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The E-Conning-Me

Observer Viewpoint | Friday, October 10, 2008

Like Banquo’s Ghost, Washington keeps reappearing with new ways of spending our money, the latest being the bailout plan. Unlike Macbeth, we all see this spectre. Who would believe it? A rush to spend a trillion dollars, out of our future earnings.

The troubled Troubled Asset Relief Program (TARP). There are obvious problems with this plan and there were alternatives! What exactly is going on? Mortgages to borrowers who could not afford them. Everyone betting that the housing bubble would continue bubbling heavenward.

Unfortunately, starting around 2007 the housing bubble burst. Suddenly people were attached to mortgages that exceeded the value of their homes. Here comes jingle mail; people were just walking away from homes and mailing the keys to the bank.

How did this disrupt the markets?

An example: JP Morgan Chase issues 100 dollars in mortgages. They realize that these mortgages are too risky and pool all their mortgages together and sell them in the form of a security to Lehman Brothers. Lehman Brothers purchases these securities by borrowing funds from Merrill Lynch, who receive money market deposits from investors, and by using their own equity. Let us suppose that Lehman Brothers purchased these securities with four dollars of equity and 96 dollars of commercial paper from Merrill Lynch. Now, let us suppose that these securities lose five percent of their value. Suddenly, Lehman has negative equity. They must declare bankruptcy. Additionally, Merrill Lynch only receives 95 dollars of the 96 dollars they lent back. People don’t realize how much Merrill Lynch actually lost, they only see their ties to Lehman Brothers, and these questionable mortgage backed securities, and they immediately go on a bank run at Merill Lynch for their money market accounts. Merrill Lynch has trouble covering this bank run, and, suddenly, the commercial paper market isn’t functioning the way it should. (It is important to note that even though Merrill Lynch and Lehman Brothers together function as a commercial bank, neither is, and, thus, neither was subject to governmental restrictions (like backing six percent of their assets)

One should note that questions remain as to are those “95 dollars” of mortgage backed securities really worth 95 dollars (are they securities representing mortgages in volatile Florida or relatively stable Manhattan)? What is the true value? Banks are having trouble trusting each other, due to the ambiguous value of these assets and are refusing to lend money to one another because they fear that the lender will suddenly declare bankruptcy.

What the bailout plan supposedly will do is take these troubled assets out of the market in order to restore confidence and re-establish the market. But TARP is poorly written and places a crown on Secretary Paulson who would be accountable only after the fact when all of our money is out the barn door. Some of the obvious questions are: How will these negotiations take place? How will we minimize the costs to the taxpayer? Surely, the corporate banker in the negotiations will be more personally invested in the price paid by the government than the government agent? Face it, this burden will be inflicted upon the American taxpayer, and not the Wall Street speculator, who engaged in these risky ventures. Is this fair? Essentially, the government, having bailed out Wall Street, has morphed risky ventures into arbitrage opportunities.

As Luigi Zingales, a finance professor at the University of Chicago, said, “It is time to save capitalism from the capitalists.” He recommended that the government fail to provide financial assistance of any kind. He proposed that the government impose compulsory credit for equity (many of these banks still have thriving sectors) swaps, which essentially amounts to partial debt forgiveness. Nothing new here. The United States currency used to be indexed to gold. Franklin Roosevelt deemed this invalid, and, as our national debt plummeted, he enacted partial debt forgiveness. Following this decision, stock prices and bond prices rose (the debtor and the lender both benefitted from this partial forgiveness). It worked then and would work now. But, Congress decided to spend our money.

Another alternative, in 1982, Chile was suffering a financial crisis. In response, the government issued subsidized loans to banks in the country in order to increase their capital. These loans were backed by the banks’ assets in order to minimize taxpayer risk. Additionally, the banks were not able to enjoy profits until the loans were paid off. This enabled banks to issue loans, which is essential to an economy, but it also laid the burden of restoring economic prosperity upon the financial world. After severalyears, the Chilean financial system recovered. Thus, government issued asset-backed loans to the financial institution is another potential solution worth investigating. Congress said no.

Some argue that we needed to act quickly to restore confidence in the market. But, at 8579 and falling, that didn’t work and raises a bigger question. What happens if we lose confidence in the government? There should have been due consideration for a trillion tax dollars. Unfortunately, taxpayers spend more time buying a computer. Congress’s precipitous actions will haunt our generation for years to come. And the bankers skip merrily away. Oh, Congress. Another year, another plan, and again, we are not being greeted as liberators.

Peter Kelly is a senior majoring in economics and mathematics. His true name is shannon and his third wish is for a planet full of unicorns. He can be reached at [email protected]

The views expressed in this column are those of the author and not

necessarily those of The Observer.