WHAT’S A FREE MARKETEER TO THINK? Volume 3
In light of the ongoing financial crisis, on Monday of this week (September 22), I invited think tank and other colleagues from around Minnesota and the nation to address a purposely free-wheeling question: “What’s a free marketeer to think?”
We published four quick-turnaround columns in Volume One on Tuesday, another four in Volume Two on Wednesday, and we’re pleased to broadly disseminate six more in Volume Three today by David Himebrook of Arbor Capital Management in Minneapolis; Randall Holcombe of the James Madison Institute in Tallahassee, Florida; John Hay, formerly of the Prudential Life Insurance Company of America; Jake Haulk of the Allegheny Institute in Pittsburgh; Tom Schock of Capital Growth Real Estate in St. Paul; and Gordon Anderson of the Professors World Peace Academy, also in St. Paul.
Please note most of these columns were written just before the White House and congressional leaders reached their tentative – and then dashed – agreement on Wednesday night (September 24). We will continue publishing creative and important pieces like these as we receive them over the next ten days or so.
Many thanks, and as always, I welcome your comments.
Mitch Pearlstein
Founder & President
Center of the American Experiment
“Much Like the War Bonds of the 1940s”
By David Himebrook
I begin with the assumptions that a bailout of some sort is necessary and that $700 billion is the correct amount needed to stabilize the system. The current alternatives being discussed are considered government bailouts. They would be more accurately described as taxpayer bailouts under which the taxpayers have nothing to show for their participation other than a functioning financial system. My proposal calls for a government “facilitated” indirect program to be funded primarily by the American tax-paying public.
In general it would work as follows. The Federal Reserve would purchase the securities in a manner consistent with existing plans. All securities would be placed in a pooled structure. All taxpayers would then be able to purchase units of the pool at the price consistent with that paid by the Federal Reserve. These units would be marketed much like the “war” bonds of the 1940’s to finance the war of survival for our financial system. A patriotic duty to participate.
In order to enhance the attractiveness of this investment the government would allow a one-time contribution of up to $100,000 per taxpayer to a tax-free, IRA-like account to fund the purchases. These contributions would be fully deductible for federal tax purposes over five years without restriction.
These securities would be hold-to-maturity in nature with the only cash flows coming from collections of the underlying pooled securities.
If only the top 5 percent of taxpayers participated to the full extent the program would be nearly 100 percent privately funded. It would be hoped that taxpayers at all levels would participate giving them a feeling of direct participation in the solution and an improved national savings rate.
Under this proposal the opponents who claim the government is bailing out “Wall Street” would lose standing as most funding would be private and voluntary. For those who think the government actually stands to profit from the ultimate collection of these securities, this plan would allow those profits to flow through directly to those individuals who contributed to the solution in direct proportion to their contribution. For those who think individuals wouldn’t buy these worthless securities, let them know that we the taxpayers are buying them under any solution, the only difference being whether or not we have something to show for our purchase. If the securities prove worthless then that loss will be born by those who made a voluntary decision to participate.
From the government perspective, the forgone tax revenue on the IRA-like contributions seems to be a small concession for a direct funding by U.S. citizens.
Let’s recognize some bailout is necessary and try to structure it in an optimal fashion that is not just lose/lose for the taxpayer. The appropriate pricing for the “junk” securities from the financial industry remains an issue but no more so under this proposal than under others.
David Himebrook is a partner with Arbor Capital Management in Minneapolis.
Government Actions Encouraged Wall Street’s Risky Business
By Randall G. Holcombe
Many observers blame the current financial crisis on a breakdown of private markets. A more careful look shows that government policy, step by step, led to the current crisis.
First, Fannie Mae and Freddie Mac were created to help provide mortgages for people who didn’t qualify for conventional mortgages. As government-sponsored enterprises (GSE), they rapidly grew to where their debt was nearly half the size of the federal government’s debt.
As long as housing prices rose, they could handle their debt. When prices fell, they rapidly became insolvent. This wasn’t a surprise. Experts had warned that they might collapse, but low-interest loans to poorly qualified buyers were too popular for Congress to rein in those lenders.
In part their popularity was due to the mortgages, but it was also because the GSEs used profits generated from their favored status in the “market” to make campaign contributions and offer high-paying jobs to congressional staffers. They purchased political support.
A related problem began with the Community Reinvestment Act (CRA) of 1977. If lenders wanted to expand their lending, they had to balance their loans to financially secure buyers with loans to buyers who did not meet the conventional mortgage criteria.
