Is a Bailout Actually Necessary?

The problem at the heart of the demand from the financial sector for a bailout of Fannie Mae, Freddie Mac and other failing financial businesses comes down to one very simple thing, the practice of many modern businesses of relying on the availability of large amounts of easy credit for their day to day operations.

Fannie Mae, Freddie Mac and banks and other institutions dealing in mortgages essentially sucked up all the credit. As real estate prices went down, the assets supporting their over-leveraged loans went down in value and all of a sudden the credit they were using exceeded the credit which should have naturally been available in the marketplace and as a result credit for everyone else started to disappear.

For Mr. Joe Citizen this means it’s currently quite hard to get a loan from certain sources, though you might be surprised to find that your local credit union or small bank which has always lived within its means has no real problem giving a credit-worthy customer a loan at a very low rate. For Mr. Fred Corporate Fat Cat it means that all the short-term credit tricks he used to pull to meet payrolls while lining his pocket and expanding his operation all at the same time are no longer available. All of a sudden he finds he has to use his actual revenues to pay his bills, including payments on past loans.

So while Mr. Joe Citizen just decides he doesn’t need a cash-out refinance to convert the outhouse to a sauna, Mr. Fred Fat Cat goes a little crazy and runs screaming to the government for some sort of assistance because he’s forgotten how to run a business that operated on a simple cash profit basis.

But wait. Might a lot of this just be irrational panic?

70% of the businesses in the US are small businesses which do operate on a standard cash profit model. They make stuff or buy stuff and then sell it at a markup and use the profits to cover expenses and make or buy more stuff, and so on. They don’t actually need extensive credit beyond maybe the mortgage on their property. The same is true of many quite large corporations who operate on a simple business model despite their size. So in fact the panicked companies are quite small in number and although they may be quite large in size and financial footprint, they still make up only a small fraction of the total economy.

As for the tumbling house of cards of bad loans, the truth is that most of the assets those loans are based on have not become worthless. Less than 5% of loans are or have been foreclosed on. Even in hard-hit California real estate prices have only dropped 40% while real estate sales are up 56% which helps to offset losses. In the similarly troubled Miami area prices are down 27% but sales are up 22%. This suggests that real estate in these markets was severely over valued. In other parts of the country prices have dropped far less and sales are also up. Nationwide home values are down only 9.5% since last year. Not counting low-end and subprime loans, selling prices are down only 5.3%. 35 out of 50 states had a decline of less than 5% or even an increase in home values. Nationwide sales are down only 2.2% over last year. That’s hardly a market crash. Taking the problems in the low-end market into account it likely means that sales and prices of most homes have remained stable. The real problem seems to be geographically isolated. In most parts of the country prices are down only slightly and sales are also down slightly. In areas where homes were overvalued like California and Florida prices are down much more, but sales are booming.

The not entirely dismal picture of the real estate market suggests that Fannie Mae and Freddie Mac, which only sit on about half the nation’s loans, are mostly in possession of loans based on good assets which could be sold at a reasonable price, while only a small fraction of their inventory is severely reduced in value or likely to have to be foreclosed on. Being highly leveraged makes any decline in asset value or revenue seem much more dramatic, but shouldn’t any business be able to survive a temporary 10% decline in income?

What is very clear is that if taking such a relatively small hit is going to destroy these mortgage giants, they certainly don’t deserve a bailout. As businesses they deserve to go under and have someone else take on their assets. The problem is that with them controlling 50% of the mortgage market there’s no one but the federal government big enough to take on their debt load, and there’s a fear that if they go down they will drag everyone else down with them, meaning the whole worldwide banking and investment system which owns at least some stake in them.

So they do need some sort of help, but the question is whether a wholesale bailout at $700 billion plus a few hundred more billion for other associated screw-ups in the mortgage industry, is really necessary or if some smaller scale solution might be possible which doesn’t leave the taxpayer holding the bag.

Some market watchers think that such a bailout might be the deal of the century for taxpayers, buying all of these assets at a fraction of their potential value and then when the real estate market improves the government turns a tidy profit. The key to this is that unlike normal businesses the government can afford to hang on to unprofitable assets until they turn profitable a few years down the road. What that suggests is that what these overextended companies basically need is more time, not more money.

One solution that would be cheaper than a bailout would be a long-term conservatorship, where the government basically runs Fannie Mae and Freddie Mac exactly as they are now until such a time as they become profitable again, using mortgage payments and other income to gradually reduce their debt to asset ratio until they look like something someone would actually want to invest in again. The average mortgage ends up paying out almost 3 times the asset value of the property, so holding onto those properties and taking payments will return the company to financial solvency much more efficiently over the long term than selling off assets will. This idea of a ‘freeze’ on Fannie Mae and Freddie Mac is advocated by former Federal Reserve economist Arnold King at the Cato Institute.

Professor Luigi Zuniges suggests a hybrid restructuring plan similar to a Chapter 11 bankruptcy where some debts would be forgiven in exchange for some assets, essentially having the government take over the worst of the debt and then restructuring Fannie Mae and Freddie Mac with more oversight and only their better assets. This would still cost a couple of hundred billion dollars, and any return on the assets would be much slower in coming to the government, but it would put the failing institutions back on their feet very quickly.

Ironically, ultraleftist economist Paul Krugman offers what I consider one of the most conservative responses to this situation. He points out quite correctly that normally when problems like this happen at a smaller scale the answer is for other private institutions to step in and take over and refinance or buy out the failing institution. The problem here is that no one is stepping forward because of the lack of liquidity in the current environment. So his answer appears to be for the federal government to work with private institutions by backing them with financing so that they have the resources to carry out a private takeover with government oversight and backing. This makes a lot of sense because the assets are genuinely valuable if the risk in taking them over were reduced in the short term to make the investment attractive to private companies.

Newt Gingrich proposes a reform-only solution which is appealing. It would include major changes in taxes and regulation which would revitalize the economy to pull us out of the crisis without massive government spending. This would likely include a repeal of the business-strangling Sarbanes-Oxley Act, complete elimination of the capital gains tax which our major economic competitors have already done, elimination of the ‘market-to-market rule’ and a comprehensive energy independence plan to remove that equally huge economic burden and develop the domestic energy economy. I’d add to this plan a reduction of the corporate tax to 15% or less to bring back businesses which have fled because of our hostile tax environment.

The existence of these other possible approaches and many other proposals out there, makes it clear that a bailout is not the only answer to this problem. Some of these alternatives offer much more positive ideas for long term economic health and all of them cost much less than a full-scale bailout. McCain and the Republicans did manage to stop the original bailout plan this week, but now we face a revised version which may be only marginally better. We’ll know details soon.

Whatever happens, those who ran Fannie Mae and Freddie Mac into the ground as a private piggybank ought to be held accountable. The plan must not include gratuitous earmarks such as the ridiculous plan to use it to funnel money to the voting fraud machine at ACORN, and it must include some sort of reasonable oversight provisions. The less it costs the taxpayers the better, and the more it involves private rather than public solutions the better. This should be looked on as an opportunity for meaningful reform, and if that takes a bit longer than just throwing money at the problem, then it’s worth the wait.

Digg!

About Dave 536 Articles
Dave Nalle has worked as a magazine editor, a freelance writer, a capitol hill staffer, a game designer and taught college history for many years. He now designs fonts for a living and lives with his family in a small town just outside Austin where he is ex-president of the local Lions Club. He is on the board of the Republican Liberty Caucus and Politics Editor of Blogcritics Magazine. You can find his writings about fonts, art and graphic design at The Scriptorium. He also runs a conspiracy debunking site at IdiotWars.com.

7 Comments

  1. You laid it out more clearly than anyone else I could find, so thanks for providing a good resource.

    Dave

  2. I don’t buy it.
    Granted, if these were all private investment decisions, there might be a profitable (though risky) outcome. The argument here depends on the proposition that government bureaucrats can run these operations better than a profit-motivated businessman.
    Given the persistence of the underlying market defects and distortions, I don’t think anyone could possibly make a profit. If the actual base problem had been eliminated, then there would have been no need for government intervention at all.
    The idea that government can and should compete in any market is not just perverse, it’s nonsense. By it’s nature, the bureaucratic incentives are strictly to comply with a host of vague laws and fickle legislators … whose agenda is to get elected, not earn a profit.
    Anyone willing to work in that environment is – almost by definition – incompetent.
    Their only hope – a provision of the bill – is to nationalize all of their competitors, so no one can recognize their future blunders.
    In any case, I will lay odds that nobody outside the executive branch will have any idea what the TARP clan is doing. “For the good of the country”, all of it’s operations will be kept secret for decades [to avoid those nasty “speculators” who might make a profit]. It will be “off budget” and nobody at Treasury will answer any Congressional questions related to operations. The bill allows the Secretary of the Treasury to do whatever he wants and report whatever he pleases.
    That is what nationalization of the economy requires.

  3. Banned SNL Bailout Skit: More Truth than Fiction
    A legion of Democrat lawyers has almost totally quashed a take-off on the real bailout causes, offered by Saturday Night Live.
    The only remaining on-line copy that I could find was at:
    http://msunderestimated.com/

    It probably won’t last long, though Michelle Malkin’s transcript might avoid the wrath of Soros for a few days:
    http://michellemalkin.com/2008/10/07/the-forbidden-skit-full-transcript-and-screenshots-of-snls-sorossandler-bailout-satire/

    Enjoy.

  4. I’ve got nothing. I’m still trying to deal with the fact that after the public so clearly rejected the original bailout proposal they then went and passed the same damned thing with $140 billion of pork added onto it. It’s completley insane.

    We’ll see as far as the assets regaining some value. A number of economists seem to think that the majority of the loans are based on sound collateral. And they will be privatizing the loans when they sell them off to private bidders, so the government isn’t going to stay in the mortgage business indefinitely, or so we hope.

    Dave

  5. It’s completely insane.
    In the current political environment, there is only one prime motive: fear.
    Legislators were a) afraid of losing the campaign support of Bush, McCain, “leaders”, the RNC, RNCSCC and the RNCCC and b) afraid that they would be alleged to have “caused” a huge market collapse, and c) afraid that some voters would realize that they – or their predecessors – caused the whole problem in the first place.

    … they will be privatizing the loans when they sell them off to private bidders …
    Read the bill. There is no obligation whatever to sell the assets to private bidders. In many cases, they will probably be buying derivatives which have no asset backing at all … they are claims on cash flow.

    … so the government isn’t going to stay in the mortgage business indefinitely, or so we hope.
    Purely a vaporous hope. There is nothing in the legislation that requires the Treasury to ever abandon the powers it has been granted. As long as there is $1.00 to be spent or collected, the government retains the power to “deputize” any financial institution.

  6. I don’t see fear as the motive for adding all that pork to this bill. I see that as mainly a function of arrogance and greed. And if they are stil operating then certain people aren’t scared enough yet.

    Even if the treasury has no obligation to sell the assets off, they do seem to be planning to do so. We’ll see how that develops.

    dave

Leave a Reply

Your email address will not be published.


*