Another Recap of the Financial Crises
While not increasing general price levels, and while the housing bubble was not universal, loose monetary policy inflated housing markets. Land-use regulations made the bubble worse in some parts of the country. Two more elements were necessary to achieve a level of pain beyond the standard: 1) the addition of new financial instruments (slice, dice, and leverage), 2) the push by government to promote homeownership among people with high credit risk — the Community Reinvestment Act (CRA) which forced banks to meet lending quotas in these target groups. Finally, adding Fannie and Freddie to the mix as a collecting tank of pain took the situation from painful to disastrous.
The Bailout
The U.S. Treasury intervening in AIG (taking an 80% equity stake and extending a loan at 11.3%) pushed investors holding stock in other financial firms vulnerable to similar interventions to sell their shares. While these firms held the same debt as before, the debt-to-equity ratios became much worse which, in turn, led regulators to increase their capital requirements and caused their credit rating to be downgraded . This made it impossible for these firms to raise capital (by either selling new shares or floating bonds).
These initial case-by-case steps by the U.S. Treasury had the secondary affect of making the situation worse. By late September, “Wall Street” was gone. The surviving four investment banks were either absorbed or transformed into commercial banks. Lehman was allowed to go bankrupt.
Paulson’s proposal is not in the same league as the Smoot-Hawley tariff of 1930 or Nixon’s wage-price freeze in 1971. The plan is certainly less frightening than his initial case-by-case attempts. The core idea was to buy mortgage-backed securities at a deep discount. These could likely be sold later at profit and earn income in the meantime. But, that point is now moot as the protections Congress added would require bank executives to impoverish themselves and their stockholders before dealing with the Treasury. Only companies in dire straits would participate which thwarts the purpose.
Much of the plan that Congress actually passed made little sense. Republicans, forgetting the cost of insuring savings-and-loan depositors in the 1980s, insisted on fee-based insurance. The fee becomes a tax on the safest securities to subsidize the riskiest. And, there isn’t enough data to determine what such a fee should be anyway.
The Emergency Economic Stabilization Act (EESA) also demanded that the Treasury acquire warrants. Conservatives who expressed fear about mortgage-backed bonds as well as critics of derivatives were both strangely enthusiastic about warrants which are a riskier derivative equity position similar to long-term call options. The Treasury is given virtually unlimited power to confiscate the wealth of stockholders of any company foolhardy enough to play this game. Ironically, the warrants would make it more expensive for the Treasury to buy mortgage-backed securities, and therefore make it less likely those securities to be resold at a profit for taxpayers.
