Is the Bailout Plan the Beginning, Or the End, of the Economic Collapse?

THE DAY AFTER SARAH PALIN passed her campaign midterm exam, the Congress passed a Wall Street bailout bill. In reacting to the news, the Dow Jones Industrial Average did worse than Palin did in her excruciatingly manneristic ninety minutes on stage with Joe Biden, falling 157 points on the news of a 263-171 House vote that guaranteed $700 billion to purchase “toxic assets” believed to be the root cause of the financial crisis.

Not as bad as the declivitous 777-point drop five days earlier, when the House rejected the administration’s first attempt to pass the bailout plan. But hardly a market rally celebrating the government’s rescue of the finance sector.

On the same day that the House passed the bailout package, the New York Times reported on an April 2004 hearing at the Securities and Exchange Commission (SEC). At the hearing, which at the time went largely unnoticed by most media, five big Wall Street investment banks pressed for and received from the SEC an exemption from capital reserve requirements that restrained investment at their brokerage units.

The exemption pertained only to Wall Street’s biggest investment banks, with assets greater than $5 billion, and freed up billions they were required to hold in reserve against losses on investments. The new funds would be invested in “mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.” The same instruments that now comprise most of the “toxic assets” to be purchased with the $700 billion approved by Congress.

Among the five investment banks leaning on the SEC was the Goldman Sachs Group, Inc. Its CEO at the time was current U.S. Treasury Secretary Henry Paulson. When the bailout package came to the House floor for the second time, at the beginning of October, some congressional representative might have observed, if only for the record, that the Treasury secretary was one of the Wall Street players responsible for the crisis—even if Goldman Sachs had made fewer bad investments than most on Wall Street.

Paulson moved directly from Goldman Sachs to the Treasury Department in 2006. President Bush himself persuaded Paulson to leave the private sector to replace John Snow at the Treasury, aware that Paulson had good reason to hang on at Goldman Sachs. For two successive years, Paulson’s pay had increased 26 percent, as Goldman’s compensation committee piled bonuses onto his $600,000 salary to reward him for two years of record earnings. The year after the 2004 SEC meeting described in theTimes, Paulson’s $38.3 million compensation package set a Goldman Sachs record.

“We’ve said these are the big guys,” said SEC Commissioner Harvey J. Goldschmid at the April 2004 meeting. “But that means if anything goes wrong, it’s going to be an awfully big mess.”

One of the big guys Goldschmid described four years ago has just been handed $700 billion—roughly the cost of six years of war in Iraq or ten years of Barack Obama’s proposed health care plan—to clean up an awfully big mess.

BANKERS RULE—No one should be surprised that Paulson’s initial crack at a bailout bill was only three pages long, a length suitable for a directive drafted by a Wall Street CEO.

“You have to imagine that whoever is running Goldman Sachs is running it with a pretty iron fist, with consultation with his immediate deputies,” said market analyst Barry Ritholtz, on a conference call organized by the market consultant group RiskMetrics. “I think that process was brought into Treasury with Paulson. And when you look at the way this White House has pushed various ideas forward, it’s not exactly a paragon of respecting experts, consensus building and [bringing] the smartest guys into the room. . . .” Ritholtz said.

Nouriel Roubini is a New York University economics professor. He seized the public’s attention by warning that the United States was facing a severe housing crash, soaring oil prices, declining consumer prices, and defaults on mortgages that would cost trillions of dollars in mortgage-backed securities gone bad. All of these are glaringly evident today.

But Roubini actually sounded this alarm at an International Monetary Fund meeting in September 2006. At the time, he also warned that the gathering storm posed a threat to the solvency of government-sponsored mortgage underwriters Fannie Mae and Freddie Mac. On the same conference call in which Ritholtz described what he believed was a flawed process in creating the bailout, Roubini said it appeared that bankers and representatives of banking associations had written a plan that best serves their own interest.

“I think it was really a rush job, in which the legislation was mostly essentially written by the banks and their associations,” Roubini said. “So I’m not surprised that Paulson would like to do something that is going to be a significant bailout of the shareholders of the banking institutions.”

Roubini called it a “major scandal” that no professional economists were consulted on the bailout bill. (Two hundred economists, many of them from the nation’s most prestigious universities, signed a letter to Congress opposing the bailout.)

