Tag Archives: subprime

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.

What does China think about the bailout?

All the talk these days is of the government bail-out of the foolish (high-risk when already ahead) banks who sold mortgages to people who could not pay them back. Some of the banks then turned around and sold these bad mortgages to even more foolish banks, who are in even worse trouble. This has already destroyed the large investment banks of the United States, with every one of them now bankrupt, bought, or transformed. But the liquidity trap (see this excellent column by Paul Krugman explaining the problem, courtesy of Marginal Revolution). It’s a complex issue, and I do not understand it. Too many smart people are saying too many different things, many of them unexpected

So instead, I’ll trust China. China has nearly as much of a stake in America’s economic status as we do, and China (unlike America) has a ruling class made of engineers, instead of lawyers.

But what does China think about the bailout?

China Expat says that China is belittling the idea:

As China Finance, China News, and Chaobao Financial News stated, these actions by the Federal Reserve is only “creating money that does not exist which leads to the inflation of liquidity,” and that by showering the bailout on just a handful of stupid financial companies (my take), the Federal Reserve is “only protecting and encouraging large companies’ wrong doing.”

Yet McClatchy newspapers says that China cheers the news:

China voiced reassurance that the U.S. plan would contain the crisis, while South Korea and Japan pondered whether it would provide protection for banks that are holding distressed American mortgage debt.

As stock markets rallied around East Asia, analysts worry that Washington will print more money to finance the bailout, an action that could weaken the U.S. dollar, lift commodity prices and fan inflationary pressures.

President Bush called Chinese leader Hu Jintao early Monday local time to explain the $700 billion rescue plan of the U.S. financial sector, which is shaping up as possibly the largest bailout of private industry in American history. The state news agency, Xinhua, said Bush told Hu that “his government was well aware of the scope of the problem, and had taken and would continue to take necessary measures to stabilize the domestic and world financial markets.”

So what does China think of the bailout?

Petrodollars Recycled to America’s Underclass?

Wolf, M. (2008). Challenges for the world’s divided economy. Financial Times. January 9, 2008. Available online: http://www.ft.com/cms/s/0/9a62eaa8-be14-11dc-8bc9-0000779fd2ac.html?nclick_check=1.


As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard note in a brilliant new paper, this had similarities to the recycling of petrodollars to developing countries that preceded the debt crisis of the 1980s. This time, surplus savings were, in their words, “recycled to a developing country that exists within the US”: the subprime borrowers. The consequences for banks also look disturbingly similar.

One is tempted to say “People who were harmed will learn from this experience,” but many might not. While there’s plenty of in-group variation, between-income-group variation in general intelligence is stark. Many of the people who were directly bitten by the subprime mess are precisely the people least likely to learn from their experience.