The Financial Crisis: Bailouts, Failures and Death Panels

Apr.14.10 | About: Financial Select (XLF)

They are now making jokes about death panels — not to pull the plug on Grandma in the reformed health-care regime, but to pull the plug on banks and other large institutions posing risk in the reformed financial regime.

Preventing failure doesn’t seem to be the goal. Triggering and punishing failure are the goals. The folks are mad and they want heads to roll. Off with their heads.

But whose heads? As is often the case with mob rule, the innocent get rounded up with the guilty, especially when guilt is not clearly defined. Babies do get thrown out with the bath water.

What are the six phases of a crisis?

1. Enthusiasm

2. Disillusionment

3. Panic and hysteria

4. Search for the guilty

5. Punishment of the innocent

6. Praise and honor for the nonparticipants

This is about number 4 and number 5: The search for the guilty and the punishment of the innocent.

Who’s guilty? Why, the bankers of course. They caused this mess. Everybody knows that. Yes, everybody does know that, but that doesn’t make it true.

There are over 8,100 banks in the country. You can count on the fingers of one hand, two at most, the banks that securitized any subprime loans. On the contrary, most banks were not sellers, but buyers, of mortgage-backed securities. They took them to be safe and liquid investments, as suggested by their AAA ratings.

Most bankers were victims of the subprime crisis, not villains as they are portrayed in the press and at Tea Parties alike. Bear Stearns, Merrill Lynch (MER), Lehman Brothers (OTC:LEHMQ), Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS) were not commercial banks; they were investment banks.

Fannie Mae (FNM) and Freddie Mac (FRE) were not banks, and the decline in their underwriting standards was mandated by Congress, to promote home ownership among the poor.

Virtually all the subprime mortgages were made by nonbank mortgage brokers that fell between the regulatory cracks. Subprime loans embedded in mortgage-backed securities were time bombs set to go off when their low teaser rates expired and adjusted up.

The collateral damage of those explosions was magnified by excessive debt and leverage of those caught with them on their balance sheets when the music stopped. How did the subprime lenders and securitizers face themselves in the mirror? How could they rationalize their behavior?

Well, if house prices kept rising at rapid rates, borrowers would get enough equity to refinance before their day of reckoning. Continued house inflation would bail them out.

Of course, we don’t hear much these days about what triggered the panic. All the attention has turned to what made financial institutions vulnerable to the collateral damage—on how the dominoes got so close together.

Congress has figured it out: Excessive pay. Bonuses. Greed!

In the 1987 movie, Wall Street, greed was good, according to Gordon Gekko, who also opined that lunch was for wimps. But, this time around, greed is bad, and lunch is good, presumably.

Whether good or bad, I’m sure greed will always be with us. Greed, plus the connection between high risk and high reward, mean that financial crises also will always be with us. We can regulate against the last one, but not the next one. Our attempts to do so, however, will lead to overregulation, as usual. We will always find our way around the regulations.

When the financial crisis bubbled to the surface in the fall of 2007, most of my libertarian friends instinctively said “Don’t bail anybody out,” “Let them fail.” Part of that hard line was visceral. Firms in danger of failing must have done something wrong; so they deserved to be punished.

The more intellectual argument for avoiding bailouts is a moral hazard argument. You don’t want to bail out bad decisions, or too much risk taking, or future leaders will follow in the same footsteps.

Future decision makers may emulate risky business practices if they think they might be bailed out too if things go bad. That logic is okay, except that the decision makers and the owners of the failed institutions were not bailed out.

What do Bear Stearns, Merrill Lynch, Lehman Brothers, Fannie Mae, Freddie Mac, and AIG have in common? Among other things, their CEOs were fired, and their stockholders lost their money. Their leaders were hauled before Congressional Committees for a public flogging and humiliation. These were not the kind of bailouts that future decision makers would hope for.

Public anger over the so-called bailouts has only intensified since those scary days in September and October of 2008 when we were looking into the abyss.

Our memories are short, and we seem to think that the way things turned out was the only way they could have turned out. Given the range of possibilities, the actual outcome was closer to the optimistic end of the range than the pessimistic end.

We got only 10 percent unemployment rather than 25 percent, as in the Great Depression. The recession, bad though it was, lasted about 18 months—not 10 years. Bank failures number in the low hundreds rather than the thousands. But this relatively favorable outcome was not preordained.

