[Peace-discuss] A clear explanation from a Nobel prize winner

[C. G. Estabrook]

	Better Bailout
	By Joseph E. Stiglitz
	26 September 2008
	The Nation

The champagne bottle corks were popping as Treasury Secretary Henry
Paulson announced his trillion-dollar bailout for the banks, buying up
their toxic mortgages. To a skeptic, Paulson's proposal looks like
another of those shell games that Wall Street has honed to a fine
art. Wall Street has always made money by slicing, dicing, and
recombining risk. This "cure" is another one of these rearrangements:
somehow, by stripping out the bad assets from the banks and paying
fair market value for them, the value of the banks will soar.

There is, however, an alternative explanation for Wall Street's
celebration: the banks realized that they were about to get a free
ride at taxpayers' expense. No private firm was willing to buy these
toxic mortgages at what the seller thought was a reasonable price;
they finally had found a sucker who would take them off their
hands--called the American taxpayer.

The administration attempts to assure us that they will protect the
American people by insisting on buying the mortgages at the lowest
price at auction. Evidently, Paulson didn't learn the lessons of
information asymmetry which played such a large role in getting us
into this mess. The banks will pass on their lousiest
mortgages. Paulson may try to assure us that we will hire the best and
brightest of Wall Street to make sure that this doesn't happen. (Wall
Street firms are already licking their lips at the prospect of a new
source of revenues: fees from the US Treasury.) But even Wall Street's
best and brightest do not exactly have a credible record in asset
valuation; if they had done better, we wouldn't be where we are. And
that assumes that they are really working for the American people, not
their long-term employers in financial markets. Even if they do use
some fancy mathematical model to value different mortgages, those in
Wall Street have long made money by gaming against these models. We
will then wind up not with the absolutely lousiest mortgages, but with
those in which Treasury's models most underpriced risk. Either way, we
the taxpayers lose, and Wall Street gains.

And for what? In the S&L bailout, taxpayers were already on the hook,
with their deposit guarantee. Part of the question then was how to
minimize taxpayers' exposure. But not so this time. The objective of
the bailout should not be to protect the banks' shareholders, or even
their creditors, who facilitated this bad lending. The objective
should be to maintain the flow of credit, especially to mortgages. But
wasn't that what the Fannie Mae/Freddie Mac bailout was suppose to
assure us?

There are four fundamental problems with our financial system, and the
Paulson proposal addresses only one. The first is that the financial
institutions have all these toxic products--which they created--and
since no one trusts anyone about their value, no one is willing to
lend to anyone else. The Paulson approach solves this by passing the
risk to us, the taxpayer--and for no return. The second problem is
that there is a big and increasing hole in bank balance sheets--banks
lent money to people beyond their ability to repay--and no financial
alchemy will fix that. If, as Paulson claims, banks get paid fairly
for their lousy mortgages and the complex products in which they are
embedded, the hole in their balance sheet will remain. What is needed
is a transparent equity injection, not the non-transparent ruse that
the administration is proposing.

The third problem is that our economy has been supercharged by a
housing bubble which has now burst. The best experts believe that
prices still have a way to fall before the return to normal, and that
means there will be more foreclosures. No amount of talking up the
market is going to change that. The hidden agenda here may be taking
large amounts of real estate off the market--and letting it
deteriorate at taxpayers' expense.

The fourth problem is a lack of trust, a credibility gap. Regrettably,
the way the entire financial crisis has been handled has only made
that gap larger.

Paulson and others in Wall Street are claiming that the bailout is
necessary and that we are in deep trouble. Not long ago, they were
telling us that we had turned a corner. The administration even turned
down an effective stimulus package last February--one that would have
included increased unemployment benefits and aid to states and
localities--and they still say we don't need another stimulus. To be
frank, the administration has a credibility and trust gap as big as
that of Wall Street. If the crisis was as severe as they claim, why
didn't they propose a more credible plan? With lack of oversight and
transparency the cause of the current problem, how could they make a
proposal so short in both? If a quick consensus is required, why not
include provisions to stop the source of bleeding, the millions of
Americans that are losing their homes? Why not spend as much on them
as on Wall Street? Do they still believe in trickle down economics,
when for the past eight years money has been trickling up to the
wizards of Wall Street? Why not enact bankruptcy reform, to help
Americans write down the value of the mortgage on their overvalued
home? No one benefits from these costly foreclosures.

The administration is once again holding a gun at our head, saying,
"My way or the highway." We have been bamboozled before by this
tactic. We should not let it happen to us again. There are
alternatives. Warren Buffet showed the way, in providing equity to
Goldman Sachs. The Scandinavian countries showed the way, almost two
decades ago. By issuing preferred shares with warrants (options), one
reduces the public's downside risk and insures that they participate
in some of the upside potential. This approach is not only proven, it
provides both incentives and wherewithal to resume lending. It
furthermore avoids the hopeless task of trying to value millions of
complex mortgages and even more complex products in which they are
embedded, and it deals with the "lemons" problem--the government
getting stuck with the worst or most overpriced assets.

Finally, we need to impose a special financial sector tax to pay for
the bailouts conducted so far. We also need to create a reserve fund
so that poor taxpayers won't have to be called upon again to finance
Wall Street's foolishness.

If we design the right bailout, it won't lead to an increase in our
long term debt--we might even make a profit. But if we implement the
wrong strategy, there is a serious risk that our national
debt--already overburdened from a failed war and eight years of fiscal
profligacy--will soar, and future living standards will be
compromised. The president seemed to think that his new shell game
will arrest the decline in house prices, and we won't be faced holding
a lot of bad mortgages. I hope he's right, but I wouldn't count on it:
it's not what most housing experts say. The president's economic
credentials are hardly stellar. Our national debt has already climbed
from $5.7 trillion to over $9 trillion in eight years, and the
deficits for 2008 and 2009--not including the bailouts--are expected
to reach new heights. There is no such thing as a free war--and no
such thing as a free bailout. The bill will be paid, in one way or
another.

Perhaps by the time this article is published, the administration and
Congress will have reached an agreement. No politician wants to be
accused of being responsible for the next Great Depression by blocking
key legislation. By all accounts, the compromise will be far better
than the bill originally proposed by Paulson but still far short of
what I have outlined should be done. No one expects them to address
the underlying causes of the problem: the spirit of excessive
deregulation that the Bush Administration so promoted. Almost surely,
there will be plenty of work to be done by the next president and the
next Congress. It would be better if we got it right the first time,
but that is expecting too much of this president and his
administration.

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