with you completely. But I think there must be some alternative, positive action or a compelling argument for the government doing nothing in this specific case that convinces enough of the general populace to make it politically tenable.
3.31.2009 7:30pm
David Welker (www):
martinned,

With respect to economics, I am not sure what saying it is an "actual science" means. Is sociology an "actual science"?

If you mean it is just like Physics and Chemistry, I don't think you could be more wrong.

------

With respect to the issue of "moral hazard" I think the concept is much more valid with respect to predictably repeatable events. If the government only "might" bail you out, then the degree of over-investment by a "rational" investor (and I am not sure that investors are all that rational) will be lower.

It is not as if no one who made bad bets has lost any money, right? Actually, they have. And, it has been quite unpleasant.

Furthermore, this sort of "moral hazard" cannot be eliminated merely be a government decision not to bail out a company that is "too big to fail" in a particular circumstance. After all, even if a particular company is not bailed out this time, still, the government "might" bail out companies in the future (perhaps when it is controlled by a different political party or even the same political party.) The fact that the government chose not to bail out Lehman did not prevent it from bailing out AIG. And this was so even though the government was still controlled by the same political party.

The "solution" to this problem of moral hazard isn't to do anything stupid, like let the financial system collapse. I think Geithner's proposal to give the government more power to make something other than a binary decision (either allow complete failure or bailout the company) would better address the problem of moral hazard.

Anyway, the problem of moral hazard isn't something we would want to eliminate completely anyway. The fact that there are emergency rooms that are available regardless of the ability to pay might hypothetically cause individuals to "over-invest" in eating Big Macs. But, guess what, rational individuals would not eat as many Big Macs as people do now anyway. The consequences of having a heart attack are pretty dire, even if it doesn't kill you. But, many people still irrationally eat too many Big Macs and similar foods.

I think that the hyper-rational humans that are presumed by an excessive concern with moral hazard is as much myth as reality. If people were rational, they would not destroy their health by eating bad foods. But, if people aren't even fully rational when it comes to their health which is much more important, what makes you think they would be fully rational when it comes to their money?

It should be noted that concerns about "moral hazard," if taken far enough, would justify being extremely harsh in all sorts of areas of life. For example, doesn't bankruptcy cause "moral hazard" by allowing entrepreneurs to somewhat normal lives with a "fresh start" after making business mistakes? Wouldn't entrepreneurs be more cautious if they had to pay for the "full value" of any business decisions, even if that put them in an indentured servitude like state for the rest of their lives? What about eliminating debtors prison? Hasn't that perhaps lead to people taking more risks? What about allowing corporations to get away with limited liability? Does the fact that one can only lose their investment and nothing more when they buy stocks not lead arguably lead to "over-investment"? Wouldn't investors be more cautious in investing if they were on the hook for the full consequences of their investment going badly (yes, you must pay for all of those torts caused by that corporation you invested in, even if that exceeds the amount of your investment), including losing possibly more than the amount invested.

What I am saying is that I think that when it comes to issues of "moral hazard" we probably do not need to be "precise" in ensuring that the "full pain" of a mistaken prediction about the future is felt by the party making the mistake. (And I think the question of what amounts to the "full pain" of a decision where the future was predicted incorrectly is in many cases rather arbitrary. Is "full pain" losing your investment? All of your assets? Your freedom?) It probably is enough to simply ensure that there is "enough pain" which is a slippery concept and leave it at that.

Anyway, this side point about moral hazard to the side, liberal economists like Joseph Stiglitz and Paul Krugman might be right and Geithner's approach here might not be optimal. Or maybe liberal economist Brad DeLong is right to be more hopeful. We will just have to see.

But I am pretty damn sure that Ilya Somin's post here, to the extent that it implicitly assumes a very crude and savage approach to the concept of moral hazard is optimal, does not really lend any insight into that issue.

I think a much more interesting conversation on that topic is here.
3.31.2009 7:36pm
David Welker (www):

For a start, we can get government out of the business of subsidizing dubious private investments. Even if we can't think of a way for the government to make the situation better


Oh, so surprising. Somin just gave the same solution for this problem as he gives for everything. Do nothing. Everything else in his mind is just an elaborate justification for the same simplistic solution to all problems.

It is very interesting to me how ideology renders intelligent people stupid.
3.31.2009 7:40pm
Thoughtful (mail):
DW: One of my favorite economists summarized the situation this way: We have already tried something (the bailout) and it didn't work. It's time to try nothing. PhD in economics. So perhaps the idea of doing nothing is not as radical and ideological as you think. Just because a policy is easy to understand doesn't mean it's simplistic.
3.31.2009 8:00pm
ShelbyC:

It is very interesting to me how ideology renders intelligent people stupid.


You sure do make your point. He proposes getting government out of the business of subsidizing dubious private investments as a solution for everything?
3.31.2009 8:01pm
David Welker (www):
Hi typical "solution for everything" is for the government to do nothing.

I don't mean literally "everything." But close enough.
3.31.2009 8:03pm
David Welker (www):
His typical "solution for everything" is for the government to do nothing.

I don't mean literally "everything." But close enough.


Note to self: Must actually read over comment once before posting.
3.31.2009 8:03pm
ShelbyC:
@David Welker:

I'd imagine government doing nothing is not his solution for murder, robbery, etc.

When you have an ideolgy that confines governement to one arena and keeps it out of another, it isn't necessarily stupid to apply that consistantly, is it?
3.31.2009 8:12pm
Andy Freeman (mail):
> Just a nitpick: imho, economics is actual science. So rather than describing Stiglitz and Sachs as "liberal economists", it would be fairer to describe them as economists who are liberals, or liberals who are economists, or something along those lines.

Since their "scientific conclusions" can be predicted (somewhat) from "liberal", the label "liberal economist" is completely fair. In fact, given such adjective's predictive power, their usage should be mandatory when applicable.

The utility of such labels is one thing that distinguishes chemists and astronomers from economists.
3.31.2009 8:13pm
David Welker (www):

We have already tried something (the bailout) and it didn't work. It's time to try nothing. PhD in economics.


Let A1 = do x1
Let A2 = do x2
...
Let A71 = do x71
Let A72 = do nothing
Let A73 = do x73
...
Let An = do xn


That we have tried, let us say A235, does not imply that we should do A72 rather than say A150.

That your favorite economist uses "logic" to conclude that we should do A72 because A235 has been tried would indicate a serious deficiency in logic.

Like I said, ideology renders intelligent people stupid.

Second, it is hard for me to understand how the bailout has already "been tried" when it hasn't been given enough time to be implemented yet.

I am actually inclined against the approach taken by the administration. I prefer that the government allow these companies to go into bankruptcy and then, and only then, provide funds for a percentage of the money owed to counter-parties after substantial haircuts. Make sure everyone who made a bad business decision feels "some" pain. At least that is the approach I would be inclined to. Honestly, with due humility, I am not 100% that this would be the best approach because I think it is a really tough problem.
3.31.2009 8:14pm
Andy Freeman (mail):
> His typical "solution for everything" is for the government to do nothing.

Note the absence of an argument that doing nothing in this case is worse than the "something" being proposed....

While doing nothing may not always be the best approach, I've never seen a situation where doing nothing was the worst alternative.
3.31.2009 8:20pm
David Welker (www):

When you have an ideolgy that confines governement to one arena and keeps it out of another, it isn't necessarily stupid to apply that consistantly, is it?


Is it stupid to have an ideology that is so damn simplistic for a world that is considerably more complex?

Like I said, ideology has lead otherwise intelligent people to come up really moronically simple solutions to complex problems. In that respect, I would suggest that libertarianism has striking similarities with communism. Pol Pot was so convinced that the world would be a better place if only all those "evil capitalists" in the cities lived like peasants in the countryside.

Result of forced evacuation of the cities? Mass starvation.

Just maybe the simplistic division of the world into "evil capitalists" and "good peasant farmers" doesn't "work" for a considerably more complex world.
3.31.2009 8:25pm
David Welker (www):

I've never seen a situation where doing nothing was the worst alternative.


That something isn't the worst possible solution does not mean that it isn't a horrible solution.

In response to a small pain in your finger, the doctor decides to amputate your leg. Now, this solution isn't as bad as if the doctor decided to amputate your head, but it still is a pretty horrible "solution."

