Monday, September 22, 2008

Hitting the Mule

How do you get a mule to turn at the end of a row? Simple, you shout in one ear, kick it in the leg, pull on the other ear and hit it with a 2x4. Now that you've got its attention....

Now that I've had a weekend to consider the trillion dollar 2x4 I think the so called bailout may be, as the germans say, an ungeborenes kind, an unborn child.
I also think it should be.

Disrupting the credit availability of a system run amok on credit is not something to be taken lightly. But neither is the bill for the taxpayer of astronomical proportions with nothing in return.

The Fed over the past few years has micromanaged the interest rates, investment banks have borrowed with extremely high leverage and inadequate capital and the easy mark for incrementally higher returns was the mortgage market.

Investment and pension funds desperate to increase returns above the risk free treasury note bought into belief that real estate values only go one way, up. The rewards for bundling mortgages into marketable securities became so profitable, every investment bank sought to obtain more and more of this debt. Underwriting standards evaporated.Investors worldwide clamored for the mortgage debt considered safe and many cases with the implied blessing and backing of the U.S. government.

Housing prices soared above normal ratios of equity or income to debt. The end was predictable if not in the midst of the maelstrom. Income had to catch up with debt or debt with income. We are now in the midst of debt catching up with income. Debt is being destroyed at an ever accelerating pace and this bailout is seeking to transfer the debt being destroyed to the taxpayer. Not very sporting of the AIG's and Morgan Stanley's of the world.

So now we have debtors in unaffordable homes, which are still above the long term housing equilibrium price. We have investment banks with inadequate capital and non-performing assets on the books. The government solution is to murmur the recent mantra, "mistakes were made." Responsibility without consequence just doesn't cut it.

The homeowners lulled into believing that a home is a giant atm machine refilling with cash each time the value went up, and the value never falls, are not without blame. But we live in a society of relentless marketing and what investment types call "asymetrical knowledge." Knowledge is not equal. The mortgage broker lists the reasons to borrow and the homeowner shrugs and says, "sounds good, I trust you."

And how will the government price this toxic debt it is intending to buy? If it offers the bank below market rate, there is no incentive for the bank to sell it. If offered at more than market, the taxpayer eats the difference and hopes that the value will increase enough over time to dig out of the hole.

Let them fail. Let the market buy the assets at the market price and the owners of the bank absorb the loss. It is the invisible hand of creative destruction. The market cleans itself out by taking resources away from the losers, so it creatively destroys the losing companies and reallocates resources to the winning companies. How to manage the bankruptcy of an entire system is the question.

Surely a trillion dollars can be used more effectively to bridge the abyss of personal pain. If the government must be involved a more proactive fiscal approach would surely be preferable to one that rewards the profligate risk taker. We have infrastructure needs left wanting for years. Bridges, water systems, schools. Find a way to build a trillion dollar bridge connecting national need with citizen pain. If we have to give up a trillion dollars let's find a way to give it to ourselves. Privatizing profit and nationalizing losses is a perversion of capitalism.

John Barnyak