Treasury to Buy Equity in U.S. Banks

Well, it looks like what I was worried about is going to happen. The Treasury Department will be buying equity in 9 of the U.S. largest banks. What I find particularly dishonest was this line,

Therefore, the Treasury had little choice but to “jawbone them into taking the money in a coordinated fashion all at the same time.”

“These are healthy institutions, and they have taken this step for the good of the U.S. economy,” Paulson said of the financial firms.

When you have the coercive power of the the United States government backing you up, telling the public you “jawboned” them vs. “strong armed” them is contemptible.

Further, the idea here is to prevent people from learning which banks are in the most trouble and also to preserve such troubled banks–i.e. corporate welfare.

And again, this doesn’t address the problem of having politicians meddling in the home loan market. Traditionally home loans were made to people who had 20% of the selling price as a down payment, had a good credit record, and had an income that could justify the future mortgage payments. However, the result of this is that lots of people, who vote by the way, couldn’t get loans for a house of their own. So the politicians threw them a nice bone, in return for voting for the politicians in the future, of requiring lending institutions to make loans to people who didn’t have the 20%/good credit/high enough income to make the payments. Now some effort was made to make sure that people had at least the last two of the three, but it still increases the risk to the lender.

Then government sponsored entities (GSEs), Fannie Mae and Freddie Mac, got involved with securitizing mortgages. This effectively hid the risk in mortgages, it did not reduce it. To reduce it you’d have to go back to the traditional way of doing home loans and possibly even increasing borrowing requirements (higher credit score, higher income, larger down payment, etc.). So then comes along the Federal Reserve that was worried about deflation during the last recession and they dropped interest rates to a very, very low level which sets in motion both a boom in housing and a boom in home buying. Throw in the exotic mortgages that were developed to side step to an even greater extent credity and income requirements you had a the makings of a speculative bubble. Buy a second house, maybe do a few repairs/improvments then sell it 6 months later for a tiddy profit. Rinse and repeat and lots of money.

The government’s dirty handprints are all over this current crisis. Are they the sole cause of it? No. But looking back over the last serious economic crisis in U.S. (and world) history and you see similar patterns. During the 1920’s there was lots of irresponsible behavior on the part of people, but at the start of the recession the government did some really dumb things that turned a recession into a depression. Namely staying on the gold standard. This had the effect of deflating the currency massively. And what happens if you are a firm and are facing constantly declining prices? Suppose you buy $1,000 worth of inputs and produce 500 units of output. What is the price you have to charge to break even? $2. But if the price is declining when you buy the $1,000 worth of inputs you might find yourself facing a price of $1.5 meaning you have to take a loss. So economic activity slows down leading to unemployment. At the same time the gold standard meant the government had to do what it could to balance the budget so taxes were raised (in 1932). This made matters even worse. Then Smoot-Hawley comes along and doesn’t help either.

Now we aren’t making the same mistakes we did in the 1930s, but we very well might be making additional mistakes by letting the government have even more control over the economy. The government is run by politicians, who by their nature are craven and greedy (for power), and we expect this to be some sort of magic bullet? I can’t help but think it is a mistake. And in looking at the stock market right now we see it heading right back down to 8,500. Coincidence? Maybe, but I’m not at all comforted by the idea of the people who can’t even keep track of the Defesnse Deparment Budget or prevent massive amounts of Medicare fraud getting involved even deeper into another segement of our economy.

FILED UNDER: Economics and Business, Government, US Politics, , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Steve:

    The issue is this… if you are going to have a doctrine that some firms are “too big to fail” then there needs to be government involvement…. because the doctrine itself is government involvement, and it encourages risky behavior by counter-parties.

    At this point, if you are rescuing firms and banks, then it is only fair to have the government get equity — it is the best way to ensure that tax payers have a change to get their money back.

    The alternative approach is to (a) scrap the TBTF doctrine, (b) reduce regulation, (c) allow banks and firms to fail.

    But the alternative approach isn’t a panacea. Finance did not begin in the 1930. Look at the panics/collapses of 1837, 1857, 1873, 1893, and 1907. None of the government’s dirty hands on those, and yet market collapses ensued, banking runs occurred, and the “real economy” suffered severe consequences.

    I really wish people would stop assuming that there is no relevant economic history here other than 1929 and 2008.

  2. DC Loser says:

    I guess we’re all Socialists now. What’s all this fuss about the Dems being socialists?

  3. PD Shaw says:

    If we’re all socialists now, it has more to do with social security and other entitlements than it does buying bank shares. After all, the U.S. ran national banks before Marx penned his Manifesto.

    And Bernard, I would say the government had a hand in the Panic of 1837. First, Jackson killed the national bank and encouraged land speculation as the result of his Indian removal policies. Then to curb land speculation Jackson issued his Specie Circular which undermined confidence in the remaining banks.

    I take from that history that attacking banks as corrupt and spendthrift in the middle of a financial crisis doesn’t do squat for the economy.

  4. PD… well, right, but the government can never be completely hands off, so there will always be some influence. 1837 is a fascinating case for all sorts of reasons, though ultimately the specifics are pretty far removed from current financial conditions.

