The Washington Panic

Thursday night’s negotiated sale of Washington Mutual to J.P. Morgan Chase was a nifty bit of financial plumbing that minimized the damage to taxpayers while putting a banking zombie in sounder hands. Hats off to Jamie Dimon at Morgan and Sheila Bair at the Federal Deposit Insurance Corp. Now if our political class could rise to the occasion, we might get on the path to a sounder financial system.

[The Washington Panic] AP

From left: John McCain, John Boehner, Nancy Pelosi, President George W. Bush, Harry Reid, Mitch McConnell and Barack Obama.

The uproarious debate over the Paulson plan comes down to one main proposition: Are we going to give the government a new tool and resources to protect the financial system, or not? No one tried harder than we did to avoid arriving at this pass, but now that we’re here our vote is that this government intervention is justified to defend the system.

The critics have many good arguments, not least that neither the current Treasury nor the Federal Reserve inspire great confidence. Hank Paulson and Ben Bernanke have practiced ad hoc-ery for 13 months, piling up serial bailouts only to watch the panic get worse. They are finally attacking the problem in a systemic way, however, and with enough resources to begin repairing the larger damage. The execution risks are real, as in any government exercise, but the risks of doing nothing are just as real for the economy and for believers in free markets.

Above all, the risk is that the current panic will damage the overall economy and lead to a deep recession that causes a further decline in housing values and continues a spiral to even greater financial problems. The libertarian blogs are full of tut-tutting that the economy has held up surprisingly well, and for a year we’ve been arguing the same thing. But there’s no guarantee this will continue, especially as unemployment climbs and as evidence grows that banking distress is squeezing credit to small and big business alike. Credit spreads over Treasurys are back at agonizing levels, as investors and lenders flee from even plain vanilla risks.

Background on a Crisis

  • The Paulson Sale 09/24/08 — Taxpayers are going to put up capital one way or another.
  • A Mortgage Fable 09/22/08 — Beltway trilogy: the Fed, Fannie Mae, and Bear Stearns.
  • Stopping the Panic 09/20/08 – Now the task is to protect taxpayers and restore markets.
  • Be It Resolved 09/19/08 – Paulson and Bernanke ask Congress for a resolution agency.
  • The Fed and AIG 09/18/08 – Nationalizations aren’t stopping the financial panic.
  • McCain and the Markets 09/17/08 – Denouncing ‘greed’ and Wall Street isn’t a growth agenda.
  • The Fed’s Epic Day 09/17/08 – It’s only fair to praise the central bank when it does the right thing.
  • Surviving the Panic 09/16/08 – A resolution agency, steady monetary policy, and a big tax cut.
  • Wall Street Reckoning 09/15/08 – Treasury Secretary Hank Paulson’s refusal to blink won’t get any second guessing from us.

Nobel economics laureate Gary Becker is no alarmist, but this week he wrote on his blog, “I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy in a major depression.” Anyone who thinks that capitalism will fare better after a crash should recall that the 1930s didn’t end politically until 1980.

Another reality is that taxpayers are already going to pay to refinance the banking system. The only issues are how and how much. If the Paulson plan fails, the Fed will still have guaranteed $29 billion for Bear Stearns, will still own AIG, and will still have a balance sheet that increasingly piles up ugly assets. Those are taxpayer obligations too. Meanwhile, banks will continue to fail, and the Treasury and FDIC will eventually have to come up with the capital to rescue those. One hope of the Paulson plan is that it will mean fewer such failures by letting banks sell bad assets for which there is now no market.

To be sure, the Secretary did his cause no favors by the way he has sold it. He couldn’t even describe the auctions by which Treasury would acquire assets, leading critics to claim that it would overpay as a nontransparent, backdoor way to recapitalize the banks. Mr. Bernanke disavowed that on Tuesday before the Joint Economic Committee:

“Now, the presence of a large buyer would obviously raise prices above the fire sale level. However, I am not advocating that the government intentionally overpay for those assets. [Our emphasis.] Rather, what I’m saying is that it’s possible for the government to buy those assets, to raise prices, to benefit the system, to reduce the complexity, to introduce liquidity and transparency into these markets and still acquire assets which are not being overpaid-for in the sense that under more normal market conditions, and if the economy does well, most all of the value can be recouped by the taxpayer.”

This strikes us as a fair prospect if the bill is clean enough, especially if Treasury starts the auction process and then quickly hands it off to a separate authority led by an experienced, and politically independent, financial pro. William Taylor and Al Casey did well leading similar resolution efforts after the S&L mess because they didn’t care if they got another job. Mr. Paulson needs to find a similar manager for this one.

The Paulson idea also seems better than the “insurance” plan for bank assets that House Republicans are now proposing. That idea would still put taxpayers at risk if the assets fall in value, but with little potential upside. Meanwhile, the assets would remain on bank books, making it that much harder for banks to raise private capital and resume normal lending.

The House GOP intervention may still be fortuitous if it focuses on killing the many Democratic ideas that are making the Paulson plan worse. They could draw a line against the Barney Frank-Chris Dodd proposal to put 20% of any upside from the eventual Treasury resale of the assets into an “affordable housing” funds for their political allies.

They could also resist the plan to let bankruptcy judges repudiate mortgage contracts, as well as the attempts to prevent foreclosures that are probably inevitable anyway. This will only delay the day that housing and mortgage securities find a bottom. And they could make sure that any government ownership of banks that participate isn’t so punitive that the auctions won’t work or that would further slow a recovery to normal lending.

There’s more than a little irony in Members of both parties claiming to care about the taxpayer after supping for so many years at the table of Fannie Mae and Freddie Mac. Along with easy credit from the Fed, those government companies caused this mess, and Congress inhaled the mania while it lasted. Where were those “no bailout” slogans when they might have prevented the problem?

We also have to marvel at Newt Gingrich’s ability to pirouette as a fiscal conservative hero now that he’s a TV pundit. When he had responsibility as Speaker of the House, he acquiesced to the Clinton Treasury’s plan to use the U.S. Exchange Stabilization Fund to bail out holders of Mexican debt. We also recall his lobbying for the Medicare prescription drug benefit.

The U.S. banking system continues to be under enormous stress, and if managed well the Paulson plan offers a decent prospect of preventing it from further infecting the economy. It might save taxpayers money in the long run. Yes, some bankers will remain in business when they wouldn’t otherwise, but Schadenfreude is not a policy and revenge against what’s left of Wall Street isn’t worth the potential harm to innocents on Main Street.

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