That something is not the "worst alternative" is close to completely worthless in evaluating a proposed solution, at least in the general case.

(Of course, you are really saying something if there are only two choices in a particular context.)
3.31.2009 8:31pm
ChrisIowa (mail):
The problem is that the values of the loans on the banks' balance sheets is supposed to be valued at the market under the mark to market rules. But there is no market, so the value cannot be determined by the market or must be assigned a value of zero. Geithner's plan is intended to develop a market so they can be assigned a value.

Each loan has a cash flow into the bank for a given time, given an interest rate for that time the value of that asset can be determined. The loans in the aggregate have a default rate, or a risk of a near-zero value. There are ways of assigning all the needed values, that is how all the actors in the market will assign value. It seems to me that instead of Geithner's plan, it would be sufficient to substitute a formula.
3.31.2009 8:53pm
Michelle Dulak Thomson (mail):
David Welker,

If a Republican Administration had proposed something like this — huge amounts of dubious but potentially valuable stuff to be auctioned off to private investors, with the investors getting the bulk of any profits but the government taking the bulk of any large losses on itself — would you think about it as you do now?

I'm not nuts about it, judging as well as I can from what I know — but, then, I don't know enough to be capable of judging it. The moral hazard problem is there; but so are these assets, which eventually have to be valued some way or another, yes? Geithner's scheme makes the first step of attaching some dollar value apart from the nominal one on the banks' books that everyone seems to agree is bunkum. And maybe if people start trading in these things again, they'll be able to separate wheat from chaff, or at least sound wheat from spoiled wheat.

But can you imagine the response were a McCain Administration to try this? Socialization of risk and privatization of profit; a bunch of fat cats pick up everything, keep the gold, and leave the American public with the dross ... and the tab.

I can't figure out whether the muteness so far on the Left is due to a real blindness as to how this works, or to a charitable assumption that Obama will make it come out all right further along.
3.31.2009 9:00pm
Bruce Hayden (mail):
Is it stupid to have an ideology that is so damn simplistic for a world that is considerably more complex
Maybe the problem is extremely complex, and so are some of the putative solutions. But I don't see Ilya's point being all that complex or obscure. It is really rather simple - someone is likely to make huge amounts of money on this, and, at worse, isn't going to lose any. Heads they win, tails they break even. Wish I could be on that gravy train, but obviously can't, since I can't make the minimum investments required.

Of course, the firms being let in on this deal may ultimately be held to the same sort of compensation limits that AIG, GM, etc. are supposed to be. We shall see. I expect complications though with the billions that are likely to be slopping around here.

Of course, if you can refute his point, then fine. But so far, waving hands and moaning about how complex it is, isn't persuasive. Some times things really are that simple.
3.31.2009 9:01pm
Allan Walstad (mail):
Politics is a lot like professional wrestling, isn't it? Quite a spectacle requiring much talent and practice, but ultimately rather less of substance than meets the eye. Bush blows treasure on wars and bailouts, people vote Obama in for "change," and Obama blows more treasure on war and bailouts. How can that be? Because most professional pols have a lot more in common with each other than with most of the rest of us. Their astronomical arrogance permits them the conceit of being able to control outcomes everywhere and everywhen. Their talent for getting votes does not necessarily translate into any special wisdom.

This whole Chicken Little fear that the world goes bust if big banks fail is the purest of poppycock. The buildings are still standing. The computers and phones are still there. People's expertise has not vanished. Factories, land, and other productive capital remain. If a house of cards collapses, the fact is you can't eat, wear or live in a house of cards. When firms go bankrupt, their assets are divided among creditors. If people generally desire banking services, there is every incentive for other people to get in the business of providing those services at a profitable price. Yes there will be some disruption while things get sorted out, but is that really worse in the long run than having the Fed print a trillion greenbacks to toss to the four winds, while the Treasury drags us trillions deeper into debt to China?

Government meddling in the market got us into this mess. More government meddling is not the solution. Oh, and by the way, simple does not equal simplistic. It is indeed a fairly simple idea that people should be free to pursue their goals and purposes non-coercively in a market economy, with a strictly limited role for government. What is simplistic is the notion that Obama, Bernanke, and Geithner can steer the economy like driving a car down the street.
3.31.2009 9:17pm
trad and anon (mail):
That was my first thought when I heard of the Geitner plan. I hope it works, but I am not optimistic.
3.31.2009 9:46pm
Ricardo (mail):
...muteness so far on the Left

Are Joseph Stiglitz and Paul Krugman not members of "the Left"? "Progressives" seem to have become disillusioned with Obama some time around day 5 of his presidency.

This whole Chicken Little fear that the world goes bust if big banks fail is the purest of poppycock.

1931 saw a record number of bank failures in the U.S. and also saw an enormous contraction of GDP and industrial production as well as a steep rise in unemployment. Milton Friedman argued it was really the bank failures of 1931 that turned the already severe recession of 1929-1930 into the Great Depression. The U.S. also fared particularly bad in the Great Depression compared to countries that devalued their currencies and cut rates in order to open up lending to troubled banks.
3.31.2009 9:48pm
Ricardo (mail):
Each loan has a cash flow into the bank for a given time, given an interest rate for that time the value of that asset can be determined. The loans in the aggregate have a default rate, or a risk of a near-zero value. There are ways of assigning all the needed values, that is how all the actors in the market will assign value. It seems to me that instead of Geithner's plan, it would be sufficient to substitute a formula.

Sorry, but excessive use of formulas was really one of the many reasons for mess we are in now. Where does the default rate we substitute into the formula come from? Once upon a time, it came from observing the market in credit default swaps. We now know that implied default rates that came from the CDS markets were pure garbage.
3.31.2009 9:57pm
David M. Nieporent (www):
Like I said, ideology has lead otherwise intelligent people to come up really moronically simple solutions to complex problems. In that respect, I would suggest that libertarianism has striking similarities with communism. Pol Pot was so convinced that the world would be a better place if only all those "evil capitalists" in the cities lived like peasants in the countryside.

Result of forced evacuation of the cities? Mass starvation.

Just maybe the simplistic division of the world into "evil capitalists" and "good peasant farmers" doesn't "work" for a considerably more complex world.
First, you mistakenly assume that those deaths were a bug rather than a feature for the Khmer Rouge.

Second, leaving aside the simplistic nature of cliches like "the world is complex," your argument makes the point even while you miss the point. Precisely because the world is complex, the government is unlikely to do a good job, and thus the government doing nothing is likely the best option.
3.31.2009 10:10pm
Ariel:
David Welker,

In response to a small pain in your finger, the doctor decides to amputate your leg. Now, this solution isn't as bad as if the doctor decided to amputate your head, but it still is a pretty horrible "solution."

No, this is akin to going to taking your pain in the finger and going to President Obama to ask him to help you. Sure, you might get lucky and he would know the answer. But odds are your doctor would be a better source.

This may be "ideology" in the sense that you accused Prof. Somin of having a do-nothing ideology. I would just call it common sense - don't ask a President to be a doctor (unless he is a doctor). In business-speak, this is outside of his core competency.

Arguably, it is within Geithner's core competency - but, as head of the New York Fed during the crisis, he hasn't exactly been oracular.

In general, who has better information about what is going in inside Company X: Company X or the government?
3.31.2009 10:10pm
Moneyrunner43 (www):
Ricardo,

You may wish to note that the FDIC was created in 1933 so that the banks that failed in 1931 cost their depositors their savings. That may have had a tiny bit to do with the events that followed.

Not to change to subject, but I'm surprised that despite the vast array of legal talent at the Volokh conspiracy, I have not seen a posting on the legal basis for the powers of the President to fire the civilian head of a private corporation and the board of directors of said corporation. I may have missed that essay and if so I apologize in advance. But after all the histrionics about Bush's actions during his term in his role as commander in chief, Obama's firing of GM's entire legal leadership is breathtaking.

See here:
It may not be legal, but who's going to stop him?

Rush Limbaugh had a caller on today who asked the question: what gave Obama the power to fire the chairman and the board of directors of GM; and replace the chairman with his own pick? Rush rightly called this a

...junior high school understanding of civics101...

and answered

"Who's to stop him?"

But this is precisely the sort of question that I would expect to be asked by most thinking people.



