Little did Chairman Bernanke realize, I am sure, when he gave the speech before the National Economics Club in Nov. 2002 that earned him the nickname “Helicopter Ben,” that he would be relegated to back-seat navigator as Helicopter Hank shoveled taxpayer dollars to his former Wall Street friends. Secretary Paulson has jumped from one “deal” to another in an effort to stave off the necessary re-pricing of assets (including not just financial assets, but houses) needed to restore stability to financial markets. None of the deals struck so far have succeeded. Remember the Super-SIV? Success as a “deal maker” who focuses on the short term and how to make a quick buck hardly qualifies one to set financial policy. Making deals with high returns in the short run may take skill and be good for investors and shareholders, but may not be the best interests of the country or taxpayers, especially when the actions taken can have both large long-run costs and entail unintended consequences. Here are some thoughts on long-run costs and consequences:
Federal Reserve Independence – The independence and role of the Federal Reserve has been significantly changed in ways that may even effectively have repealed the Fed-Treasury Accord of 1951. During and following WW II the Federal Reserve artificially pegged interest rates at an extremely low level to facilitate the financing of the war, and prices were kept in check by wage and price controls. In 1951 the pegging of interest rates stopped and the Federal Reserve began to function as a true independent central bank. Now, the Fed again appears to have become subservient to the Treasury, which is not only calling the shots in terms of how this crisis will be dealt with, but is also using both its balance sheet and that of the Fed to pump resources into the financial system and take in bad assets. With the government holding a large portfolio of mortgages, the Fed’s ability to fight inflation will be conflicted, because each increase in interest rates will impose capital losses on those holdings, making it more difficult to sell them back into the marketplace and delaying getting them off the Fed’s and government’s balance sheets. This is only one instance of the kind of conflicts that the portfolio changes will entail.
Toxic Waste – Bringing real estate and possibly other highly suspect assets onto the government’s books with only vague ideas as to how the assets will be priced, managed or liquidated holds the potential to create the biggest toxic Super Fund yet. To be successful in enabling financial institutions to restore their balance sheets, the prices paid for the assets acquired will have to higher than can be economically justified, given the likely losses embedded in them. Otherwise, if the mortgages were purchased at prices even approximating their current values, then losses would result and have to be borne by the sellers (financial institutions), which would require write downs, destroy their capital base and lead to insolvency for some. Bill Gross of PIMCO argues that the mortgages are a good deal for the taxpayer (putting aside the fact that PIMCO holds mortgage-related assets whose prices will be buoyed by the policy), because they can be held to maturity and financed at low Treasury rates. His argument is similar to that articulated yesterday by Chairman Bernanke who suggested that loans might even be priced close to par, and are suspect on several counts. First, the assets will have to be acquired at inflated values and many are likely to go into default. Thus, the returns will likely be substantially lower than the face interest rates the assets carry. If they are packaged and sold into the private sector, it will have to be at a loss relative to the price paid by the government. Second, with the huge increase in government debt and liabilities, Treasury rates are sure to increase, and this is even more likely if the Fed is constrained from addressing the inflation that will surely come with the flood of liquidity into the market place. Higher rates will lower the margins on carrying these assets and perhaps even inducing both negative carrying costs and capital losses if the general level of rates increases.
Treasury Blank Check –Secretary Paulson is using scare tactics to gain essentially a blank check in dealing with the crisis, which would pass on to his as yet unknown successor. If approved as drafted, the Treasury plan would entail minimal oversight, preclude judicial review of decisions made and prices agreed to, and enable Treasury to let noncompetitive bids for asset management contracts. Such carte blanche authority is proving hard for Congress to stomach who know that they will be held responsible for what happens long after Secretary Paulson leaves town.
The judicial exemption is particularly important. Firms with underwater assets who sell them at prices which indicate they were overvalued on the firm’s books would subject the sellers to penalties under Sarbanes-Oxley. Preemption of judicial review would provide an additional protection to institutions selling assets, grandfathering in misleading valuations and perhaps even masking actual insolvency.