“Any serious expert on banking would have told you that to re-capitalize the banks, the exception in most cases is to buy the toxic assets,” Roubini said. Yet the purchase of toxic assets is what most of the $700 billion will be used for. Roubini said that undercapitalized banks are commonly re-capitalized through “injecting common stock shares or preferred shares . . . so essentially you are providing liquidity but also providing capital to the banks.” The plan the president signed into law on October 3 moves money on a slower and more circuitous route toward bank recapitalization.

Another evident flaw in the Paulson plan has to do with how to value the toxic assets—in this case dicey home loans that have been chopped up, repackaged, and sold as mortgage-backed securities, which the Treasury will buy and hold to sell at a later date. If institutions are undercapitalized, selling assets on their books at anything close to fair value still leaves them undercapitalized. The plan only fixes the banks’ problem if Treasury purchases the assets for more than market value. It’s “cash for trash” at premium prices.

DIN OF INEQUITY—One particular flaw in the Paulson plan is evident even to those of us who don’t understand the arcana of collateralized debt obligations and credit default swaps. Six thousand home loans are foreclosed each month. An undetermined number of those loans are the result of subprime scams perpetrated during an exhilarating moment when some lenders were selling their products to anyone who could sign an application form. (Remember the “NINJA” loansNo Income, No Job, and No Assets?) The victims of the subprime-mortgage lending scandal that caused the crisis get no relief out of the $700 billion bailout.

While Congress was wrestling with its bill, a number of reasonable plans to rescue homeowners were being floated, not all of them by radical wealth-redistributors. Columbia Business School Dean Glenn Hubbard, who served as the chair of President George W. Bush’s Council of Economic Advisers, worked with his colleague Chris Meyer on a proposal they outlined in the Wall Street Journal:


We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into thirty-year fixed-rate mortgages at 5.25 percent (matching the lowest mortgage rate in the past thirty years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify. . . . Rising mortgage spreads and down-payment requirements are what’s still driving down housing prices. We need to stop this decline. . . .

Hubbard and Meyer even provide for borrowers whose houses are “under water”—worth less than the total amount of the loan. “These mortgages could be refinanced into a thirty-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Home Owners’ Loan Corporation.” There were other plans to help borrowers. Democratic legislators proposed allowing bankruptcy judges to reduce loan interest and in some cases principal in order to keep borrowers in their homes writing monthly checks to their mortgage lenders.

Johns Hopkins professor of economics Christopher Carroll, who also proposed bankruptcy relief for some distressed borrowers, wrote that even a limited role for bankruptcy judges was vehemently “shouted down.” Much of the shouting was done by lobbyists from the Business Roundtable and U.S. Chamber of Commerce. “We don’t think this should be something that advances every pet interest, or tries to overhaul the entire system, or takes a pound of flesh from those who got us into the mess,” Chamber vice president R. Bruce Josten said to Peter Stone and Bara Vaida of the National Journal.

The Roundtable did succeed in making a place for foreign bankers, such as Barclays and UBS, in the bailout. “There are [foreign] companies with U.S. operations that play a significant role in the mortgage market,” the Roundtable’s Scott Talbott told the National Journal‘s reporters. Shutting borrowers out of a plan that provides $700 billion to clean up a mess created by lenders and speculators recalls John Kenneth Galbraith’s observation that “the only respectable socialism in America is socialism for the rich.”

THE BEGINNING OF THE BEGINNING—The morning after the House passed the bailout plan,New York Times columnist Paul Krugman predicted that before January 20, 2009, Congress would be back to vote on bailout 2.0. Krugman is not the only economist who considers the plan that Paulson pushed through Congress the beginning, rather than the end.

The bailout bill is part of an ongoing process. Over the past month, the Federal Reserve absorbed as much as $29 billion in losses from investment bank Bear Stearns, loaned the insurance combine A.I.G. $85 billion and then promised $37.8 billion more, and absorbed some debt from collapsing thrift Washington Mutual. While Congress debated the Paulson plan, the Fed pumped $600 billion into domestic and foreign banks in an attempt to encourage lending.