And via Gartman...


Now, however, we know that he, along with the entire Board of Directors, was forced to stand down by the Obama Administration. We have scanned through our copy of the Constitution that we keep by our desk at all times for easy reference, and nowhere in its main body, nor in the Amendments, can we find reference to the Federal government's right to seek control of a business and to run it on behalf of the people of the country.

We are not legal scholars here at TGL, and we are open to arguments by such scholars proving the constitutionality of what the Administration has done, but in our reading of the work by the Founding Fathers and by their antecedents we find it not. This decision frightens us. What then is to stop the Administration from seizing control of some utility because the company's carbon footprint is larger than the Administration wishes it to be? What is to stop the Administration from taking control of a corporation because its debt structure is too leveraged, according to Administration guidelines? What is to stop the Administration from taking control of a company because it has not met Administration demands on affirmative action? At first these appear to be reductio ad absurdum cases… but are they really, in light of the GM decision?
3.31.2009 10:19pm
Curt Fischer:
How do we know David Welker is not succumbing to a "world is too complex for ideologies" ideology?
3.31.2009 10:19pm
Moneyrunner43 (www):

His typical "solution for everything" is for the government to do nothing.


I know what struck me about this formulation. It's something Obama uses very frequently, the use of false choices. It usually goes somehting like: "I have decided to spend a trillion dollars on this problem while those rascally Republicans want you to freeze in the dark."

This is what the media refers to as nuance. it usually causes their legs to tingle.
3.31.2009 10:31pm
Ariel:
Moneyrunner43,

The Commerce Clause, aka the plenary power clause (in the post-Lochner understanding), will be their excuse. If government can regulate Farmer Filburn's growing wheat for his own personal purposes, because it might affect the interstate market for wheat, why shouldn't government be able to do this?

some time, Congress's power grew dramatically through the post-Locher era by having plenary power. Art. 1 gave only legislative powers herein granted, with plenary power only coming from the post-Lochner era. Art. 2 gave plenary executive power to the president. The interesting thing about Obama's action is that it was him who did it and not Congress. While Congress can claim plenary legislative power under the post-Lochner understanding, this makes you wonder what the limiting principle is for plenary executive power - this makes the Bush unitary executive people seem like small beans. They at least asserted things that were historically related to the executive powers - like war.
3.31.2009 10:35pm
frankcross (mail):
Moneyrunner, your rant misses a very obvious fact. Obama did not force Wagoner to step down. He simply said that for GM to receive federal money, Wagoner must step down. That is neither complicated legally nor politically. Indeed, it is no different from a crucial investor making the same demand of a company.
3.31.2009 10:37pm
Ricardo (mail):
You may wish to note that the FDIC was created in 1933 so that the banks that failed in 1931 cost their depositors their savings. That may have had a tiny bit to do with the events that followed.

A fair point. Whereas today, much wealth is held in the so-called "shadow banking sector" -- for instance, shares in money market funds that purchase commercial paper of off-balance-sheet Special Investment Vehicles (SIVs) started by investment or commercial banks. Since you seem to agree that the government has a legitimate role in insuring financial counterparty risk, the only question is where to draw the line. Much of the bailout policies under both Bush and Obama are based on exactly this idea.

Someone above said the bailout hasn't worked. Well, we don't know that because we can't observe the alternate universe where no bailout occurred. It's reasonable, given your point about the FDIC above, that without a bailout, things would be a lot worse as billions if not trillions of dollars in money market funds could have evaporated by now.
3.31.2009 10:52pm
RPT (mail):
"Prof Somin:

For a start, we can get government out of the business of subsidizing dubious private investments."

That has been one of the cornerstones of Republican government since long before its recent champion Reagan.

Wagoner leaves with $20,000,000? Is that a problem? Seriously, there are no systemic countervailing forces to incompetent and/or criminal corporate executives except the government. The power of shareholders is practically zero.
3.31.2009 10:54pm
Moneyrunner43 (www):

In general, who has better information about what is going in inside Company X: Company X or the government?

Oh, that's an easy one: the government. The people who are in government have shed their parochialism, they are honest, they don't play favorites, they pay more than their fair share and they always know what's right. And they are very, VERY good at preventing disasters and managing complex things.
3.31.2009 10:55pm
Putting Two and Two...:
I've read and watched many discussions of this crisis. Whenever someone suggests "doing nothing" and allowing the chips to fall where they may, the response is that doing so will lead to the collapse of the financial system. I've yet to see an exchange in which the proponent of doing nothing, suggests an alternative result.

I'm not saying there isn't one, just that no one articulates what "doing nothing" would result it. Maybe no one wants to scare the horses...

What I don't get is why those of us who hold these "toxic mortgages" don't get the opportunity to buy them ourselves. Yes, yes, that would just "reward" me for taking out a mortgage during a housing bubble. But if I'm willing to pay, say, 70% while the only other offer on the table is from someone who offers 30% (and they got no small part of their funds from investments made while running up the bubble), is that really so bad?

Maybe I'm missing something....
3.31.2009 10:59pm
Michelle Dulak Thomson (mail):
Ricardo,

Are Joseph Stiglitz and Paul Krugman not members of "the Left"? "Progressives" seem to have become disillusioned with Obama some time around day 5 of his presidency.

You're entirely correct, and I owe the Left an apology. What I ought to have said is that Obama is being cut an unbelievable amount of slack by many, many people who would've broken out in hives had a Republican tried this sort of thing.

Again, I'm not in a position to say whether it's good or bad policy. But I do know what sort of uproar there would have been in my heavily-Democratic environs if someone of the opposite party had floated it. And, as things stand, I'm not hearing the noise.
3.31.2009 11:02pm
RPT (mail):
Isn't it true that socialization of risk and privatization of profits is the essence of modern "conservative" government? That is how the system is intended to work.
3.31.2009 11:04pm
Ricardo (mail):
In regards to GM, I recall that when there was a shakeup in management at Citigroup, a delegation flew to Riyadh to meet with Crown Prince Abdullah -- a major shareholder then -- to get his permission for the proposed change. GM would probably be at the start of the liquidation process now if it wasn't for the bailout (or "receivership" or whatever) from the government. Therefore, it's reasonable for the government to have some say in how the company is run.
3.31.2009 11:05pm
BGates:
there are no systemic countervailing forces to incompetent and/or criminal corporate executives except the government

I think you'll find Republicans tend to favor government action against criminal corporate executives, as long as "criminal" is defined as "law breaking" and not "doing things I dislike".

The countervailing force to incompetent executives is more competent executives in other companies.
3.31.2009 11:12pm
Moneyrunner43 (www):
Frankcross, your snark implies a knowledge of the events of this weekend that I doubt you possess.

Obama did not force Wagoner to step down. He simply said that for GM to receive federal money, Wagoner must step down.

Right. The guy pointing a gun at me is not forcing me to give him my money, I decided to do that of my own free will having considered the alternative.

And by the way, if they are receiving that federal money you refer to why are they planning bankruptcy? Todays's headlines has that scheduled for June. They could have done that without a "bailout."

I don't know how things work in your world, but generally boards of directors fire the chairman of a company. In this case they were all fired by President Obama. If you insist it was all voluntary, I would hate to learn what Liberals call coercion.


That is neither complicated legally nor politically. Indeed, it is no different from a crucial investor making the same demand of a company.

Doesn't the government takeover of a private company and installing its own managers bother you in the least? Doesn't it remind you of other times and other places? In a country where the line between the government and economic activity (industry) no longer exists, the consequences for personal freedom are chilling.

Case in point. Now that GM is run by the government, with access to the treasury, here's what it can offer:

New management means a new plan. GM is announcing a new marketing program it is calling "GM Total Confidence". GM is also offering what amounts to a partial insurance program for car payments in case of job loss. If a car buyer loses their income (that is to say, is qualified for unemployment benefits) within 24 months of purchasing a GM vehicle, GM will make as many as 9 payments for up to $500/month. There is also a sales incentive package with GM offering to pay the balance owed on trade-in vehicles. This is on top of other incentives such as 0% financing. A new warranty covers 5 years and 100,000 miles (thanks apparently to the federal government).


