A DL Member Angel Cruz on the bailout: You should be afraid

Angel presents a perspective on the bailout that you may or may not agree with, but the solution outlined below deals with the problem, and it's not a band-aid to cover the wound.

As I sat here watching the Bailout Bill debate on the House floor I was overwhelmed with fear.  The bill being considered was not drawn from a thoughtful game plan.  In fact the $700 billion is admitted as "picking a really big number", and the additional $150 billion added to the bill is not part of any plan but merely pork tossed out to grease the vote.  $850 billion tossed into the wind hoping something good will happen.

Paulson is correct that the signal lights of our economy are all flashing red but there is no reflection on how we got here and what it will take to undo the mess.  The Paulsen/Senate/House plan commits the VERY same mistakes that got us in trouble by placing most of its faith in financial alchemy.  The investment banks and ratings agencies thought you could reduce the risk by slicing up these mortgages even though the system had been working just fine.  Now we are told that by the government pulling all the slices back together real value will be recreated.  Yes, for the banks, because we will be overpaying!

The proposal shows little evidence of having learned the lessons of information asymmetry which played such a large role in getting us into this mess. The banks will pass on their lousiest mortgages. Paulson may assure us: we will hire the best and brightest of Wall Street to make sure that this doesn’t happen. (Wall Street firms are already licking their lips at the prospect of a new source of revenues: fees from the U.S. Treasury.) But even Wall Street’s best and brightest don’t exactly have a credible record in asset valuation; if they had done better, we wouldn’t be where we are. This also assumes that they are really working for the American people, not their long term employers in financial markets. Even if they do use some fancy mathematical model to value different mortgages, those in Wall Street have long made money by gaming against these models.  We will then wind up not with the absolutely lousiest mortgages, but with those which Treasury’s models most underpriced risk.  So what are the major flaws in proposal as passed?

There are three critical flaws in the proposal.  The first is that it relies—once again—on trickle down economics: somehow, throwing enough money at Wall Street will trickle down to the benefit of Main Street, helping ordinary workers and homeowners. (The irony is that Wall Street was itself destroyed in an act of trickle
up economics—in its rush to make sure that the money it had discovered at the bottom of the pyramid was moved to the top.) Trickle down economics almost never works, and it is no more likely to work at this time than at any other. Even if it “works,” it’s neither the most efficient nor the fairest way of addressing the problem.

The second is that it sees the fundamental problem as a crisis of confidence. That no doubt is part of the problem; but the failure of confidence is because the financial markets made some very bad loans. That’s not just a matter of imagination or perception. It’s reality. There was a housing bubble, which supercharged our economy, and that has now burst. Best estimates are that house prices have a ways to fall before they are back to normal. We might be able to stop overshooting; but that is perhaps the best we can hope for. And if prices do continue to fall, there will be more foreclosures.  The bad loans have created a hole in banks’ balance sheets. That has to be repaired. If the government pays fair value for these assets, it will do nothing to repair that hole.

The third is that real contractionary dynamics are already in play, and this proposal does nothing about that. Even if the proposal were implemented quickly, there would be some credit contraction. But beyond that, states and localities are hurting, and are cutting back expenditures.  Household balance sheets are weaker, and we can expect consumers to contract expenditure—or at least not expand it at a pace to sustain growth. The U.S. economy has been sustained by a consumption boom fueled by excessive borrowing, and that will be curtailed. But an economic slowdown will exacerbate all our financial problems. The President has made it clear that he will veto any effective stimulus bill, including an extension of unemployment benefits.

Of course this bill downplays foreclosures.  Large amounts of foreclosures may accelerate the downturn, and may result in overshooting, and so it is important to address the foreclosure problem. Let’s be clear about one thing: the Administration’s view that the $700 billion bail-out will ensure that the mortgages the market views as bad aren’t really so bad is a fantasy. The fact is that loans were made on the basis of inflated prices, and real estate prices are falling.  No amount of talking up the market is going to change that. But direct aid to homeowners can make a difference.

That is why it is also absolutely essential that we deal directly with the foreclosure problem and Joseph Stiglitz provides a map.  Joseph Stiglitz states the Paulson plan is like providing massive blood transfusions to an ailing patient while vast internal hemorrhaging is occurring. Unless we deal with the underlying source of the problem, the bleeding of our financial system will continue.  Stiglitz says there are three things we could do easily and quickly, and for a fraction of the price of the Wall Street bail-out. "First, we can make housing more affordable for poor and middle income Americans, by converting our mortgage deduction into a cashable tax credit.  The government pays in effect 50% of mortgage interest and real estate taxes for upper income Americans, yet for poor Americans it does nothing. This reform is, in any case, long overdue. Secondly, we need bankruptcy reform allowing for homeowners to write down the value of their homes and stay in their houses, in addition to the help that the current legislation proposes. Thirdly, government could assume part of the mortgage, taking advantage of the lower interest rate at which it has access to funds and its greater ability to demand repayment. In return for the lower interest rate—which would make housing more affordable— it could demand from the homeowner the conversion of the loan into a recourse loan (reducing the likelihood of default), and from the original holders of the mortgage, a write down of the value of the mortgage to say 90% of the current market price."

Sounds good to me.

Angel

We must not be enemies. Though passion may have strained it must not break our bonds of affection. The mystic chords of memory, stretching from every battlefield and patriot grave to every living heart and hearthstone all over this broad land, will yet swell the chorus of the Union, when again touched, as surely they will be, by the better angels of our nature.

Abraham Lincoln

I would add that in addition to directly helping those in danger of foreclosure, there is in addition another crisis that no one is talking about:  We are a nation of financial illiterates.  There is an expectation that we should "just know" how to manage our money.  As some of us know, that is not the case.  And since our economy is based on consumerism, our nation has turned into a nation of debtors.

We should immediately start a national educational effort that will help people to obtain a basic level of financial literacy.  Start with schools, but reach out to everyone and anyone that is in need.  That is the real way to keep our country on an even financial keel.