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The independence and role of the Federal Reserve has been significantly changed in ways that may even effectively have repealed the Fed-Treasury Accord of 1951.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.
Right now, the principal political objections to the plan center on executive compensation. While holding executives’ feet to the fire in return for government support may play well at election time, there are other ways of creatively incenting executives through the use of claw-back and other compensation schemes. The key concern for Congress should be accountability, incentives, and a well-articulated exit strategy. But when these concerns were expressed by Congressional leaders yesterday, lip service was paid by those testifying; yet specific proposals, for example, to commit funds but ration them out in tranches over time, were rejected out of hand by Secretary Paulson.
Mutual Fund Guarantee– In an effort to protect the entire mutual fund industry, even though only one fund has actually “broken the buck,” Treasury indicated that it would protect the deposits in all mutual funds – the exact details were left to later. Clearly, Treasury never considered that a blanket guarantee would significantly encourage uninsured bank depositors to move their funds from banks to mutual funds. So the policy was modified to apply to only money fund deposits made on or before Sept. 19. This is just one example of a knee-jerk policy put in place without thinking through the consequences or who might be affected. Now, how are the money funds going to be able to modify their accounting and record-keeping systems to keep track of which funds in which accounts represented money on deposit before Sept. 19th and which were added thereafter? This is not the only case of policy making on the fly that hasn’t been thought through. The SEC’s passage of temporary short-sale restrictions and then its continual modification of the rules is another example.
Liquidity versus Capital – Commentators and regulators have both described the current financial crisis as a problem of liquidity and confidence. This mischaracterizes the problem. Confidence is not an animal spirit but rather, in finance, comes from knowing what the risks are and from transparency in terms of understanding the values of assets that credit is being extended against. When either or both of those attributes are missing – as they have been in the current crisis – rational lenders stop providing credit. To deal with the so-called liquidity problems, the solution offered has been to flood the market with liquidity in the form of central bank high-powered money, by either purchasing bad assets or swapping the use of good assets (US Treasuries) for bad assets (mortgages and mortgage-backed securities). Yet firms have failed or exited the market both in mortgage lending and investment banking despite the flood of liquidity. The reason is that their problems weren’t ones of liquidity but rather of excessive leverage and insufficient capital to absorb losses. The solutions previously put in place don’t address these fundamental underlying problems. Adding high-powered money to the system or purchasing assets doesn’t make the losses go away, nor does it inject capital into institutions that need it, nor does it stabilize housing prices, which is the foundation upon which the value of mortgages and mortgage-related assets rests. Monday, the Federal Reserve relaxed restrictions in the control provisions of the Bank Holding Company Act, which will make investments in banking organizations more attractive to private equity and hedge funds. This is perhaps the first policy change made that may actually attract more capital into the industry.
Moral Hazard – In his testimony yesterday, Chairman Bernanke repeatedly expressed concern about moral hazard and the need to deal with it. But the discussion was woefully empty of what would or should be done to limit the moral hazard incentives that the emergency actions taken have created. In a wonderful sequence, two British comedians (John Byrd and John Fortune) captured the essence of the moral hazard that has resulted from our handling of the subprime crisis. Near the end of the skit, the question was posed to the investment banker, what lessons about moral hazard might be drawn from saving troubled investment banks. He responded that the lesson was, “If you are going to make a cockup, make it a really big one.” Well, saving mutual fund investors, nationalizing Freddie and Fannie, providing support for the acquisition of Bear Stearns, and supporting AIG all send a clear message to the managers of large institutions (Lehman Brothers notwithstanding): if you are big enough, politicians and regulators will gladly commit taxpayer money to avoid a problem. With the disappearance of the two remaining investment banking firms through their conversion to bank holding company status, they have opted for regulation and oversight in return for complete access to the Fed’s safety net and protection against the realization of catastrophic downside risks. Others have quickly perceived that if your problems are “big enough” then the government may bail you out. The big three auto makers have already found their way to Capital Hill seeking loan guarantees; community bankers are lobbying Congressional leaders that they too should be included in the asset purchase program being suggested by Treasury, in order to dump their troubled commercial real estate and development loans; and the parade is not likely to stop there.