Main Street or Wall Street?

This argues that the “Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street”:

How Main Street Will Profit, by William H. Gross, Commentary, Washington Post: …Today, our seemingly guaranteed living standard is threatened…. Finance has run amok because of oversecuritization, poor regulation and the excessively exuberant spirits of investors… [P]roduction, and with it jobs and our national standard of living, is declining.

If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest — a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit. That, of course, has been the attempted remedy over the past 12 months. But recent events have made it apparent that this downturn differs from recessions past. …

And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from “troubled financial institutions” to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that.

In effect, the Treasury will have the fate of the American taxpayer in its hands. The … purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below “par” or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction — financial derivatives — that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards.

The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street… Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance — between private incentive and government oversight.

Experts of all political persuasions are saying the same thing, something has to be done (which makes it different from Iraq). They could all be wrong, that is true, but nevertheless, they are almost all on the same page.

Maybe we can absorb such a shock with our vaunted flexibility, some people want to find out and teach the financial industry a lesson, but me, I’m not taking that chance. People’s livelihoods are at stake. A massive credit meltdown is nothing to mess around with. Period. I want action that protects people from the consequences of credit drying up, and we were perilously close to that in the wake of the Lehman failure.

We need to make sure the bailout doesn’t turn into a massive giveaway to financial institutions, no doubt about that, but I am not about to risk the jobs of so many people through inaction, and I’m convinced there are scenarios where the downturn could be very, very painful for the typical household.

So this isn’t a question of if we should act, it’s a question of how we avoid a giveaway. On that front, I’m not as convinced as Gross is that the plan, as I understand it, will lead to the gains he predicts. That is part of what the current objections to the plan is about, addressing these types of concerns.

The plan doesn’t have to be completed tomorrow, there’s time to get the details right, but we can’t waste time either. Tensions are building and they explode without warning. Nobody knows for sure how how much time we have until the next problem erupts, and what kind of chain reaction might result.

Peoples’ lives are nothing to be toyed with, and if a bailout is the only way to avoid the chance of massive meltdown and widespread job loss, so be it. Protect Main Street first and foremost, but give away as little as possible to Wall Street in the process.

One more issue. Why so much money, why do we need $700 billion? One problem is that we can’t know the exact size of the problem. How do you determine the size of the problem when you are uncertain about which assets will be problematic? If we knew for sure which assets would have plunge in value, and the size of the plunge, we wouldn’t have a problem with uncertainty to begin with and there would be no problem to solve. So if we insist on a precise answer to this question, we won’t get it.

But still, why so much? After Lehman was allowed to fail, banks refused to lend to each other other, even overnight. If the bank you lend your money to gets in trouble before paying you back, and if the government is not going to step in and prevent failure, then you could lose all the money you loaned and go into default yourself. It’s not worth taking that risk, so loans don’t get made at all. That’s what led to the need for a massive bailout, the problems that occurred after Lehman failed. The lesson was that the government couldn’t let banks fail, not for awhile anyway, and they didn’t want to keep bailing banks out one by one – that wouldn’t have been politically wise or economically sound. A massive bailout to get it done all at once was the better option.

The key to solving the problem is for banks to believe that if and when the bank failure dominoes start falling, they will still get back the money they’ve loaned out. It’s no different than your decision to leave your money in your bank right now (you are making a loan to the bank in return for interest and services). So long as your deposits are protected by the FDIC, there’s no reason to worry, but if that protection is lifted, you wouldn’t feel so safe and would likely take your money out – you won’t be so willing to make the loan.

Here’s Dean Baker on the question of why so much money is needed (via email):

The issue is that banks are worried that other banks will go bankrupt, so that they won’t trust them with their money, even on an overnight loan.

If Paulson and Bernanke get up and say “don’t worry, we’re going to make sure that all the loan obligations get honored,” but are only standing there with $100 billion, then banks may still not believe them, thinking that they don’t have enough money to make good on all the potentially bad loans. This can cause them to make runs on other banks, pulling their money out and causing a crisis (as in what happened last week).

The idea of the $700 billion is that this is supposed to be a huge sum, so that when P&B get up and say “don’t worry,” people believe them.

There obviously is no way of saying how much is enough to create belief. Given the sums needed for AIG, $100b to $200b would almost certainly be too little. Maybe $300 b or $400b would be sufficient, but there is no guarantee. $700b is very impressive, so it would almost certainly do the trick.

Originally published at Economist’s View and reproduced here with the author’s permission.

One Response to "Main Street or Wall Street?"

  1. Diogenes   September 25, 2008 at 8:09 am

    I call BS Mark! Looks like all the MBAs that were geniuses want to prserve their fat non-productive jobs. This bailout punishes the prudent, the saver, the person who DELAYED GRATIFICATION to have a better future. If this passes, the up to now responsible ones will get the message loud and clear…borrow all you can and default…daddy will bail us out.