How would you like to run a private auto company and compete against a company that can add features and benefits that do not have to be paid out of profits but out of the treasury?
3.31.2009 11:21pm
Ricardo (mail):
Frankcross, your snark implies a knowledge of the events of this weekend that I doubt you possess... And by the way, if they are receiving that federal money you refer to why are they planning bankruptcy? Todays's headlines has that scheduled for June. They could have done that without a "bailout."

I would be careful with those accusations of others not knowing about recent events. The biggest concern with even the threat of bankruptcy of an auto-manufacturer up until now is the fact that the warranties they offer would be virtually worthless. This would cause a plunge in auto-sales and would merely accelerate its descent in a manner analogous to a bank run.

In fact, President Obama announced on March 30 the creation of the Warranty Commitment Program which removes warranties from bankruptcy restrictions and subsidizes the cost of guaranteeing warranties in the event a car-maker goes under. This program removes one of the principal objections to bankruptcy for a major auto-maker.
3.31.2009 11:36pm
Ariel:
Moneyrunner43,

How would you like to run a private auto company and compete against a company that can add features and benefits that do not have to be paid out of profits but out of the treasury?

I know it wouldn't qualify as a taking, but it should.
3.31.2009 11:45pm
Splunge:
Nobel Prize-winning liberal economist Joseph Stiglitz points out that the Treasury Secretary Tim Geithner's plan to have the government subsidize investments in "toxic assets" creates a serious moral hazard:

Holy cow, Somin, this is only true as long as government doesn't change the rules later. After the amusing AIG bill of attainder, after all the retroactive rules changes to TARP -- what on Earth makes you think when Team Obama says here are the rules folks that this time they really, really, cross their heart hope to die mean it?
3.31.2009 11:58pm
Tatil:

Right. The guy pointing a gun at me is not forcing me to give him my money, I decided to do that of my own free will having considered the alternative.

Come on... CEO begs for money, the investor says "I don't trust you. I will not invest unless I can bring in my own team", CEO resigns. He could wait until existing shareholders or board members who represent them arrange a vote, but what is the point. In a lot of companies, if a major shareholder lets his low opinion of the management known, CEO usually resigns before the paperwork is completed. No gun, no coercion... CEO does not own the company, he manages it on behalf of investors.

I'd rather government let GM go bankrupt rather waste taxpayers' money on it, but equating "government as an investor asking for a better management team" to "I am commander in chief, torture is legal if I say it is" does not make any sense.


Case in point. Now that GM is run by the government, with access to the treasury, here's what it can offer:

Didn't Hyundai start such a promotion months ago?
4.1.2009 12:07am
11-B/2O.B4:

Whenever someone suggests "doing nothing" and allowing the chips to fall where they may, the response is that doing so will lead to the collapse of the financial system. I've yet to see an exchange in which the proponent of doing nothing, suggests an alternative result.



I'll claim no specific expertise on the subject, but it seems to me, the banks and companies that have unworkable assets and business plans go under, their shareholders pound sand and curse fate, the whole economy tanks for a short while, and a new, more efficient one replaces it. Will it hurt? Yes. Will it hurt more than a fifteen-year depression fueled by government interference and inflation? Doubtful.

The government got us into this, and the government most certainly will not get us out. The current economic situation is a perfect example of what happens when the federal dipshits attempt social engineering with governmental financial clout. The "toxic assets" we refer to today are the government mandated and sponsored perks of yesterday to increase homeownership among the poor. Sounds great yeah? Except that it doesn't actually work, and now the corporations that the feds paid, cajoled and coerced into financing these loans are going tits up.

Timeline:

1: Feds decide too few poor people own houses
2: They use Fannie and Freddie to start a financing bubble to reach people who can't afford mortgages.
3: The rest of Wall Street gets in on the action
4: Guess what? Wishful thinking doesn't confer the ability to pay a mortgage
5: Companies who tied up their funds in crap mortgages get hosed and beg for bailouts.
6: Taxpayers foot the bill. Now we let the same bankers who went along with the Feds to create a false housing bubble buy the same "toxic" or "legacy" assets, they make all the profits, and we pony up if it all goes to hell.
4.1.2009 1:06am
RPT (mail):
"BGates:

I think you'll find Republicans tend to favor government action against criminal corporate executives, as long as "criminal" is defined as "law breaking" and not "doing things I dislike"."

I expect that over the last eight years there is not one example of Republican support for the criminal prosecution of any corporate executive for anything. Please find one if I am wrong.
4.1.2009 1:09am
Ricardo (mail):
1: Feds decide too few poor people own houses
2: They use Fannie and Freddie to start a financing bubble to reach people who can't afford mortgages.
3: The rest of Wall Street gets in on the action


For the n-th time, your stages 2 and 3 are the other way around. When you have some time, Google "Facing Strategic Crossroads Fannie Mae" -- you will find an internal presentation made at Fannie Mae that makes clear that in 2005, Wall Street firms as well as Countrywide were surpassing Fannie Mae in terms of issuing mortgage backed securities and purchasing loans due to laxer standards. Fannie and Freddie were late to the game. For instance, "The two product lines that are driving the majority of leakage to private label are Alt-A and Subprime [this is Fannie Mae speaking in 2005]."

This is all well-trodden ground. The government also didn't force ratings agencies to rate the senior tranches of CDOs and MBSs as AAA nor did it force investment banks to leverage themselves 30 to 1 to purchase these and lower rated assets.
4.1.2009 1:39am
Guest12345:

I expect that over the last eight years there is not one example of Republican support for the criminal prosecution of any corporate executive for anything. Please find one if I am wrong.


Do the names Ken Lay or Jeff Skilling ring any bells? Maybe Martha Stewart or Bernie Ebbers? Sarbanes-Oxley which passed in 2002 with 214 out of 216 Republicans voting yea? Passed the senate with 47 out of 48 Republicans voting yea?

Seriously have you been dead the last eight years?
4.1.2009 3:53am
wb (mail):
Time to curb the moral hazard by raising the capital gains tax or even impose targeted higher taxation on gains from the Geithner progran.
4.1.2009 4:47am
Moneyrunner43 (www):
Ricardo, I try to be careful but sometimes even I make mistakes. However, in this case I don't think I did.


I would be careful with those accusations of others not knowing about recent events. The biggest concern with even the threat of bankruptcy of an auto-manufacturer up until now is the fact that the warranties they offer would be virtually worthless. This would cause a plunge in auto-sales and would merely accelerate its descent in a manner analogous to a bank run.



Your explanation for a private car company staying out of bankruptcy is a commonly accepted one given by the previous chairman of GM, Rick Wagoner. It's his excuse for not filing for bankruptcy. If you accept that, I can't dissuade you. However, I'm not persuaded because private companies in Chapter 11 can place certain assets such as reserves for warrantees in separate accounts with the approval of the judge. In fact, all companies with warrantees now account for the assumed cost of repairs in their books and it should be no problem for a bankruptcy judge to set those funds aside. That's why I always assumed this was a BS excuse.

What Obama has instead done is switched GM's warrantees from the assets of the company to the backs of the taxpayers. All of a sudden we have the awesome ability to buy a car even if we are going to lose our job and you, the taxpayer will make the payments.

Tatil,

I have no problem with a private investor demanding the shake-up of a corporation's management if they have skin in the game. If they have the votes of the shareholders or if the board agrees, fine. But a government is a little bit different than a private investor. A government has the power to do things a private investor cannot; way beyond the withholding of money. That is why there is a vast difference between Barack Obama, President, calling up GM's board and Chairman and telling them they are out and, say, Warren Buffett telling them he won't buy into the company unless they change management.

That's what even Leftists like Krugman fail to address when they disagree with the Obama policies. They have no problem with the government take-over of business. Correct me if I'm wrong, but Krugman's complaint is that Obama is not spending enough.

And Hyundai, with a 2.4% market share is not offering to let you keep the car and make the payments for you, it will take the car back as long as you put no more than $7,500 worth of wear and tear on it. My objection to offers like this is not the offer itself. If Hyundai wants to dip into its private coffers to make this offer and increase sales, I say go for it. But the GM (Government Motors) offer is shouldered by the taxpayers and as far as I am aware not part of any law passed by congress.