The push to extend mortgages to less qualified buyers was amplified by the Home Mortgage Disclosure Act (HMDA), passed in 1975 and expanded in 1991 to require lenders to report rejection rates by race. Lenders were put on notice that their lending practices would be examined for evidence of bias, with violators facing the possibility of fines as high as $500,000.
The CRA was broadened in 1995, allowing the securitization of sub-prime mortgage loans. Securitization combines a large number of loans into a security that can then be sold. The idea was that while some loans might default, most would not, so the securities would spread the risk and make it safe to hold portfolios of sub-prime loans.
An obvious drawback is that the originating lenders had little incentive to consider mortgages’ long-term prospects because the loans are held only a short time before they’re sold off and securitized.
A third factor in this crisis was easy-money policy adopted by the Federal Reserve Bank early in the decade to mitigate the effects of an incipient recession exacerbated by the after-effects of the September 11, 2001 terrorist attacks.
Low rates meant lower-cost mortgages, further enabling people to buy houses. But the increased demand pushed
prices up, and many buyers wouldn’t have qualified for mortgages except for the relaxed standards.
Worse, many borrowers used variable-rate mortgages. The idea was that in a rising housing market, owners who couldn’t afford to refinance if the rates rose could always sell and turn a profit.
As long as interest rates remained low and housing prices rose, the problems were hidden. From 2004 to 2006, however, the Fed boosted the Federal Funds rate to 5.25 percent, pushing up mortgage rates and bringing the artificial housing boom to an end.
Those mortgage-backed securities, so attractive when interest rates were low and housing prices were rising, lost their luster quite abruptly when conditions changed. Firms that held lots of them found themselves in trouble. AIG, which insured such mortgages, foundered and was effectively nationalized.
The current crisis has two root causes. First, the federal government tried to extend home ownership to people who formerly wouldn’t have qualified for mortgages. This vastly increased the risk, which was hidden because mortgages were quickly resold, bundled, and “securitized.” Second, the Fed’s artificially low interest rates enabled the mortgage-backed security market to grow rapidly.
So government policy, not the free market, created much of the current financial crisis. Market participants aren’t blameless, however. Nobody forced Wall Street’s large investment banks to take big risks. They willingly accepted such risks in pursuit of bigger profits.
Why should the government now support the firms that made risky bets and lost? To do so would forever change our financial markets, which can work only if firms that accept risk in the pursuit of profit also suffer the loss if the market turns against them.
To bail out firms that made risky bets and lost would mean, at best, supporting managed capitalism and, at worst, the nationalization of financial markets. The long-term harm would far exceed any short-term financial stability a bailout might bring.
Randall G. Holcombe is DeVoe Moore Professor of Economics at Florida State University and Senior Fellow of the James Madison Institute in Tallahassee.
No Returning to Capitalism as We Have Known It
By John Hay
I’m truly a “Free Marketeer.” A graduate of the Wharton School at Penn and a retired vice president of the what used to be known as the world’s ‘largest and greatest” insurance company, a “mighty pump” (as Fortune magazine then characterized it), whose money pump helped to drive the economy back in the 1950s and ‘60s – the Prudential Insurance Company of America, as it was known then. That grand prominence, of course, has been diminished, though Prudential Financial is still very much a great company and has been holding up pretty well under the current onslaught.
What’s happened within our capitalistic economy over the past couple of weeks was inevitable, almost prophetic, had we but been able to read the tea leaves. How could it have progressed in any other way?
We now have almost three generations of citizens who have experienced few, if any, remarkable economic hardships in their lives. Nothing has been so serious as to keep them from the shopping malls. No one in government has asked them for any sacrifices through the Vietnam and Iraq wars. And everyone in government has told them they can have it all, regardless of the consequences. Indeed, there would be no consequences. Just keep consuming, and we will be OK.
Interest rates were so low (and relatively speaking, still are) that money was almost free. It was loaned, and then traded creatively on secondary markets, with abandon. Almost any Joe or Jane could qualify for any kind of a loan. Extraordinarily obscene amounts of money were being made on Wall Street, by people of just ordinary talents. But we now all know that sordid story. Now the markers are being called in, and we’re about to pay the piper.
Enter the politicians! Inevitable. Like vultures circling far above a wounded animal, waiting for it to die before they pounce and pick at the carcass. The two presidential candidates know absolutely nothing about economics and can’t even begin to understand the current problems, but, of course, that doesn’t keep them from mouthing off. Fire Cox! Yeah, right. No doubt, that will take care of everything. And Nancy Pelosi, Harry Reid, Chris Dodd, and Barney Frank will inevitably agree before this week is out to Hank Paulson’s and Ben Bernanke’s $700 billion bailout “solution.” But not before making Paulson and Bernanke sweat before the TV cameras. And not before taking the stage themselves and pontificating their righteous and populous views before the American people. Quite a show, if the consequences were not so terribly serious.