    But my point is the bigger one… limiting government intervention is all well and good, but it requires a corollary principle of letting the chips fall where they may… and that can be very, very painful.

    What I object to is the hidden argument in much of the conservative bailout critiques — which is that absent government intervention, the market would effectively self-regulate and somehow avoid cycles of boom and bust. I think the historical evidence is clear that is not the case.

    So you can live with booms and busts or you can try to smooth things out. But there is no panacea here unfortunately.

  5. steve says:

    If you insist on reading the daily market ups and downs as vindication or condemnation of particular policies you will be disappointed. Stick to chicken entrails. It seems much more likely to me that the market is realizing the extent of this coming recession. Would that economics was a more precise science.

    Steve

  6. Steve Verdon says:

    But my point is the bigger one… limiting government intervention is all well and good, but it requires a corollary principle of letting the chips fall where they may… and that can be very, very painful.

    And the Great Depression wasn’t painful? 1938 wasn’t painful? This time around isn’t going to be painful? Sorry, but this is just lame, “It could hurt without Uncle Sugar propping us up….” When the reality is Uncle Sugar helped get us into some of the worst economic crises in history.

    If you insist on reading the daily market ups and downs as vindication or condemnation of particular policies you will be disappointed.

    Boy somebody flunked reading comprehension. I didn’t insist on anything. My point is that the market appears extremely pessimistic despite the grand and glorious rescue plans. Could it be a vanilla recession? Maybe, but the current loss to the DJIA seems overly large for just that. I’m thinking the market is thinking the bailout wont work and might make matters worse. Maybe I’m wrong though.

  7. President Obama is going to have to deal with some terrible inflation, and perhaps stagflation, as a result of these “fixes.”

    Goodness gracious, does this mean New Deal II is on the way?

  8. od says:

    If you’re going to give $700 billion you’re involved, period. It makes more sense to at least get something for it (ie shares) than to just basically give it away. When the market is solid again the gov’t can sell the shares (at a profit for the taxpayer).

    The other, and better, option was simply to let the market play itself out without putting any tax money into it. But if the gov’t is going to get involved, it should do so with an eye to making a long term profit for taxpayers – otherwise its just welfare for bankers.

  9. tom p says:

    The government is run by politicians, who by their nature are craven and greedy (for power),

    Ok Steve, and banker’s aren’t?

    In your last post on this subject you seemed to lay the blame squarely on the CRA (banker’s never would have made these loans if Gov’t had not made them do stupid things) except that everything else I read lays it on Credit Default Swaps (which were unregulated) and hid the inherent risks. Your view?

    My contention is that the real problem is that these bankers, thru their lobbyists, had these regulations written for their own (short term) benefit. Your view?

    To put it a little more succinctly, the real problem is the interface between private enterprise and gov’t regulation, and how do we make that work?

    And I am sorry, but I do not think “getting the gov’t out of it” is a viable answer…. Remember the “Golden Rule”, “The man with the gold, makes the rules.” which leaves you and I out of it, because “craven and greedy” are not qualities limited to politicians.

  10. PD Shaw says:

    Bernard, I think I agree.

    Any crisis can be blamed, in part or in full, on the government, either by act or omission. But I’m not sure I follow the libertarian corollary at all, that because the government screws up (and ahem the private sector will screw up from time to time), the government cannot be part of the solution.

    It’s certainly true that if the government eliminated the home mortgage interest deduction tomorrow, it would make the problem worse by further devaluing home prices. Certainly there are government policies that can make the situation better. That we are not certain what those policies should be should make us cautious, but not gun shy.

  11. Steve Verdon says:

    Ok Steve, and banker’s aren’t?

    No Tom, they aren’t, but then again they aren’t setting national policy are they? They are setting policy for their bank. Bit of difference don’t you think?

    In your last post on this subject you seemed to lay the blame squarely on the CRA….

    You need to brush up on reading comprehension. The politicization of the home loan market is one of the things what got this thing going. Was it the sole cause? No, but to pretend otherwise and look for a sole cause is fools errand.

    My contention is that the real problem is that these bankers, thru their lobbyists, had these regulations written for their own (short term) benefit. Your view?

    My view is that discretionary government policy is able to be manipulated and that is rarely a good thing. It is failure of government no matter what happens since it results in profits for some and losses for others that really aren’t earned, rent seeking.

    To put it a little more succinctly, the real problem is the interface between private enterprise and gov’t regulation, and how do we make that work?

    You don’t, at least with discretionary policy. That was what won Kydland and Prescott their Nobel in economics a few years ago. Rules rather than discretion. But then policians don’t like that since they can’t do favors for their friends.

    And I am sorry, but I do not think “getting the gov’t out of it” is a viable answer…. Remember the “Golden Rule”, “The man with the gold, makes the rules.” which leaves you and I out of it, because “craven and greedy” are not qualities limited to politicians.

    A bit overly simplistic since no single person has all the gold, and I’m not sure I that the “golden rule” is worse than the “gun rule”. You know, the one where the man with the most guns makes the rules, and that would be the U.S. government.