Bailout

In a Washington Post op-ed this morning, Harvard economist and McCain adviser, Martin Feldstein, called for the Big Three automakers to enter bankruptcy to rewrite excessive union contracts.  President-elect Obama and Congressional Democrats seem set on providing loans with conditions to restore long-run financial viability similar to the bill hammered out by House Financial Services Chair Barnery Frank yesterday.  Although the House is expected to pass it later this week, I doubt it will get through the Senate because of Republican opposition.  Next year, something like it is very likely to be enacted.

Today at about 5 p.m., President Bush, presidential candidates John McCain and Barack Obama, and congressional leaders will walk out of the White House and support a modified "Troubled Asset Relief Plan (TARP)," as agreed upon in negotiations with Treasury Secretary Paulson and Fed Chair Bernanke over the past few days.  Congressional leaders hope to pass a bill this weekend.  If they fail to do so, the markets are poised for a big downturn early next week.  If they succeed in passing the bill, the markets will rally and the Treasury Department will start the long process of disposing of these troubled assets at taxpayer expense that could easily exceed $300 b.  I expect the bill to pass this weekend.

The Washington Post's Steven Pearlstein wrote a particularly good column on the looming auto industry bailout this morning.  He cites the auto industry as one of the least deserving of a bailout, but concludes a bailout is necessary.  This is beginning to look like how Washington policymakers see it too. 

Just as students are about to apply for their loans for next fall, many lenders have stopped making student loans. This week, two of the largest, Citicorp and Bank of America, pulled out. Higher educational institutions are rapidly switching back to direct loans from the government, but the Department of Education may be swamped despite the fact that no student has been denied a loan yet and despite DOE's claims that it's ready to make loans that private lenders won't.

Sallie Mae's CEO Albert Lord wrote two days ago in Wednesday's quarterly earnings report, "Today's environment is the most difficult we have seen in our 35-year history of student lending. It has become obvious that we can only meet the enormous student credit demands we are seeing at Sallie Mae if there is a near-term, system-wide liquidity solution."

Yesterday afternoon, the Senate cleared the way to pass a $14.9 b. housing stimulus bill, H.R.3221, next Tuesday, that won't stimulate housing much.  They did that by killling Senator Durbin's (D-IL) amendment to give bankruptcy judges the power to rewrite first mortgages.  That was a deal-breaker for the mortgage lending industry.  It was also the only thing that might have helped those facing foreclosure, albeit as the cost of raising future mortgage interest rates for the increased risk that future mortgages might be written down.

On Sunday, March 16, the Federal Reserve crossed a big line directly bailing out a non-depository financial institution and our fifth largest investment bank, Bear Stearns, for the first time since the Depression. The Fed forced Bear Stearns out of existence by loaning J.P.Morgan Chase $30 b. to purchase it at a fire sale price of $236 million on Sunday after Bear Stearns stock closed with a market valuation of $3.5 b. on Friday, March 14th.

The transaction raises a lot of questions. The ones I would like to deal with are: Why didn't the Fed just let Bear Stearns go bankrupt? How big a windfall was this for J.P.Morgan Chase? What risks does this Fed action pose for the future?

We don't know why the Fed took this action. Their press release announced the action in one sentence without any explanation.