Tuesday, September 23, 2008

It's Not a Bailout, It's a Handout

The Congress and other key members of the federal government are busily negotiating what is commonly referred to as a bailout of the financial system. In fact this is no bailout. It is a handout to certain individuals, a transfer of wealth from the many to the few, some of whom are quite wealthy already.

Moreover, the handout does not address the very real, but manageable, problems of the financial system. The proposal is backward-looking, forcibly diverting money from productive pursuits and using it to chase bad loans down the garbage disposal. The damage from the bad loans cannot be undone, and they and their associated bad assets can make it down the drain without taking taxpayer money along.

On the subject of bad assets, Congressman Barney Frank would have us believe that the taxpayer stands to make a profit from this program. Impossible. Treasury Secretary Paulson and President Bush have been very clear that they intend to buy the worst financial assets available. Due to the complex securitization of mortgages and the hesitancy of the assetholders to write them off, many of our coming purchases are already worth zero, with no hope of ever appreciating in price.

Former Speaker of the House Newt Gingrich recently told NPR’s Melissa Block that “I was just reading an analysis by a very sophisticated person who said that there's been at least one leak from a congressional staff briefing by Secretary Paulson, in which he clearly indicated he intended to buy assets at above their market value.”

If the assets were in fact undervalued, as Barney Frank says, then there are people with money who should be happy to buy them of their own free will. Investors are willing to do the work needed to separate good from bad. This is the work needed to drag the system through, but it cannot happen if the Treasury hands people the opportunity to exchange nothing for something.

The Congress and the Treasury are acting in a state of panic. President Bush says that they have no choice. Secretary Paulson says this is better than the alternative. One has to wonder what “alternative” he has considered because there are plenty of better options to choose from.

One perfectly viable alternative for Congress is to do nothing. We already have a bankruptcy system that is equipped to deal with this. Banks that are insolvent should be forced to go through the bankruptcy process. There is no such thing as “too big to fail.” These banks have already failed. All that remains is to determine who will bear the consequences, those responsible for the failure or those of us who had nothing to do with it. I think I can speak for us all when I say we taxpayers have our own problems.

They tell us that inaction will lead to a complete financial meltdown, but there is no justification for this claim. Yes, there is counterparty risk, but there is no reason why it would increase if bankruptcies take their course. What’s more, those counterparties knew (or should have known) the risks and they entered into those counterparty agreements freely.

So what would happen if we say no to this handout. Shareholders of insolvent banks would lose their investment. Bondholders would lose some or all of their investment as their claim is reduced to the proceeds of the bankruptcy proceedings. This is a bad outcome for those people, but it is no catastrophe.

There is no reason to believe that economic losses would extend past the stock and bondholders. Counterparty obligations would still be met and customers need not lose because strong banks will rise up to serve them and the viable portions of the failed banks would be preserved and taken over by more competent managers.

Stocks and bonds represent ownership stakes in a risky endeavor. Gains on those stakes exist because the possibility of loss exists. These assetholders have already agreed to accept the losses in the event of failure. This has always been true and it must remain true. If we proceed with this handout, the only results will be financial loss for hard-working Americans and a windfall profit for a select few.

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