The Obama administration seems to be making billion and trillion dollar commitments of your and my money on the fly. I'm just asking (1) is it legal and (2) is this the way to go?
4.1.2009 7:45am
Andrew Hamilton (mail):
The whole TARP program is not morally hazardous, in the economist's sense that it will lead people (or the government) to take unwarranted risks. It is, rather, an effort to mitigate the damage from earlier morally hazardous investments that have failed so colossally that the entire economy has been placed at risk. The truly damaging moral hazard is behind us. The TARP program, including the Geithner expansion, is a temporary effort to prevent further collapse. The government will be at greater risk within the parameters of the Geithner plan than the private investors, but the government and the nation will be at even greater risk if credit flows are not restored. The government may take losses on some toxic assets, but employment will increase and tax revenues will improve as the economy resumes growth, so the government and the taxpayers benefit indirectly. The government also gets 50 % of the upside. For those rightly concerned about reducing the moral hazard of all government guarantees, the issue is what will be the legal and regulatory framework going forward. It is not the Geithner plan.

I place Stiglitz with Krugman as among those economists who save their rationality for econometrics: rigorous economics, reckless politics.
4.1.2009 8:28am
RPT (mail):
"Guest 12345:

Do the names Ken Lay or Jeff Skilling ring any bells? Maybe Martha Stewart or Bernie Ebbers?"

I did not say that there were no prosecutions, but that there were no prosecutions of corporate executive crime that had Republican support. I need some reference to the latter. Stewart was trivial. Lay and Skilling certainly do not fit into that category and both were generally defended by the GOP. Ebbers I will have to look at. Please provide me references re R support for the prosecutions.
4.1.2009 8:33am
Joshua (mail):
11-B/2O.B4: I'll claim no specific expertise on the subject, but it seems to me, [if gov't does nothing] the banks and companies that have unworkable assets and business plans go under, their shareholders pound sand and curse fate, the whole economy tanks for a short while, and a new, more efficient one replaces it. Will it hurt? Yes. Will it hurt more than a fifteen-year depression fueled by government interference and inflation? Doubtful.

Doesn't the answer hinge a great deal on any number of peripheral (and possibly unknowable with any degree of certainty) factors? One that comes to mind is how China, Russia, Iran, Mexico, Venezuela, North Korea, the Saudis, al Qaeda, etc. might take advantage of our short-lived but acute national weakness in the event of an economic collapse, in ways that aren't necessarily possible with the mere "controlled descent" (don't you just love that euphemism?) that Obama and company are attempting. Yes, even if the economy tanks it won't stay down forever, but while it is down we probably won't have the money even for basic stuff like homeland security. And a nuked-out major port or two is bound to put a bit of a damper on any economic recovery.
4.1.2009 8:58am
Adam J:
Joshua - You must live in a scary world, where you think any number of international powers are waiting to nuke the hell outta us if we show a moment of weakness. Back in reality, most should realize that all of those nations (except Al Qaeda) have economies that depend far to much on us being good little consumers to bomb the heck outta us (not to mention fearing the consequences far more then any dubious benefit). Not to mention all those nations are probably in fact quite glad that we have assumed the incredibly expensive job of international peacekeeper.
4.1.2009 9:28am
xpq9 (mail):
"Oh, so surprising. Somin just gave the same solution for this problem as he gives for everything. Do nothing. Everything else in his mind is just an elaborate justification for the same simplistic solution to all problems."

Damn you can beat a strawman like no other. In your view doing nothing means

"For a start, we can get government out of the business of subsidizing dubious private investments. Even if we can't think of a way for the government to make the situation better, we can at least prevent it from doing things (like the Geithner plan) that make it worse."

which means you believe government is currently (or in years past) not in the business of subsidizing dubious private investments, or generally, government is not involved in anyway whatsoever in the business world. Saying laws should be retracted, regulations decreased, etc., is not "doing nothing". But you sound tough stating that though.
4.1.2009 9:29am
Houston Lawyer:
"Do the names Ken Lay or Jeff Skilling ring any bells? Maybe Martha Stewart or Bernie Ebbers?"

I did not say that there were no prosecutions, but that there were no prosecutions of corporate executive crime that had Republican support. I need some reference to the latter. Stewart was trivial. Lay and Skilling certainly do not fit into that category and both were generally defended by the GOP. Ebbers I will have to look at. Please provide me references re R support for the prosecutions."


All of the aforementioned were prosecuted by the US govt while the Republicans were in charge. This GOP support for corporate villians is all in your head.
4.1.2009 9:49am
rosignol (mail):
A lot of people are so busy pointing at trees that they're not noticing the forest.

Obama isn't bailing out GM, he's bailing out the UAW.

Follow the money.
4.1.2009 9:51am
Guest12345:

I did not say that there were no prosecutions, but that there were no prosecutions of corporate executive crime that had Republican support.


This article from the Washington Post seems to create a rather good case for a Republican supporting prosecution:

Within two weeks of the announcement that WorldCom had filed the largest bankruptcy case in U.S. history, President Bush signed an executive order creating a government-wide task force to root out business crime. Bush told reporters a few months later that the multi-agency task force "is sending a clear warning and a clear message to every dishonest corporate leader: You will be exposed, and you will be punished. No boardroom in America is above or beyond the law."

Today, more than two years after the task force's creation, federal prosecutors and securities regulators have helped convict a number of high-profile chief executives, including the former leaders of drugstore chain Rite Aid Corp. and cable television provider Adelphia Communications Corp. Government lawyers have indicted many more -- including Enron's Lay, WorldCom's Bernard J. Ebbers, and HealthSouth Corp.'s Richard M. Scrushy -- all of whom pleaded not guilty and are awaiting trial.

There have been some losses and charges that prosecutors are overreaching in an effort to bring high-profile cases, but federal prosecutors involved in the task force have convicted more than 500 corporate wrongdoers as of last month, according to a task force report. That is out of 900 suspects criminally charged, with many of those trials still pending.
4.1.2009 9:59am
SeaDrive:
(I think this may be the layman's version of what Andrew Hamilton posted above.)

The moral hazard on the old loans is a fact to be dealt with. The government should not be party to new deals that increase the overall moral hazard.
4.1.2009 10:04am
Random3 (mail):
Yeah, but those examples don't count, cause, um, cause they just don't! So find me some examples besides those! And not trivial ones like Martha Stewart! Cause she was trivial! Bet you can't find any examples.
4.1.2009 10:06am
Adam J:
I agree with Somin's belief that the government shouldn't be engaging in Geither's bailout, however it's pretty clear to me that certain private corporations, not the government, share the lion's share of the blame for getting us in this mess. I find it quite disingenious to blame the government, who obviously didn't require these banks to leverage themselves to absurd degrees and sell securities of dubious virtue. Nor were the banks which were subjected to the "mighty muscle of the federal governments" largely responsible for brokering the mortgages that created this clusterf@#k. Instead it was almost completely unregulated mortgage brokerages like Countrywide. I find it incredibly annoying that the people who offer seem to offer the most cogent criticism of this bailout plan also seem to be engaged in a campaign to rewrite the cause of this recession as a failure of government. Maybe it's just me, but I believe that the private corporations that failed must suffer the consequences of their poor choices, and governments role should be limited to insuring it doesn't happen again thru insuring better oversight, transparency &ensuring fraud is punished more effectively (and limiting the collateral damage if possible to the more innocent affected parties)
4.1.2009 10:08am
rosetta's stones:

Andrew Hamilton (mail):
The whole TARP program is not morally hazardous, in the economist's sense that it will lead people (or the government) to take unwarranted risks.


Of course they'll take unwarranted risks, if they have confidence and even assurance that the government will bail them out. That should have been the whole point here: To avoid giving them that confidence and assurance, moving forward.

When people have to pay the consequences for their actions, they act accordingly (and this behavior describes the "science" of economics.)
4.1.2009 10:08am
Curmudgeon:

Professor Stiglitz, speaking at a conference in Hong Kong, said that the US government is essentially using the taxpayer to guarantee the downside risks, namely that these assets will fall further in value, while the upside risks, in terms of future profits, are being handed to private investors such as insurance companies, bond investors and private equity fund

If this true, my big question is how can us 'little guys' get in on the deal? Or will only insurance companies, bond investors and private equity funds be invited to participate?
4.1.2009 10:18am
Bruce Wayne:

As Stiglitz suggests, this privatization of profits combined with socialization of losses is likely to incentivize overly risky investments that taxpayers will be left holding the bag for. It may also lead to misallocation of resources, as investors transfer funds from more economically efficient uses in order to take advantage of Uncle Sam's blank check for investing in "toxic assets."


Simplifying things, why isn't this, at bottom, the same as the government agreeing to stake me to a trip to a casino, agreeing to cover any losses but not to participate in any gains? Why would I ever leave the blackjack/craps/poker tables? To play and play, making one bad bet after another, and to be shielded from the consequences is, I would think, pretty much the definition of moral hazard.
4.1.2009 10:25am
frankcross (mail):
Moneyrunner, I'm not sure what your point is, but I think you are being contradictory. The government is able to pressure management as a condition of management receiving money and other benefits. That was my point. That seems to be your point. What is your theory for why this would be illegal? It may be a bad idea, though I'm encouraged by the bankruptcy strategy. But why would it be illegal. The government does this with states all the time.
4.1.2009 10:41am
ShelbyC:

Of course they'll take unwarranted risks, if they have confidence and even assurance that the government will bail them out. That should have been the whole point here: To avoid giving them that confidence and assurance, moving forward.



Hell, is there anyone that doesn't believe that anticipation of a bailout let some of the folks to take the risks they took?
4.1.2009 12:14pm
Andy Freeman (mail):
> Or will only insurance companies, bond investors and private equity funds be invited to participate?

One interesting question is whether the banks in question will be allowed to participate.

Part of the deal is that banks can pull back assets if they don't like the offers, and they get to make that decision after the offers have been made. (That "after" distinguishes this from a "reserve price" situation.)

The whole point of the PPIP is to get folks to pay higher than market prices by providing subsidies. Banks want to shed the real crap, but would like to keep the good stuff at a better basis and reduced risk. PPIP may be just the vehicle for them to do so.
4.1.2009 12:15pm
Andy Freeman (mail):
> That something isn't the worst possible solution does not mean that it isn't a horrible solution.

That's true. However, it doesn't tell us whether doing nothing is better or worse than what we're actually doing. Heck, it doesn't even tell us whether doing nothing or the current proposals are horrible.
4.1.2009 12:18pm
Clayton E. Cramer (mail) (www):

[E]conomists Peter Wallison and Charles Calomiris describe in this paper. Wallison deserves some credit for warning about this danger back in 2005.
Actually, even earlier. The September 30, 1999 New York Times article about Clinton's leaning on Fannie Mae and Freddie Mac to do more subprime mortgage lending quotes Wallison as warning that this was going to lead to a huge government bailout.

There are other factors, but the government pressuring GSEs, and the GSEs pressuring private lenders to make risky loans, is probably the single largest factor in this disaster. Republicans (including Bush's Secretary of the Treasury Snow) warned in 2003 about this, and Democrats refused to get in the way. I wish Republicans had been a bit more aggressive on this, but the Democrats largely created this disaster--and of course, they are now the beneficiaries of it, in that they got control of the government, and can now reward their billionaire campaign contributors.
4.1.2009 12:27pm
Bruce Hayden (mail):
Obama isn't bailing out GM, he's bailing out the UAW.
I think that is what has to be kept in mind whenever the question of bankruptcy comes up. A bankruptcy would do two things bad to the union. First, the court could tear up the union contract. And, second, probably GM's biggest problem in competing with foreign car companies (even manufacturing here) is their legacy pension and health care obligations. There are guys younger than I who were given early retirement that includes a gold plated health care plan.
4.1.2009 12:56pm
Bruce Hayden (mail):
Simplifying things, why isn't this, at bottom, the same as the government agreeing to stake me to a trip to a casino, agreeing to cover any losses but not to participate in any gains? Why would I ever leave the blackjack/craps/poker tables? To play and play, making one bad bet after another, and to be shielded from the consequences is, I would think, pretty much the definition of moral hazard
Again, heads those getting these deals win, and tails they break even.

What I hadn't thought about before, but someone brought it up above, is the question of who, exactly, will be offered this sort of deal by our government? The problem is that the likely recipients of this largess will be foreign.
4.1.2009 12:58pm
Adam J:
Clayton E. Cramer - Are you just making this up as you go along? I suppose the GSEs are to blame for creating ARMS to sell, a ridiculously complicated financial product to try and market to your average homebuyer. I suppose they're also responsible for investors somehow thinking that the securities that were backed by these loans were liquid gold? If investors didn't incorrectly evaluate the risk then there's no air to fill the bubble- government can't make investors buy these ludicrious mortgage backed securities- and they offered investors no incentives to buy them.

And really, how could the GSEs pressure private lenders to make risky loans? What pressure do they have to apply- private lenders typically kept the whole show inhouse &didn't typically use the GSEs to securitize- more profits for them. If there was all this government pressure, it's quite bizarre that when this disaster imploded the GSEs had the smallest market share they've ever had in securitized mortgages.

Plus, most of the silliest loans occurred in 2004, when mortgage brokers were apparently willing to offer absurdly risky mortgages to homebuyers who's ability to pay was dubious, to put it mildly. But of course that was the democrats fault... nevermind that they weren't in power.

Personally, I think that the most blame that can be sent in the direction of the democrats is that they let the Fed drop the interest rate to absurdly low levels. That probably went a long way to helping set the stage for this disaster.
4.1.2009 1:17pm
George Smith:
Adam J - The GSEs didn't have to pressure private lenders to make risky loans. All they had to do was be willing to buy them, and that was all the guys down at Phil's Mortgage Company needed to make the loans. Once sold to Fan/Fred, Phil's had the commission and the loans were off their hands. Once pooled into MBS, the loans were off Fan/Fred's hands.
4.1.2009 1:37pm
David Welker (www):

First, you mistakenly assume that those deaths were a bug rather than a feature for the Khmer Rouge.


The point still holds. The libertarianism pushed by Somin and the sort of communism advocated by the Khmer Rouge are both extremely simplistic in terms of the bottom-line, if implemented, do not result in good results.


Second, leaving aside the simplistic nature of cliches like "the world is complex," your argument makes the point even while you miss the point. Precisely because the world is complex, the government is unlikely to do a good job, and thus the government doing nothing is likely the best option.


Doing nothing is a choice with consequences. Among all the choices that either private or government actors could make, probabilistically, since the world is complex and there are so many possible choices, it is unlikely that the absolute best decision of out the N plausible decisions will be made.

Your simplistic proposal to get around the problems that arise because of this complexity do not work. Because the solution of doing nothing needs to be evaluated in a particular context, just like any other decision.

Look, libertarians are like idiots in school who when taking multiple choice tests always select answer C. Yeah, sometimes C is the right answer. But you have look and understand the problem before you know. Libertarians for some reason do not think they have to look and understand the problem. Further, when they do look at the problem, it is nothing more than an elaborate fiction masquerading as analysis. They are going to mark C on the answer sheet no matter what. In that case, why not spare everyone the fake analysis.

Precisely because the world is complex, everybody is going to have a difficult time evaluating certain important decisions. This includes both private actors and government actors.

That doesn't mean the best answer is always to do nothing.

Maybe you think that the answer to any problem is always to bury your head in the sand, but I beg to differ.
4.1.2009 1:46pm
David Welker (www):

There are other factors, but the government pressuring GSEs, and the GSEs pressuring private lenders to make risky loans, is probably the single largest factor in this disaster.


Please back this up with empirical evidence. Alternatively, don't pretend you have anything to contribute to the discussion.
4.1.2009 1:49pm
David Welker (www):

Again, heads those getting these deals win, and tails they break even.


Tails they lose their investment, actually. Do the actual facts matter to you people?

Do they feel the "full pain" of the loss? No. Do they feel "some pain" if they lose? Absolutely.

Look, there is moral hazard everywhere. If a CEO makes a bad business decision, he does not feel the full pain of the decision. If he makes a good decision, he does not enjoy the full benefit. The CEO's interests are not in perfect alignment with the interests of corporation he or she directs.

Does a rational individual thus automatically conclude that the whole idea of corporations is therefore irredeemably flawed? Not necessarily. Incentives do not and cannot be aligned with absolute precision. (And thank goodness, because this would be a really dull world otherwise.)

The bottom-line is this. Imperfectly aligned incentives (which is all moral hazard really is at the end of the day) are both inevitable and not necessarily disastrous. Of course, all other things being equal, it is better to have more aligned rather than less aligned incentives. In fact, it is quite important to not have incentives too misaligned.

But aligning incentives is not an all or nothing proposition.

Some of you arguing against the Geithner plan are supposing that the incentives are completely misaligned. But, what you are asserting does not match the facts, if that matters at all to you.
4.1.2009 2:02pm
Adam J:
George Smith- "Once sold to Fan/Fred, Phil's had the commission and the loans were off their hands. Once pooled into MBS, the loans were off Fan/Fred's hands." Correct (well partially, Fan/Fred got stuck holding the bag on a bunch of the MBS that they couldn't sell when the crap hit the fan, hence the fed takeover). Also, Fan/Fred had a smaller market share then before the bubble, because Countrywide, other mortgage brokerages and investment banks took over a larger share of the MBS business. Fan/Fred excerbated the problem by joining in the disaster (in epic fashion no less), but the other companies led the market in securitizing ARMs and other highly risky mortgages. Plus, it didn't help that idiot companies like AIG sold incredibly underpriced insurance on these MBS which made investors much more confortable buying them since the credit swaps protected the risk.
4.1.2009 2:07pm
David M. Nieporent (www):
The whole TARP program is not morally hazardous, in the economist's sense that it will lead people (or the government) to take unwarranted risks. It is, rather, an effort to mitigate the damage from earlier morally hazardous investments that have failed so colossally that the entire economy has been placed at risk. The truly damaging moral hazard is behind us.
It's not literally morally hazaradous, since you can't be retroactively such; what we do now can't influence people's past behavior. But it's effectively morally hazardous since it sets a precedent which will lead people to take those unwarranted risks, on the assumption that they'll be bailed out by TARP 2.0 (or TARP 3.0, or whatever we're up to at that point).
4.1.2009 3:02pm
Adam J:
David Welker- I agree with your assessment of the downside risks, however I'm more concerned with broader systemic risks that are being created by this bailout. Companies already have a number of reasons to overpay for rapid expansion with limited regard to the financial consequences of expansion(increased market power, executive compensation, prestige, etc.) Now we are adding to the list with this "too big to fail" mentality that allows the largest companies to face less exposure to the risks of their actions. Furthermore, it seems alot of government money is being handed directly into the pockets of the bad actors. It seems completely illogical to me, we want these companies face the consequences, all we should be interested in doing is limiting collateral damage to good companies who are affected by the unavailability of capital. Plus aren't we hindering private solutions to the problem, as everyone is waiting to see what they can milk from the government before changing their position?
4.1.2009 3:08pm
Adam J:
Nieporent- "But it's effectively morally hazardous since it sets a precedent which will lead people to take those unwarranted risks, on the assumption that they'll be bailed out by TARP 2.0." True that, the government should not just be concerned with a quick fix, but also with whether their actions are aiding or exacerbating the market conditions that led to the current crisis.
4.1.2009 3:13pm
George Smith:
Adam J - Yeah, lotta dumb moves by a lotta people. But if folks get strung up the yardarm, Chris, Barney and Franklin should be in the group.
4.1.2009 4:11pm
JoeSixpack (mail):
What kind of world do we live in that an adjustable rate mortgage is "a ridiculously complicated financial product to try and market to your average homebuyer"?? It is a mortgage with an adjustable rate. It could go up. It could go down. People who can't grasp this should not even be allowed to manage their own finances. They should be declared incompetent wards of the state.
4.1.2009 4:12pm
David Welker (www):

But it's effectively morally hazardous since it sets a precedent which will lead people to take those unwarranted risks, on the assumption that they'll be bailed out by TARP 2.0 (or TARP 3.0, or whatever we're up to at that point).


Why would they assume they would necessarily be bailed out in the future? Lehman Brother's wasn't bailed out.

Even if we don't bail out anyone now, that does not bind government in the future.

So, to the extent that this moral hazard is based on speculation that the government might bail you out in the future, such moral hazard will exist, regardless.

Clearly, with any company where failure has major negative consequences for the economy and the interests of the United States, there is a chance of government intervention. To the extent that speculation concerning that possibility actually influences investment decisions, it will exist regardless of what is done now.

The precedent for government possibly bailing out companies "too big to fail" has already been set long ago. That is water under the bridge.
4.1.2009 4:22pm
Adam J:
JoeSixpack - They are not complicated in basic principle, they are complicated in evaluating the various risks involved. Investment banks weren't even evaluate the risks inherent in prime rate rising, how do you expect John Q. Public to? Not to mention most of the problematic loans weren't simply adjustable, but were hybrids, options and cash flow ARMs. Also many included teaser rates, rebates, negative amortization, interest only, and ballon payments and all other kinds of nonsense.
4.1.2009 4:44pm
Bruce Hayden (mail):
Tails they lose their investment, actually. Do the actual facts matter to you people?

Do they feel the "full pain" of the loss? No. Do they feel "some pain" if they lose? Absolutely.
Ok, maybe we should rephrase this. Heads, they win up to 6x, 8x, based on their federally funded leverage, and tails they may lose their investment.

It is still far better odds than anyone can get anywhere else.
4.1.2009 8:16pm
Clayton E. Cramer (mail) (www):

Please back this up with empirical evidence.
The fact that the day that Clinton told Fannie Mae and Freddie Mac to start pushing subprime mortgages there were economists warning that it was going to be a diaster requiring a big federal bailout as soon as the market slowed down? That's pretty impressive prediction, as far as I am concerned.

Look, every mortgage lender should have said, "Sorry, Fannie, but just because you are willing to buy this risky paper doesn't mean that it is a good idea." A fair number of lenders didn't get heavily involved. But when GSEs tell lenders, "Go ahead! Write incredibly risky loans, and we'll buy it, no problem!" What amazes me is not that this encouraged risky lending--what amazes me is how many institutions had the good not to take the bait.
4.1.2009 8:41pm
Moneyrunner43 (www):
Frankcross,

Apologies for taking so long to respond. I have a day job.

Here's what you said.


Moneyrunner, I'm not sure what your point is, but I think you are being contradictory. The government is able to pressure management as a condition of management receiving money and other benefits. That was my point. That seems to be your point. What is your theory for why this would be illegal? It may be a bad idea, though I'm encouraged by the bankruptcy strategy. But why would it be illegal. The government does this with states all the time.



I don't think I'm being contradictory at all. In this thread, you -- and perhaps others -- have implied that the discussion between GM's management and Team Obama was similar to what private parties would have had about additional financing. But that is not what happened at all -- at least if media reports are to be believed. In this Wall Street Journal article it was plain that there was no negotiation, no offer to advance funds if Wagoner resigned no threat to withhold funding unless he resigned, he was simple fired … told to go, and his successor was appointed .. by Team Obama.


Inside a windowless, ornate room Thursday just across from the Oval Office, President Barack Obama and a group of senior economic advisers began the job of remaking the American automobile industry.

The first order of business: Oust General Motors Corp. Chief Executive Rick Wagoner.

It "wasn't the hardest decision," said one government official….

After the Thursday meeting at the White House, Mr. Rattner asked Mr. Wagoner and Mr. Henderson to come see him the next day. Mr. Rattner broke the news to Mr. Wagoner at his office at the Treasury, according to an administration official. Afterward, Mr. Rattner met with Mr. Henderson, and told him he would take over as GM's CEO.

Does this sound to you like there was any threat to withhold funds? Only in your imagination. He was fired like you would fire your paperboy. There was never any question about withholding funds if he did not go because his remaining was never in question. The government simply exercised dictatorial powers.

The President can fire his military officers because he's Commander in Chief. He can fire his cabinet officers because they serve at his pleasure. He can fire the US attorneys because they are his appointees (despite Liberal hysterics when Bush did it). These are all people over who he is has the power of appointment. But no government official has direct authority over private persons. Not in a free society. The theory of a free society is that the "Leader" does not have the right to tell private people what do, what job they can hold, what they can earn, where they can move, how many children they can have, what they can drive, what they may eat. In a free society that is part of the private sphere and should apply equally to you, me and Wagoner.