Ironically, it was achieved largely by the policies that are now so much maligned. It’s like “we didn’t have to take that flu shot after all since we didn’t get the flu.” We didn’t have to take extraordinary policy measures after all, since things turned out relatively well.

Hell-bent critics don’t do counterfactuals very well. We only see what happened, not what might have happened.

When you think about it, successful policies usually mean that nothing bad happens. So when substantially successful policies also have some negative unintended consequences, only the negative consequences are seen.

Students should read Frederick Bastiat on the seen versus the unseen, intended versus unintended consequences, the short-run versus the long run. Bastiat is interpreted in these matters by Henry Hazlitt.

Let’s review the Federal Reserve’s actions to deal with the financial crisis, which were unprecedented, and which used -- for the first time -- emergency powers given to it during the 1930s.

First, the FOMC reduced its policy interest rate as far as it could—from 5 ¼ percent to virtually zero.

Second, when banks were afraid to be seen borrowing from the Fed, the Fed created new auction programs to inject liquidity into the banking system.

And third, when trading in crucial financial markets dried up, the Fed stepped in as a buyer of last resort to support those markets—commercial paper, and, especially, mortgage backed securities.

As a result, the Fed’s balance sheet assets more than doubled, from about $800 billion to $1.3 trillion.

These extraordinary measures worked. The financial markets are now functioning almost normally again. The banking system is healing, but not healed.

The Fed is ending its emergency programs, and is beginning to normalize its operations and balance sheet. It has not yet reversed its policy ease, however, because Chairman Bernanke’s study of the Great Depression convinced him that a premature tightening of policy is more dangerous than remaining easy too long.

So, how much did all the Fed’s lending and investing cost the taxpayer? Not a dime.

In fact, the growth in its balance sheet increased its earnings and the amount it turned over to the Treasury’s general fund, to supplement tax revenue.

Last year the Fed turned over $47 billion of its earnings to supplement tax receipts.

Funny thing is, nobody seems to know that. The public, egged on by its pandering politicians, assumes the Fed is spending taxpayer money, not supplementing it.

Mr. Bernanke barely got confirmed for a second term as Fed Chairman, not many weeks after Time magazine named him Man of the Year for saving our financial system, and our cookies.

Well, what about the Treasury’s role in the crisis?

Treasury Secretary Paulson, with Chairman Bernanke at his side, convinced Congress to appropriate funds to save the teetering banking and financial system to protect the economy.

The alternative at that time, I really believe, would have been worse than the Great Depression.

The Treasury used about $270 billion of appropriated funds to inject additional capital into about 700 banks by purchasing preferred stock from them. The banks chosen needed help, but were judged to be viable with the extra capital.

In return, the Treasury received from the banks a healthy interest or dividend rate on its preferred stock, plus warrants giving it the right to buy the banks’ common stock later at favorable prices.

Over 700 banks received these temporary capital injections from the Treasury and virtually all have survived. The largest banks, accounting for the great majority of bank deposits and assets, have already repaid the Treasury, at a profit to the Treasury and the taxpayers.

The Treasury’s support for banks will make a profit for taxpayers, but taxpayers apparently don’t know that, and don’t want to hear it. They prefer to be mad. Sometimes holding a grudge is very satisfying. I’ve been there.

Congress decided to redirect some of the authorized funds authorized for Treasury support of banks to nonbanks, such as General Motors and Chrysler. The conventional wisdom is that some of that won’t be repaid, but I’m not so sure.

I know the new CEO of GM as a good old Texas boy, and he has vowed to repay the funds sooner rather than later. In fact, repayment has already begun.

Public anger is directed at the Fed’s lending programs and the Treasury’s bank investment program because the public mistakenly believes that taxpayer money is being spent to bail out undeserving, evil-doing bankers. Why wouldn’t they believe that? Pandering politicians are exploiting that erroneous view.

Even the administration exaggerates the cost of the so-called banker bailouts to justify a new punitive bank tax to repay what has already been repaid. Banker bashing is considered good politics, but it's very unseemly.

On this business of punishing failure because failure implies bad decisions or excessive risk taking, that may be true in good times. But bad times have a way of turning good decisions bad.

To take a different kind of example, extending unemployment benefits may create moral hazard by lessening the incentive to find a job. But that’s a bit hard nosed if the unemployment rate is 10 percent and the unemployed exceed the jobs available by 10 to 1.

Good loans to California real estate developers remain good most of the time—but not when the whole state tanks.

Disclosure: No positions