Bridge Loan to Nowhere

By Thomas Ferguson & Robert Johnson

September 22, 2008


In the movie Men in Black, Will Smith and Tommy Lee Jones team up to save the world by resolute preventive action. By contrast, America's real-life Men in Black--Treasury Secretary Hank Paulson, Federal Reserve Chair Ben Bernanke and New York Fed President Timothy Geithner--haven't done as well lately. Ever since that classical day of reckoning, the Ides of March 2008, when the terrifying specter of chain bankruptcy and currency collapse first loomed over lower Manhattan like an attacking spaceship because of Bear Stearns, it's been downhill.

A little over a week ago, the Men in Black made a fatal mistake. They allowed the aliens to vaporize the proud old firm of Lehman Brothers. Whole fleets of spaceships then immediately began attacking AIG, Wachovia, Washington Mutual, even Morgan Stanley and Goldman, Sachs. Now desperate, the Men in Black switched back to their old tactics and rescued AIG, but the damage had been done. The aliens had learned from Lehman and AIG how vulnerable Wall Street really was. Soon inter-bank markets everywhere in the world locked up. With financiers preferring treasuries that paid essentially nothing to every other asset in the world, huge runs started on money market funds.

In response, the Men in Black have now gone to Congress. They have put a check for $700 billion and a loaded gun on the table. Sign the check, they insist, and give us unreviewable power to buy bad assets, or take responsibility for the collapse of the whole financial system and, likely, the world economy.

In America's money-driven political system, leaders of both parties love to pretend that the sound of money talking is the voice of the people. Both presidential candidates and Democratic Congressional leaders are mostly nodding, with the Democrats adding trademarked noises about balancing off gifts to Wall Street with mortgage relief, another small economic stimulus program and perhaps some curbs on executive pay. Meantime, save for a handful of splendid exceptions, notably Gretchen Morgenson of the New York Times, American newspapers just keep giving their readers more reasons to keep deserting them.

Actually, there are one or two things to like in the Men in Black's latest scheme for the Mother of All Bailouts. The economic case for single-payer insurance has always been overwhelming. With all the new precedents--Bear Stearns, Fannie, Freddie, AIG, and one, two, three, many more coming-- who would now dare deny the American people a chance for similar efficiencies in health insurance?

We also confess to having a soft spot for the New Deal--that remarkable moment that gives the lie to all of today's fashionable sneers about the impossibility of effective financial regulation. We just wish that the Men in Black would draw inspiration from something besides the anachronistic language of the Gold Reserve Act of 1934, which tried to make Treasury's decisions about the Exchange Stabilization Fund unreviewable by anyone else. (See the new plan's incredible Section 8, something you would think only Dick Cheney could love.)

And who can deny it? All the "Comrade Paulson" jokes should at least be good for a decent respite from Market Fundamentalism--the notion that unregulated markets automatically give you full employment and economic stability. Right now every individual financial institution is deleveraging--that is, reducing its use of borrowed money--at a terrifying pace. Financial houses are trying to recapitalize themselves by gouging depositors, borrowers, investors and credit card holders. As a group, they cannot succeed. They are collectively digging themselves into a black hole in which the gain of one is the loss of another, unless somebody from outside puts in new money.

Paulson does not exaggerate when he implies that just soldiering on and letting markets work will trigger a depression and collapse of the currency. But if it's high time for some Big Government, the Men in Black's plan is not the way to go, unless you work on Wall Street. And even if you do, there are compelling reasons to fear it.

The plan's belated focus on a systemic solution designed to reopen money and financial markets to normal transactions is exactly right. Currently there is simply too much junk out there for anyone in money markets to be sure of getting repaid if they loan to anyone else, even overnight. Everyone knows that other institutions are full of bad assets that are hugely depressed; but each sees for sure only their own desperate condition. So nobody trusts anybody.

But there is more than one way to restore trust and restart markets. Alas, not only is the plan the Men in Black are pushing the most expensive and likely to soak average Americans the most, but it is also the most likely to fail.

What Might Work

You could simply take a leaf from the New Deal and do a bank holiday. That is, send bank examiners into all the institutions-- investment houses, and insurance companies and the other major players, as well as banks--to assess them. Insolvent ones are simply closed; everyone knows then that those that survive are solvent. Economic life restarts. The total cost is minimal. In the nineties, under Greenspan, the Fed ran away from its duty to oversee primary dealers in government securities. Voting it sufficient authority to do the job not just on Wall Street and the banks, but in any part of the system not covered by effective regulators would be far less expensive than the Men in Black's scheme.

Guess why Wall Street hates this one and why Bernanke (whose work on the New Deal is indeed distinguished, though many of his hypotheses have since been refuted ) and Paulson do not even consider it. In all likelihood much of the Street is insolvent, which is why short-sellers were going wild until the SEC banned restricted them.

The government could inject capital directly into financial institutions with a reasonable prospect of survival in the long run. This was the essence of Senator Schumer's proposal that surfaced just ahead of Paulson's announcement and that triggered the rally in world financial markets. The New Deal did this, too. It used the Reconstruction Finance Corporation, which put severe terms on the banks receiving the aid. Wall Street, of course, would love the money, but not the terms. Somebody to inspect and certify the solvency of financial houses is also a requisite for this option, which, as already noted, is anathema to the Street.

The Men in Black's choice: just have the government buy the junk, giving Wall Street real money--our money--in exchange for it. Notice three points about this one: First, the lucky firms continue merrily in business. Thus far Paulson and Bernanke's plan does not even pay lip service to reforms. It is also well to remember that as the crisis hit, Paulson was at work on a preposterous scheme calling for more deregulation on grounds that New York faced competition from foreign financial markets. It is obvious where the former Goldman Sachs CEO's heart lies.