Remember the outrage when Bush fired several of the US attorneys, something he had a perfect legal right to do? Nowhere in my copy of the constitution do I find that the government has the right to fire a private citizen from his job in a private company even if that company has received government loans. A refusal to make further loans is legal, but firing someone and appointing his successor -- unless you can point to enabling legislation for this act --does not appear to be legal. There are countries where this is done, they are known as dictatorships.

Finally you bring up the fact that the Federal government coerces states all the time -- assume you mean by threatening to withhold funds unless states act to implement policies desired by the Feds. Yes, and I find that objectionable also. But that is government to government action, not government intrusion into the private sphere. And there is always legislation authorizing the strings that are attached to federal grants and programs. But unless you can point out an instance (outiside of the Civil War) where the Federal government fired a state governor and appointed his successor, your example falls apart.


Good night.
4.1.2009 11:12pm
David Schwartz (mail):
This is an unprecedented event. I don't think we have to worry about setting precedent. There are enough reasons to think these plans won't work in the short term that I don't think we need to worry about long-term risks the "next time" this happens.

The situation is bad enough that anything that saves the short term is a good idea if it doesn't obliterate the entire country.

I think people understand this is a very special case and no reaction to it sets a precedent.
4.2.2009 6:31am
Moneyrunner43 (www):
David Schartz,

On the contrary. All unprecedented action creates precedents. Liberals screamed bloody murder over actions Bush took in response to an actual violent attack on the US that killed more people than Pearl Harbor. We were not supposed to monitor phone conversations between jihadists because we might accidentally find that a lawyer's phone call was intercepted. We were not supposed to track the movement of cash that that funds the jihadist movement because by doing so we were also monitoring private citizens legitimate cash transfers. We were not supposed to hold enemy combatants without a trail in civilian courts. We were not …. but you get the picture.

But now that a Democrat is calling a private citizen holding a civilian job and firing him and appointing his successor, we're supposed to shrug and believe that GM filing for chapter 11 is a bigger threat than 9/11? Give me a break!
4.2.2009 8:26am
Andy Freeman (mail):
>> Again, heads those getting these deals win, and tails they break even.

> Tails they lose their investment, actually. Do the actual facts matter to you people?

Given past performance, it's not unlikely that they'd be made whole or bailed out.

More to the point, break even as a worst case is actually how the numbers work out because they're going to buy a number of portfolios. Some will fail, some will work out. Worst case, most will fail, but there's enough leverage that the few that suceed will get them to break even.

Because of the way the deal is structured, it's pretty much guaranteed that significant amounts of the govt loans will not be repaid.

Consider a portfolio that has a 50% chance of losing money at price X and an 80% chance of losing at price Y. If I can buy with 90% leverage, buying at price Y makes sense. However the leverage for Y-X is at significantly more risk than the leverage for X. (Presumably the portfolio will end up worth something, so not all of the leverage will be lost.)
4.2.2009 10:58am
Andy Freeman (mail):
> Doing nothing is a choice with consequences. Among all the choices that either private or government actors could make, probabilistically, since the world is complex and there are so many possible choices, it is unlikely that the absolute best decision of out the N plausible decisions will be made.

That's true. However, we're not faced with a choice between doing nothing and doing the best possible thing. We're faced with doing nothing and what govt is likely to actually do.

In some cases, the actual govt action is better than doing nothing. However, in others, it is clearly worse.

Presumably one would prefer govt to do nothing instead of doing worse things. Obama et al have argued that the alternative to the current plan is "do nothing".

If that's the choice, the question is whether the current plan is better than do nothing, regardless of whether there is a better plan.
4.2.2009 11:35am
David Drake:
Michelle Dulak Thomson said:


I'm not nuts about it, judging as well as I can from what I know — but, then, I don't know enough to be capable of judging it.


That is the problem I have and I'd devoted quite a bit of time trying to find out facts.

Presumably, SOMEONE knows what the dollar volumes of "Bad assets" are, how many of these are straight mortgage backed notes and, if so, what percentage of the mortgages are performing and which aren't, and how many are derivatives of the straight notes, credit default swaps, etc. But I have not seen any of this info, aside from anonymous estimates.

I am in favor of the government doing what needs to be done to resolve this crisis, and NOT ONE BIT MORE.

For example, George Soros (with whom I usually disagree viscerally) had an op-ed in last week's WSJ saying that the needed regulation of CDSs is to (a) reinstate the uptick rule and (b) prohibit anyone who does not own a security from buying a credit default swap position betting that the security will default.

I think that is doable, simple, and that it may well solve in the future most of what caused the crash. However, that proposal does not create a bureaucracy in Washington or Basel or somewhere and therefore is unlikely to be enacted.
4.2.2009 2:54pm
David Drake:
Ricardo


1931 saw a record number of bank failures in the U.S. and also saw an enormous contraction of GDP and industrial production as well as a steep rise in unemployment. Milton Friedman argued it was really the bank failures of 1931 that turned the already severe recession of 1929-1930 into the Great Depression.


But isn't that because, in the absence of the FDIC, the money people had in the failed banks just disappeared? There was a huge liquidity contraction--according to Shlaes' "The Forgotten Man" which I just read, some municipalities and businesses issued scrip and lots of people had to barter.

Again, the problem is we just don't know enough to know what would happen if some banks failed. With some, the answer is probably, not much. With BofA, etc., ???
4.2.2009 3:10pm
Moneyrunner43 (www):
Then liquidity problem is partly the result of being unable to determine the value of modern mortgage backed securities. We never know ahead of time exactly how many people who buy a house will fail to pay the mortgage, but we have a statistical history that tells us that under ordinary circumstances, in times past a certain percentage, call that "x" will go into default and the house will have to be repossessed and resold.

The problems began when lending standards were abandoned due to a combination of greed; stupidity and the ability of mortgage originators to sell the mortgages instead do holding them. If a mortgage company like Countrywide can create mortgages and sell them to someone else who bears the brunt of defaults, they can poison the entire mortgage market. And they did. They were aided and abetted by crooked politicians like Frank and Dodd, mortgage packagers like Fannie and Freddie, investment banks that demanded more and more of these profitable bonds, rating agencies that fell down on the job, and the liars who took out mortgages they could not afford.

So now what? What's a defaulted mortgage worth?

Instead of getting technical, let's get practical. If I had a mortgage on my property of $500,000 and its assessed value was $400,000 what would a mortgage backed security that includes my mortgage be worth? That's a guesstimate, isn't it? Let's say I am part of a pool of mortgages and I can't afford to pay the mortgage. What is the pool worth?

There are several moving parts: the number of homes that will have to be repossessed and the resale prices of the foreclosed homes are two of the major factors. What could a vulture recover? To use real numbers, let's say my mortgage is $500,000 and the market value is $400,000. Look at your own assessment. In my case, the value of the lot is about 30% of the total assessed value of my home. So if someone took over my mortgage and burned my home to the ground, they could probably sell the empty lot for about $120,000 ($400,000 x 30%). So that's the bottom line on the value of the repossessed home, a recovery rate of 24% …. just for the land.

The current rate of people who are late or in default on mortgages is 12%. For purposes of this discussion, let's assume that this figure rises to 50%.

So a random pool of mortgages with a 50% default rate where the homes in default get burned to the ground and the empty lost is sold would have a value of 62% of face value (.5 x100% + .5 x 24%). PIMCO, the huge bond manager is offering 60%. Do you think they know something that some people who are scared out of their wits - and can't do math - don't?
4.2.2009 10:20pm
Moneyrunner43 (www):
4.3.2009 9:22pm
Kenneth Almquist (mail):
In the paper Somin links to, Peter Wallison and Charles Calomiris write:
The special relationship with Congress was the GSEs' undoing because it allowed them to escape the market discipline—the wariness of lenders—that keeps corporate managements from taking unacceptable risks.

In light of recent events, there is something almost breathtaking about the ability of these two to retain their faith in the power of market discipline. The financial landscape may be littered with the remains of companies that took on more risk than they could afford. The GSEs themselves were subject to one sort of market discipline—that of the stock market, where shareholders in the GSEs have been wiped out. But Wallison and Calomoris manage to retain the faith—market discipline may not have protected us from financial disaster in this case, but in any hypothetical case which hasn't actually occurred, they have no doubts that market discipline will work perfectly.
4.4.2009 3:18pm

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