ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Why Congress has been wary about Wall Street bailout
, October 11, 2008
As things now stand, the US taxpayer holds all the risk with no possibility of gain. Conversely, the banks being helped bear no risk and stand to make all the gain. Colin Teese reports.The real possibility of the present financial crisis in the United States is that the finance sector may be beyond saving. And, incidentally, the fact that the rescue package was conceived and articulated by the secretary of the Treasury, Henry Paulson, and the chairman of the Federal Reserve, Ben Bernanke, is itself worthy of comment.
Where on earth was President George W. Bush while all this was happening? Perhaps hoping that his invisibility would protect his Republican Party's candidate in the forthcoming election from the worst of elector backlash.
That possibility was, however, dashed by the candidate himself. Senator John McCain is now on record with his method of dealing with the crisis. "A freeze on spending," he announced boldly.1930s Depression
Marvellous! That was part of the program implemented in 1929 by Andrew Mellon, the Wall Street investment banker, then secretary of the US Treasury in President Herbert Hoover's administration. As a result, the US economy was plunged into the Great Depression, taking with it most of the developed world. It took a disastrous war to restart the world economy and 25 years for US shares to recover their 1929 values.
All this aside, what may we say about the rescue package? Firstly, its authorship. Treasury secretary Paulson was initially opposed to any rescue package. Indeed, for the previous months he had been busy telling Americans and the world that the crisis was under control.
What changed his mind? Sadly, not any commitment to Republican Party philosophy, but rather fear of a collapse of the financial system brought on by a drying up of bank lending.
Bankers, who still have no idea of the extent of their bad mortgage obligations, were fearful of undertaking further lending commitments - either to each other, or to potential customers. The drying up of inter-bank lending was especially worrying, because this is really the lubricant of meaningful trade in money.
Paulson no doubt watched all of this unfolding with alarm and, hopefully, given his background in investment banking, a sense of shared responsibility as US financial markets collapsed - taking those of Britain, and seemingly the rest of Europe, with them.
Federal Reserve chairman Bernanke is another story altogether. He can, in no way, be held responsible for any of what has happened. That honour rests firmly on the shoulders of his predecessor Alan Greenspan, who, remember, had subtly promoted himself as a financial genius.
While Federal Reserve chairman, Alan Greenspan presided over - even, some might say, encouraged - the runaway inflation of asset and house prices. Then, at the worst possible psychological moment, under pressure from Wall Street, he successfully encouraged the then President, Bill Clinton to persuade Congress to repeal the Glass-Steagall Act. This act had been introduced in 1933, in the depths the Great Depression, to regulate banking and control financial speculation. Until its repeal in 1999, it protected the investment banks and the US public from the worst consequences of imprudent bank-lending policies.
By the time Dr Bernanke took over from Greenspan, the by then deregulated financial system had begun unravelling.
The incoming chairman demonstrated a refreshing flexibility of mind. He immediately identified the principal problems confronting him in the real economy, and set about dealing with them.
With the only tool at his disposal - control over interest rates - he began cutting rates in the US. Critics immediately jumped all over him. None had identified that inflation was a second-order issue, compared with keeping the real economy - that is, actual economic output and employment, as distinct from financial speculation - alive.
Bernanke's efforts failed to isolate financial sector problems from the real economy, though it can probably be said in his defence that any other course of action would have made things worse.
Bernanke was not alone in underestimating the scale of the financial crisis and its effect on the lending propensities of banks. As it happened, cutting interest rates made them even more reluctant to lend.
Consider what might have been going through the mind of Dr Bernanke - an academic whose expertise attaches particularly to the Great Depression. It is possible to imagine him persuading Treasury secretary Paulson that some form of rescue for the banks was not merely desirable, but essential.
No doubt he might have recalled the disastrous "hands-off" approach of Andrew Mellon to the 1929 crash. Mellon, like Henry Paulson, was US Secretary of the Treasury at the time and a former investment banker with a natural hostility to bailouts.
The commentariat was probably right when it concluded that the Paulson/ Bernanke bailout plan was born of what the two men saw as a financial sector out of control.
