Bank Bailout #1

The Objectivist
THE MASSIVE BAILOUT: BAD, BAD, BAD
Dunkirk-Fredonia Observer
October 4, 2008

On Friday, October 3, 2008, the U.S. passed the Emergency Economic Stabilization Act of 2008. This $700 billion bailout authorizes the Secretary of the Treasury to spend up this amount to purchase mortgage-based securities from U.S. banks. This is an attempt to reduce the banks’ losses. According to the plan, the U.S. government will buy the securities and in return receive the mortgage payments and eventually be able to sell the securities. The maximum cost of the plan is roughly $4,635 per income-tax paying citizen ($700 billion divided by 151 million working Americans), although this figure assumes that the purchased real estate will eventually have no value and it won’t. The Bush administration convinced Congress that the plan will keep the credit market healthy and thereby ensure that consumers and businesses can continue to get credit. If the plan wasn’t enacted, the Bush administration argued, the loans would dry up and the economy would collapse.

The problem here is that housing prices are declining after being grossly inflated. As a result, people are not making their housing payments. There is also widespread uncertainty about how high many defaults and foreclosures will go. A foreclosure occurs when the lender takes over the house that was used as collateral for the loan.

In the long term, this plan will hurt the economy. First, we don’t need the plan because we are not heading over the financial cliff. Alan Reynolds of the Cato Institute points out that the U.S. economy is still growing (the real gross domestic product is up). It should be noted that there are some warning signs. The gross domestic products of France, Germany, Japan, and Hong Kong are declining. More ominously, the Dow Jones Industrial Average did drop 31% as of this past Tuesday (10/14/08). Still, this is nothing like the almost 90% drop in stock prices that occurred in July 1932. It is also worth noting that there have been 10 previous drops in the stock market (defined as at least a 20% decline in the Standard & Poor 500). Columnist Robert Samuelson points out that this includes nearly 50% drops in 1973-1974 and 2000-2002.

Reynolds also points out that bank and consumer loans are up. In fact, consumer loans are growing at the fastest rate since 2004. That is not a typo. Consumer and industrial loans are up. While giant banks have cut back on their loans, smaller banks have stepped into the breach. Reynolds points out that even loans between banks, a major concern for the bailout proponents, have only dipped modestly and in any case are very small in comparison to consumer and business loans. Even the interest rate on these loans as recently as September 30, 2008 was not out of the range of such loans in the last year.

The concern over bank failures is also premature. As of less than a week ago (September 29, 2008), there were little more than a dozen bank failures compared to more than 5,000 in the 1930s (The Great Depression) and 3,000 in the 1980s (The Savings & Loan Crisis). Where several major financial institutions have failed (Washington Mutual, Wachovia, Bear-Stearns, Lehman Brothers, and AIG), the Federal Reserve and Federal Deposit Insurance Corporation have handled the situation. The recent drop in the Dow Jones Industrial Average is distinct from bank failures.

Second, the taxpayer money that is to be used to purchase the housing loans (that is, mortgage-based securities) must come from higher taxes or loans. Because the market almost always puts the money to better use than the government, higher taxes will result in U.S. dollars being put in to less efficient use. This problem will intensify once politicians start to trade security purchases for campaign contributions and other benefits. This in turn will reduce economic growth rates. Daniel Mitchell points out that lowered growth rates have significant effects over the long term because of compounding. The slightly higher growth rates in the U.S. as compared to our competitors explain why U.S. citizens make more money than French, German, and Japanese citizens. If the money is used for loans, then the government is taking out one loan to pay off another. Again this directs resources to less efficient uses and ratchets up the debt. Skyrocketing debt is in fact one of the legacies of the Bush administration. Joseph Stiglitz, a Nobel Prize winning economist, points out that in the last eight years the debt has increased by 58% (32% when you adjust for inflation) and by an astounding $3.3 trillion. In 2008 and 2009, the deficit will likely reach record heights.

Third, the plan’s particulars are atrocious. The government will need to decide what to pay for the mortgage-backed securities. Stiglitz points out that the banks will likely get the government to pay way too much for the worst mortgages. If the government paid fair market value for these terrible loans, then the banks would still have a crippling balance sheet and the credit problem would remain. So the system depends on the banks gaming the system. In addition, housing prices are generally expected to keep on dropping. If the government buys mortgages at the current price and the prices keep on dropping, then it will be buying high and selling low, thereby hosing the taxpayers and artificially propping up housing prices.

It is worth noting that the government, not deregulation or greed, caused the mess that led to this bailout. This claim rests on two premises.

1. The government forced banks to lend to people who were poor credit risks.

2. The collapse of the mortgage market is in large part due to these people defaulting on their loans.

The first premise is uncontroversial. As Russell Roberts, an economics professor writing in the Wall Street Journal, points out, beginning in 1992 Congress pushed private-public mortgage giants, Fannie Mae and Freddie Mac, to buy more mortgages going to low and moderate income people. By 2005, the Department of Housing and Urban Development required that 22% of their mortgage purchases go to such people. In doing so, it thereby funded hundreds of billions of dollars of such loans, many of them subprime and adjustable-rate loans. In 1977, Congress passed the Community Reinvestment Act, which pressured traditional banks to lend to poor and moderate income people. In 1995 this act was strengthened and it caused an 80% increase in loans to such people. These acts along with the increased capital-gains exclusion on real estate and lowered interest rates jacked up the housing market. The average price of a house doubled from 1997 to 2005 (in contrast, inflation increased by 22%). The current default problem is due in no small part to the failure of people who were poor credit risks to pay the subprime loans and to handle vastly inflated housing prices.

Members of Congress and the White House did this initially to redistribute wealth to the poor without having to raise taxes and later in exchange for campaign money. David Boaz points out that in the last decade, Fannie and Freddie spent $170 million on lobbying, including giving $16 million to members of Congress and $10 million in soft money to the Democratic and Republican Parties. Consider the leading recipients of Fannie and Freddie campaign contributions: Sen. Chris Dodd (D-CT) (chairman of the Senate Banking Committee), Sen. John Kerry (D-MA), Sen. Barack Obama (D-IL), and Sen. Hillary Clinton (D-NY). In addition to Dodd, Rep. Barney Frank (D-MA) is the other leading villain. He helped to block any attempt to rein in Fannie and Freddie. Ideology and campaign dollars led Congress to reject the strenuous warnings and requests by the Clinton Treasury Secretary Lawrence Summers, Federal Reserve Chairman Alan Greenspan, and the Bush Administration to fix Fannie and Freddie by increasing their capital requirements, shrinking their number of risky assets, and adopting sound accounting practices.

This bill will make things worse and was brought about by corruption and leftist ideology in Congress and the White House. Every aspect of it stinks to hell.