Nouriel Roubini warns that international lending markets “are close to a systemic meltdown.” He suggests several drastic and immediate measures, such as an FDIC guarantee to insure all bank deposits, which would go far beyond the scheduled increase from the current $100,000 to $250,000 in deposits covered. As a temporary measure, unlimited FDIC insurance would discourage big depositors from pulling money out of banks they fear might fail, which is already happening and threatening bank solvency. Roubini also said that $1.5 trillion is a more realistic sum to address the financial crisis. More money and policy, he said, will be required. (As we go to press, the Treasury and the Fed seem to be taking his advice, as they moved to take equity positions in struggling banks.)

Barry Ritholtz wonders what happens in a few weeks if the market is 10 percent lower, bank lending is horrific, and a lame duck president is left to address another emergency:

“What might happen . . . is either one or both of the candidates are going to step forward and say ‘we need to convene an emergency blue ribbon panel. Let’s get some smart guys in there. Let’s break from this top-down benevolent dictator style. . . . Let’s see if we can get a few smart guys back to Bretton Woods or some other place like that to see if we can come up with a better approach, which will accomplish something and not just take the toxic paper off the balance sheets. And do what needs to be done, which is recapitalize the banks and get lending started again.'”

With the election only weeks away, the economic crisis has created an unanticipated advantage for Barack Obama. Not only is there a history of voters moving toward Democrats in times of economic uncertainty. The prospect of an erratic and shaky John McCain and an incoherent and policy-averse Sarah Palin directing efforts to save the world’s economy scares the hell out of a lot of people.

Even some people on Wall Street.

THE $639 BILLION QUESTION—Congressman Dennis Kucinich (D-OH) finally asked the question about Treasury Secretary Henry Paulson’s possible conflict of interest. At a House Oversight and Government Reform Committee hearing, Kucinich questioned CEO Richard Fuld of Lehman Brothers. Lehman is the investment bank that filed for bankruptcy in September. Kucinich began by reading from an e-mail Fuld had written to another Lehman executive in April.

“Just finished the Paulson dinner,” Kucinich read, and then said to Fuld: “[In the e-mail] you said ‘we have a huge brand with treasury.’ And ‘loved our capital raise.’

“Does any part of you feel that you were double-crossed by the secretary? That he was playing you off of, let’s say, Goldman Sachs?”

“I would certainly hope that is not the case,” Fuld said.

At the end of the hearing, I asked Kucinich if he could be more specific. “I want to know if Paulson used his position as secretary of the Treasury to push Lehman Brothers off a cliff and help Goldman Sachs,” Kucinich said.

A member of Congress was asking if the Treasury secretary had used his office to push a competitor of his former employer toward bankruptcy. Lehman was a company with $639 billion in assets, more than the gross domestic product of Argentina. Its collapse might have been the event that precipitated the global economic crisis.

There was more in the Fuld e-mail.

“You have a memo here where you say that Secretary Paulson wanted to implement minimum capital standards, leverage standards, and liquidity standards,” Kucinich said to Fuld. “These seem to be some of the things that got your company in so much trouble. Did [Paulson] ever tell you in all the conversations you had with him that he decided not to implement the minimum capital standards, leverage standards, and liquidity standards?

“Did you rely on anything that Henry Paulson told you that could have put Lehman Brothers down?”
Fuld said no.

Other questions were informed by a subtext that has Paulson supporting an $85 billion loan for insurance behemoth A.I.G., while denying life support to Lehman Brothers because of Goldman Sachs’s large exposure to A.I.G. I find it hard to believe that Hank Paulson put Goldman Sachs’s interest above the interest of his country, even if his decision to let Lehman Brothers go down turns out to a disastrous one.

But has Goldman Sachs pulled off a friendly takeover of the Treasury Department? On the day Fuld testified before the House Oversight Committee, Goldman Sachs alumnus Henry Paulson appointed Goldman alumnus Neel Kashkari (age thirty-five) to serve as interim director of the Office of Financial Stability, which will oversee the distribution of the $700 billion Congress approved for the toxic assets bailout.

Two of Paulson’s advisers, Dan Jester and Steve Shafran, are former Goldman Sachs executives. Another former Goldman executive, Robert Steel, was advising Paulson before becoming CEO of Wachovia Bank. President Bush’s Chief of Staff, Josh Bolton, initially proposed that the president appoint Paulson to head Treasury. Bolton once worked for Goldman Sachs.

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