Fannie Mae and Freddie Mac had been nationalised. Investment banks Lehman Brothers and Merrill Lynch had vanished, and a giant mortgage insurer AIG had to be bailed out. The remaining household names on Wall Street, Morgan Stanley and Paulson's old firm Goldman Sachs, were under siege. And, despite all of Dr Bernanke's efforts, capital markets remained seized up.
Something had to be done. Over the weekend of September 19-21 the Paulson/ Bernanke package was born. Initially, the entire world was staggered, first, by the size of the proposed rescue package - originally US$750 billion - and, second, that a Republican administration would contemplate any kind of bank bailout, much less one accounting for three-quarters of a trillion dollars. Many Republicans shuddered at the prospect.
Since the package involved expenditure of money, it required the approval of Congress. And it is here that Bernanke and Paulson made a large miscalculation.
Henry Paulson insisted that the office of secretary of the Treasury should have unfettered control over how the funds would be allocated. Not merely would he be answerable to nobody, but his decisions would not be subject to challenge in the courts.
Beyond that, Paulson made clear that he considered it reasonable that some of the money could be used to fund exit payments to retiring, failed chief executive officers of banks. More than any other single factor, this latter point seemed to enrage politicians, Democrat and Republican alike.
No doubt Congressman, to a man, were concerned about how any such package could be justified to the electorate, let alone to their own personal consciences. Some, presumably, recalled the fact that, in the 1997 Asian financial meltdown a decade or so earlier, the International Monetary Fund (IMF) had insisted that Asians should not
bail out their banks. And, in pushing that view, the IMF was expressing an opinion much in line with US government thinking. What was different now, some would have been asking themselves?
If there was real urgency about the proposal, then attaching unrealistic conditions to the original idea was a miscalculation. As a result, a week has been spent on negotiating what seems to be a more realistic proposal.
Congress quickly made known its view that while, reluctantly, it might be compelled to accept the idea of some bailout, the blank cheque approach would never be accepted. Strict conditions would have to be attached to any outlays of taxpayer dollars. Even with the details still to be worked out, Congress appears to have had its way.
Congressional supervision of the administration of the deal will be close and detailed. There will be no funding of golden parachutes for failed CEOs of banks. The fund will be used to acquire distressed mortgages, and, in some cases, funds so used will take up equity in the institutes being assisted - that is, if such institutions recover.
Compared with Paulson's original ambit claim, what seems to be emerging is much better. But it is far from ideal.
Actually, it is very hard to evaluate the proposal, because its purpose has not been made clear. Is the idea behind the rescue aimed at nothing more than helping failed investment houses to regroup, resume lending, and otherwise to continue exactly as before? And to prop up share prices? If so, how can such a huge outlay of taxpayers' money be justified?
The banks will have paid little or no price for their incompetence and irresponsibility. Little or nothing will have been done to improve the status of the distressed mortgages or those being displaced from their homes because of them.
And the real economy, while it might reap some benefit from the freer flow of credit, will still be inhibited from genuine recovery because of the overhang effect of the distressed mortgages on the housing and construction industry in general.
As to share prices, experts are continuing to say that the US shares are still overpriced in terms of comparing risk with return. Can re-inflating them to previous unrealistic levels help the real economy?
A far better, and cleaner, approach would be for the government to acquire the delinquent mortgages from those banks which could be prepared to exchange them for equity capital. People paying off their home loans could then be allowed to pay what they could against their mortgages and to remain in their houses.To hasten recovery
This would help stabilise the housing market, help house people who might otherwise default on their mortgages and, in so doing, help the real economy recover more quickly.
It would also provide a better deal for the public purse. By the government taking equity in the banks, if the institutions recovered with their injections of public capital, these holdings could be sold off later to the advantage of taxpayers.
As things now stand, the US taxpayer holds all the risk with no possibility of gain. Conversely, the banks being helped out bear no risk and stand to make all the gain. Some deal!- Colin Teese is a former deputy secretary of the Department of Trade.