Doug Elmendorf identifies my key frustration with the policy response to the financial sector meltdown, when he writes the following in the middle of a very thoughtful and clear discussion of the government's options:
A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions. Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a program, while banks that made the biggest commitments to low-quality mortgages and have delayed dealing with their balance-sheet problems would be the biggest beneficiaries.
This is the biggest problem in the financial sector: that through greed, corruption, or just incompetence, a large number of institutions have negative net worth and are widely connected through borrowing to other institutions that don't yet have these problems and didn't go courting them. Insurance exists to provide ex post transfers from those who were lucky to those who were unlucky in a group of ex ante similar entities. It does not exist to provide transfers from those who were careful to those who were stupid. The government should be doing its level best to make sure that greed, corruption, and incompetence are punished, not rewarded.
The government should not be using its lending authority to reinforce these institutions with taxpayer funding. It should be using that lending authority to help cushion the impact of their failure on institutions who engaged in more prudent lending policies, and even then, it should be doing so by buying assets at a discount, not a premium.
Taking the moral hazard high road is fine
but it hurts a lot of innocent people -- the lowly clerk at Lehman who lost everything in her retirement account (heavily invested in Lehman stock), for example.
Make those execs do the perp walk. In Japan these guys would be, literally, falling on their swords.
My 401K is demanding retribution.
Satisfaction
We do need to demand some satisfaction on this. These blue suits are exposed as lying frauds...if we could clawback their bonuses and salaries for having run their companies into the ground, it would be a great pleasure to watch (oh! How can I get by on only 3 houses? What about my new Soho apartment?")
But we have to think about the future, which means building regulatory features that reduce the moral hazard that arises from allowing companies to become "too big to fail" and then sticking the taxpayer with their risk. The simplest idea is to have HIGHER capital requirements for the 100 largest insurance/financial/investment banking firms, and raise them again for the top 10, and again for the top 5, and finally, the biggest gets a "punitive" insurance premium (disguised as a capital requirement) to prevent it from growing. If we deliver this risk signal to their Boards, they will sell off businesses to run at a more leveraged rate, but they will not be able to sell them to other large banks...making it less valuable to grow hysterically in the first place.
Simply put, being super-big in today's environment carries huge risk to the taxpayer, and they should pay us insurance premiums to bear it.
Options
What should be [.pdf] vs what will be, IMHO (via Tyler Cowen).
Would you be kind enought to
Would you be kind enought to name a handful of those institutions that engaged in prudent lending policies?
Just curious which ones you mean...
Just Take a Walk on Main Street
Any number of community banks are in fine shape. They are more heavily regulated (per dollar of liabilities) than are the Wall Street institutions and nationwide banks. So they couldn't get into this kind of trouble. But more importantly, they believe that their mission is to support their community, and so they simply don't engage in financial high wire acts. They will face some difficulties as the housing sector contracts and have fewer profit opportunities in a sluggish economy. But they are fine in terms of solvency.
More regulation the answer?
Sorry, but "greed, corruption, and incompetence" sounds like an apt description of members of Congress and the clowns that Clinton put in charge at Freddie Mac and Fannie Mae. And wasn't it Congress that encouraged more mortgage lending to poor risks? Is there a legitimate school of thought that holds that we can regulate our way to prosperity?
Yes, more regulation is the answer
Hunh? Is there any legitimate school of thought that unregulated capitalism has ever worked?
Phil Graham, top economic advisor to Sen. McCain, pushed a bill through congress prohibiting the regulation of Credit swaps. What a shock, 8 years later, that we have to bail out the world because of, yes, credit swaps. Hmmm.
Yes, it was a series of Congresses that continued to loosen the regulation of Fannie and Freddie, hoping that the problem would blow up when they are out of office. George II and a 6 year Republican Congress had every opportunity to fix the known issues; but in fact, they air to the bubble. You can't possibly be proposing that we not regulate these high risk financial instruments, can you?
How to Prevent a Recurrence
One simple regulation would prevent this disaster from striking again.
-- The financial institution that makes a loan must hold the loan. --
If you have to keep your loans, you are highly motivated to ensure that your borrowers are creditworthy, employed, and reliable. You would not approve the no money down, bad credit history, and unconfirmed employment mortgages that so many banks and mortgage brokers did over the past ten years.
This proposed regulation also eliminates the remortgages and mortgage derivatives that now have imploded and that greatly increased the magnitude of the crisis.
Checks and balances?
Where are the checks and balances in this proposal. Where is the oversight? "in God we trust, all others pay cash".
"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
Congress would have to be insane to agree to such a provision. Bush has run one of the most corrupt administrations in history. This has happened because Bush has dispensed with all oversight. Congress needs a seat at the table and oversight oversight oversight.
If nothing else, the administrators of this much taxpayer money needs to have someone vouch that they are honest and working to benefit the taxpayers. Real accountability. Real Accountants, not Enron Accountants.
Remember when there was too much liquidity? Remember why?
http://blogs.wsj.com/marketbeat/2006/11/21/money-thats-what-i-want/
Rewarding Those That Wrote-Down or Stayed Away
The idea of rewarding those who wrote down their loans earlier or didn't wait for armageddon is interesting. What would you think of the Treasury plan if it's goal would be to finance solvent banks' acquisition at a discount of insolvent institutions' securities? Of course that was the idea of the '82-'84 FDIC regulatory-inspired acquisitions of weak S&L's by "strong" ones, although the failure there was not so much the idea as the execution: acquirors were allowed to count "regulatory goodwill" as tangible capital, and when the '88-'89 real estate bust came calling, even "strong" S&Ls, regardless of their own recklessness, had insufficient tangible capital to support the assets they'd been "encouraged" to buy in the early 80's.
Now You're Talking