Second, there is a truly alarming likelihood that $700 billion will probably not be enough. Estimates of the total amount of junk out there vary, but the key point to hold fast to is that Bernanke, Paulson, and most financial experts have consistently underestimated the problem. Nor is there any reason to believe their forecasting is improving. Less than a fortnight ago, as Lehman was let go, the Fed was boasting that it now had a much better grip on markets than it did when Bear Stearns went down. It seems clear that even under this option, the bank inspectors had better be unleashed before much money goes out the door. Otherwise, we may well end in the worst of all possible worlds: the $700 billion is gone, but trust in the money markets remains elusive.

Third, the draft plan is silent on the prices at which assets are to be bought and, presumably later, resold. The problem of possible sweetheart deals is real and has to be addressed. Already there are reports on the web that the Treasury believes such methods are really rough-and-ready ways to get aid to firms that need it. There is also little doubt that politics colored some assets sales by the Resolution Trust Corporation, set up during George H.W. Bush's administration to dispose of debris from the S&L crisis.

Under both options 2 and 3 above, it is vital that Congress insist on reasonable terms for the public. Just as with Bear Stearns, the mere announcement of the bailout sent financial markets around the world soaring. There is absolutely no reason why some of the gains accruing both to private investors in the companies directly being bailed out and the broader market cannot be recaptured for taxpayers whose money makes it all possible.

It is easy. You can do it, for example, by taking equity in the firms you bail out and selling later. We prefer this to warrants, which are rights to buy shares at a low price that ensure a gain when they are finally exercised. Our fear is that coalitions of firms will do what Chrysler did and organize later to pressure the government not to exercise the warrants. Because there will be many of them, they are more likely to succeed.

It also makes sense to insist that firms receiving aid issue senior debt to the government with rights over all other bonds, etc., they have outstanding. That's to make sure some money comes back right from the start and that managements cannot keep all the earnings for themselves by reducing accounting profits and paying themselves more.

To recapture some of the broader market gains flowing from the injection of public money, one could place a modest new tax on interest, dividends, capital gains. "Carried interest," the ludicrous special tax break for private equity and hedge funds that not only Republicans but Senator Schumer and other Democratic Congressional leaders continue to defend, should go as part of any political deal on a bailout. It is beyond crazy to ask American workers to subsidize firms that will soon be back trying to break up their firms and throw their rescuers out of work.

And finally, obviously, it is necessary to re-regulate. Details of some reforms might require time to work out, though we see no reason they should be any more intractable than details of a bailout, which Paulson and Bernanke want to do almost overnight. Our general view is that handing out money before nailing down reforms is too dangerous; Congress should legislate at least the basics, with a promise to fix details later. If Wall Street does not like it, it does not have to accept the money.

It helps that the main reforms necessary are obvious. Compensation practices that encourage taking big risks that blow up after bonuses are paid have to go, immediately. Limits on leverage--how much financial institutions can borrow--are another no-brainer. Probably there is also need for new rules on reserve requirements across the board and restrictions on the use of insured deposits.

Above all, trading in complex derivatives--the main cause of the current disaster--has to be completely overhauled, at once. Derivatives have to be standardized and move to public exchanges that collectively guarantee them. Failure to do this will just start the whole nonsense over again. Just imagine being told a year from now that losses on credit default swaps written by firms that were bailed out under the new plan require us to pony up still more cash.

Congressional Options

It is fine for Democrats to hold out for mortgage relief and for another stimulus package. The best way to do the first, probably, is by reviving something like the Home Owners Loan Corporation that worked so well in the New Deal. That bought mortgages from people who were in danger of losing their houses and converted them into obligations that they could afford to repay. This sort of bailout has the wonderful property of directing public money to the public, rather than Wall Street. But it would still bail out Wall Street, since reviving housing and stopping mortgage defaults feeds directly through to mortgage bonds values and derivatives based on them.

But no one should be fooled by Democratic talk about mortgage relief and economic stimulus. The main focus of the design of the bailout must be the bailout itself. That is the rat hole down which $700 billion and probably plenty more will soon start disappearing if Congressman Barney Frank, Senator Dodd and, of course, Senator Obama do not walk the walk instead of just talking the talk.

The situation is dire, but it is not hopeless. A flurry of discussions with other central banks and governments may soon produce claims that international agreements hem in legislators here. Congress has a straightforward counter to this and any manipulative threats of economic collapse: Turn the gun around. Move every bit as speedily as Paulson and Bernanke demand, but pass a bill that anyone can see protects the public far better than the Men in Black's proposal. If President Bush--remember him?--refuses to sign it, make it obvious to voters who's really crashing the system for private gain. All of the House and a third of the Senate are up for re-election. Enough votes can probably be found from among Republicans who would like to survive a Democratic landslide to pass something far better than the Men in Black's bridge loan to nowhere.

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About Thomas Ferguson
Thomas Ferguson, a contributing editor of The Nation, is professor of political science at the University of Massachusetts, Boston. He is the author of Golden Rule: The Investment Theory of Party Competition and the Logic of Money-Driven Political Systems (Chicago). His latest article, with Joachim Voth, is "Betting On Hitler: The Value of Political Connections in Nazi Germany," in the February 2008 Quarterly Journal of Economics. more...
About Robert Johnson
Robert Johnson, a former managing director at Soros Funds Management, is chief economist of the Senate Banking Committee.