Friday, October 3, 2008

Why a Credit Market Bailout (Now a "Rescue") is Needed

Many Americans are furious at the prospect of spending nearly a trillion taxpayer dollars to help bailout the mistakes and greed of Wall Street firms and other financial institutions.  Their ire is justified, and I count myself as someone who is furious at the excess and greed that has taken place, but I also understand the necessity of assisting the credit markets. 

Years of minimal accountability allowed those on Wall Street to profit from risky investments, while a lack of regulation and clever financial schemes hid the true folly of this system.  Now this arrogance and greed has led to a meltdown that has consumed many Wall Street firms, some of which had existed for over a century.  A person’s first instinct is likely to be to let them suffer for the mess they created (read this article for a look at how this situation exposes a natural desire for retribution in humans) to teach them, and those in charge of such institutions in the future, a lesson. 

But this desire for retribution will likely not serve the average American very well if it blocks a bailout package (now its a "rescue" package).  There will be time for tackling the excess and greed on Wall Street and the financial industry, but at the moment their screw-ups have placed our entire economy in jeopardy.  Americans have only started to realize this in the wake of the failed first attempt to pass a bailout in the House of Representatives. 

While the securities backed by mortgages (sub-prime or not) seem like bad debt, most of them are not; it is just that the market cannot value them right now.  No investor wants to touch them and these financial institutions cannot unload them, and so they appear as giant anchors on balance sheets because under accounting rules, some sort of present value has to be assigned to them.  The problem is that when no one wants to touch them, their value has no where to go but down.  These institutions now either have trouble both giving loans and getting them, and this difficulty has spread into the rest of the credit market around the globe as everyone starts to tighten their lending practices and none of the mortgage backed securities can be offloaded quickly.   Additionally, companies need to get rid of the securities soon because their inability to get loans and the unwillingness of others to give them in the immediate future is at the core of this crisis. 

To be sure, this is completely unfair. The reckless Wall Street firms screws up, and yet they benefit because no American can afford to let them fail (this is moral hazard everyone keeps talking about).  Also, those with a mortgage who could otherwise afford to pay it and now can't because of a decline in the market, increased interest rates, or inability to get a loan/credit (due primarily because of the bad lending practices) do not have much to gain from this bailout. 

There is some tax relief for homeowners, but this is paltry.  However, relief for those with a mortgage is a dicey political issue that would likely not get passed by the current Congress.  It does look increasingly likely that Democrats will gain even greater control of Congress as well as the White House, and helping homeowners directly is a top priority on their agenda (Republicans too wish to help homeowners, but they continue to insist on more indirect market oriented methods of helping them so I am making an assumption that more immediate and direct assistance would be more forthcoming under a Democratic Congress and President). 

This deal seems to get worse and worse for average taxpayers, Wall Street gets a bailout, and if there is any help for the homeowners (some of which the lender should not have even lent to in the first place), it will not be until at least next year.  But the biggest concern that should be on every American’s mind is the failure of the credit market.  Why is the credit market so important? 

The credit market allows individuals to get loans for homes, education, cars, consumer goods and everything else they need to get by on a day-to-day basis.  Stories are starting to trickle in of people being denied a loan (credit), but whether this will continue is unknown; it does, however seem to indicate a probable consequence of a collapsing credit market.  But consumers are not the only ones who need credit. Businesses need credit to expand, buy inventory, or even just pay their employees.  Without credit, business will start to contract.  Local governments are also having trouble getting credit, which they need to keep state services going and pay employees.  It also makes it more difficult to finance the sale of state bonds, further contracting state coffers. 

The conundrum of an diversified and integrated financial system that touches every aspect of our economy (and the global economy as well) is that we are completely dependent on it continuing to maintain our own personal economic well being.  The Free Market does allow greater growth and efficiency, but not always and it will inevitably fail at some point without proper regulation.  The current failure is extraordinary, and because the financial system is integrated into all the other aspects of our economy (and Americans are extremely dependent on credit), it is bringing down the whole house of cards.

A bailout may not stave off a recession, which is another downside to this deal, but it may be necessary to avert an even greater economic disaster.  This deal is unfair for sure, and it is ironic that there is more political outrage and pushback over such a bailout when compared to issues such as going to war, but it is currently the only game in town for immediate aide (I wouldn't call it a fix, its more like putting a Band-Aid on a wound—hopefully the Band-Aid is big enough).  In the best-case scenario, the government can sit on the assets (which still have value, and once the market recovers will gain value again) and eventually make money on the bailout.  The worst-case scenario is that the bailout is not enough, or is too late to stop an economic disaster, and it won't matter if Congress forces Wall Street to pay for the losses the taxpayer absorbed because of their incompetence.  The choice is a chance at stopping a disaster or just letting it happen, hopefully Americans will recognize the need to do something, the government will make money, and Wall Street will be regulated enough to prevent the need for future bailouts.

No comments: