Swallowing the Moral Hazard Chowder

I am no longer crashing Germanicu$'s party (hope you finished those pork rinds), which means I no longer have daily access to the FT. The upside is that I have my NYT sub back, but neither has really explained the urgency of the frantic last minute bailouts and nationalizations, or who ultimately pays for the wave after wave of moral hazard. Some people see irony in the current administration handling the largest financial intervention since the Great Depression, but I just see rich assholes continue their practice of wealth-transfers straight from the public trough to their pig friends and golf partners. Floyd Norris, writing in Friday's business Times, makes the point that the bailouts are not based on size, but recklessness: too big to fail, has been replaced by too reckless to fail.

If the government is forced to decide whether to save another firm, it will face the same question it faced with A.I.G. and Lehman Brothers. Would this failure cause systemic damage to the financial system?Lehman did not measure up because its chief executive, Richard S. Fuld Jr., simply was not reckless enough as he ran Lehman into the ground.Had he had the foresight to make a lot more bad bets in the derivatives market, the government would have feared financial chaos and might have nationalized Lehman, just as it nationalized A.I.G., Fannie Mae and Freddie Mac. Or it would have subsidized a takeover, as it did for Bear Stearns.

The Paulson-Bernanke Doctrine is not “too big to fail.” It is “too reckless to fail.” If you get your company into enough trouble to threaten the financial system, Ben Bernanke, the Federal Reserve chairman, and Henry Paulson, the Treasury secretary, won’t let you collapse.

It may be that they miscalculated. Lehman’s default caused a money market fund to suffer losses, and scared investors into pulling their money from similar funds. If those funds cannot find buyers for their assets, there could be more defaults, and perhaps more failures.The Paulson-Bernanke Doctrine was born not of theory or ideology, but instead from improvising as each new crisis erupted. The Fed’s briefing on the nationalization of A.I.G. did not start until 9:15 p.m. on Tuesday night, which is not a sign of carefully thought-out decisions. When they met with Congressional leaders Thursday night to seek a plan to get cash to banks before they fail, it was almost as late.

If these nationalizations smack of socialism, it is closer to the Marxism of Groucho than of Karl. The Cox Proviso to the Paulson-Bernanke Doctrine is that the rules will change, and change again, if that is needed to avoid another failure.

From unnecessary tax breaks[1], to gobs of lost cash handled by personal friends, to the Blackwater and Halliburton scandals, and the publicly-funded army of golden parachutes now unfurling across the sky, the keystone-cops style bailouts in progress really don't seem so surprising. Pride yourself on removing all oversight, then get all generous with OPM when the chips are called in. 

Still, I'm utterly confused about what's going on. And, I'm not the only one. The bailouts seem to be happening because no one has any idea what is actually going on. The ever chipper Mr. Brooks asserts that Freddie and Fannie were over-regulated, while the dismal dudes at Freakonomics assert the opposite:.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Paul Wilmott--unlucky fellow just invested in A.I.G.--says the cancer has metastasized, meaning it don't matter where you cut.

That’s what makes the question of whether to rescue each institution such a difficult one. Sure, people have to learn a lesson. But, and this is my final surgical analogy, would that be cutting off one’s nose to spite one’s face? . . . The moral hazard is so obvious you can almost taste it.

Since no one knows what's going on, and the risks appear too great to sit on our hands, I find these proposals sensible:

• Volcker et al's, proposal to create a new federal agency to buy up bad paper, enforce regulations, and hopefully  solve the crisis
  
• A failure tax, so these assholes have to pay for their own mistakes
  
• And, my own idea, strengthen and expand anti trust regulations so no company can grow too big to fail. Once a company reaches a certain size, it should reorganize or risk nationalization. SEMCO in Brazil is a great example of what this might look like[2].

Per Norris:

If an activity is important enough to justify a government nationalization to prevent a default, it is important enough to be regulated.

Update: On Friday, the hammer finally came down, and now we're all in with another Trillion dollars. But Paulson is proposing not an independent agency, a la Volcker, but more analysts working at the Treasury. Our country is run by a band of stooges.

Ben White, in Saturday's business Times:

Among the dangers cited by economists on Friday, as word of the plan began circulating: an explosion in federal debt, higher financing costs, an escalating reliance on foreign capital, higher inflation and a further erosion of American economic sovereignty. All of these dangers, these experts stress, are hypothetical — except for the cost, which by many estimates could exceed $1 trillion.

I'm sorry, what hypothetical country are these assholes living in? Explosion in federal debt? Check. Higher financing costs? Check. Escalating reliance on foreing capital? Check. Higher inflation? Check. Further erosion of American economic sovereignty? Check. This is a list of administration priorities, not a new-found risk. What a fucking joke.

1. Paying fewer taxes while enjoying all benefits of federal insurance and services is the same as welfare.
2. Of course, SEMCO spins off companies as it grows because it's the smart thing to do, not because they have to.