The Bailout

The Bailout, as it is currently being talked about, is bad policy and must be defeated.

Secretary Henry Paulson, Chairman Ben Bernanke, and President George Bush are advocating a bailout that will buy home mortgages from financial institutions in exchange for cash. Because these institutions are free to buy or sell any time — if at prices they find distasteful — the plan advocates paying above-market rates for mortgages, and allowing the financial institutions to keep the profits.

There are two components to this plan. The first is making the investments of financial institutions “more liquid,” or more easily transferable to something else. Cash is very liquid. A mortage which is hard to sell at the price you want is not. Secretary Paulson emphasized the need for liquidity in his original address on the matter last week. Illiquidity is a well known economic problem, and this is one we should take seriously.

The other component of the plan is to transfer wealth from tax payers to these large financial institutions. The wealth transferred is the difference between what we pay for these mortages, and what the institutions could make if they just sold the mortgage. For instance, if the government pays $200,000, but the bank could only sell it for $100,00 (perhaps to the individual who is currently making the mortgage payments, perhaps to a foreign investor, perhaps to a local government, etc), then we would be transferring $100,00 worth of wealth from the taxpayers to the financial institutions. This is horrible. It reinforces bad behavior, it sets an example for others, and it prevents the market from learning the full lessons of this disaster.

On CNBC yesterday, some hosts were saying that this is “everyone’s fault,” that “no one is innocent,” that “we are all to blame.” This is not true. It is not the fault of those who did not take out risky loans, or who paid their mortgages, or the investors who were wise with their money. It was the fault of individuals who were more-than-average stupid and took out loans they could not pay back, and investors who were more-than-average risky and gave loans they could not collect. It is the fault of politicians whose response to the low credit available to blacks and hispanics was “this is racial discrimination,” rather than “this is a reflection on the relative credit worthiness of groups within the American population.” This is the fault of bad officials, bad investors, and bad politicians. It is not everyone’s job.

On NPR this morning, a reporter said that Goldman Sachs estimated that the plan — which will initially cost $700 billion — will recoup $500 billion, leading to a net transference of wealth from taxpayers to investors of only $200 billion. If this is true, two alternatives to the bailout present themselves:

1) Because the government will on average be paying 7/5ths of the actual value of the mortgages to the investors, then the investing institutions should make up the difference in non-voting preferred stock. That way, the institutions still become more liquid, the owners of these risky firms are not unduly rewarded, and the government’s investment is protected both by the value of the mortgages and the value of the preferred shares.

2) Eminent domain the illiquid assets. If your house is in the way of a new highway, or new shopping mall, that your government wants to build, it will use its constitutional power of “just compensation. While we might squabble whether the “just compensation is the current market value or the market value the U.S. government could most probably get for these properties down the road, it would not be as much under the current bailout.

All we now hear — of talk of limiting executive pay packages — is well and good, but does little to protect taxpayers from investors. It is a red herring away from the real problem: a $200 billionish giveway as a reward for incompetence.

As I write this, John McCain has already suspended his campaign and traveled to Washington to join in the negotiations. If the bailout passes in its current form and John McCain supports it, his suspension will have been a gimmick and he will display the same big-government approach to policy that I would expect from Richard Nixon. If a the bailout fails in its current form, and we don’t encourage such bad behavior by transferring hundreds of billions in wealth, then John McCain will be a leader of the same quality on economic policy that has been on the Iraq War.