It’s now far too late to let the financial markets sort this out. The American people are now used to, and indeed demand, instant fixes. Entitlements have now become, well . . . entitlements. Rescue me from my ill-considered decisions. Put these CEOs in jail (where, of course, some of them probably deserve to be!). But, above all, make me whole. Make this all go away, and do it quickly. And, as a small business owner, what are you now going to do for me? You’re taking care of the big guys, and I want my share. And then there’s Ford and Chrysler and GM, ad infinitum.
After Congress acts this week, there will be no returning to capitalism as we have known it. I’m afraid the march to ever-increasing government meddling has taken one giant step forward, never to look back. Hey, you can’t spend $700 billion of taxpayers’ money without the Democrats (and some Republicans) extracting a quid pro quo. FDR is looking more conservative every day!
John Hay is a retired executive with the Prudential Insurance Company of America.
Hayek was Right
By Jake Haulk
In yet another verification of the Hayekian warning that government involvement in the marketplace begets more government involvement, we now face the mother of all financial market bailouts, putatively to prevent a credit market collapse of economy-endangering proportion. The bailout is needed to counter the consequences of the granddaddy of government interventions in the economy. Beginning with the Community Reinvestment Act, it moved on to the congressionally forced conversion of Fannie Mae and Freddie Mac into buyers and sellers of junk mortgage paper. And now the toxicity of the colossal volume of subprime loans and the securities they back has spread like flesh eating bacteria through the financial world.
So far this year the Federal government and the Federal Reserve arranged for and assisted in a buyer takeover and bail-out of Bear Stearns; arranged a $300 billion program to help banks and homeowners in foreclosure or danger of foreclosure; created an open-ended credit line for Freddie Mac and Fannie Mae; made a loan of $85 billion to AIG; and now has recently placed Fannie Mae and Freddie Mac in conservatorship.
Despite these heroic efforts to shore up the nation’s confidence in financial markets, it has now become necessary to launch a staggering $700 billion program to buy up the ever-growing stack of bad mortgage paper and the securities they back. As of this writing, the final details are not in place and we do not know if $700 billion will be enough. And little wonder. Together Freddie and Fannie have $5.4 trillion in guaranteed mortgage backed securities and debt – about the same figure as the publicly held national debt. What’s worse they are still in business, still acquiring more loans and mortgage-backed securities.
Free marketeers have long since warned against the intrusion of government into the economy, especially the intrusions that create market distortions and moral hazards. These intrusions cause people and businesses to make misguided decisions and engage in hyper-risky behavior they would not contemplate absent the government’s promise to prevent their suffering any serious consequences for bad decisions.
Unfortunately, these warnings have not only gone unheeded, they have been totally ignored. So, all things considered, there is not much free marketeers can learn from another episode that merely confirms what they have confidently predicted would happen.
There is one new and frightening twist in this latest calamity. It has become obvious that most of the major media are completely in the tank for Obama and will report nothing that might harm his chances to be elected, including his ties to Jim Johnson and Franklin Raines, both of whom played major roles at Fannie Mae. Nor is there any mention of his being the biggest recipient of Fannie Mae contributions over the last three years. Neither will the liberal media begin to point out, as Fox News has done, the perfidy and complicity of Democratic senators and congressmen in creating the mess that Freddie Mac and Fannie Mae have become, refusing even to allow corrective legislation on a number of occasions when it was clear that the two behemoths were about to go careening off the tracks. The media have to protect those miscreants as part of the protect Obama effort. And besides, they’re in bed politically with the liberal Democrat agenda anyway.
So what we have learned to our great horror and dismay is that liberal media and some legislators have no real concern about the underlying institutional infrastructure of the United States and are willing to undermine it, even at enormous risk to the nation, if it is necessary in order to promote their selfish political goals. They will get away with it because the Bush administration failed to draw a line in the sand five years ago and say this will not be allowed to happen on our watch. And they will get away with it because as long as the American people cannot get the truth from the major media, a large number of them will continue blindly believing that it was all Wall Street greed that created the mess and Wall Street, as they all know, is a bunch of Bush-loving Republicans. Yet another media created untruth.
That’s what one free marketeer thinks.
Jake Haulk is president of the Allegheny Institute in Pittsburgh.
Same Fix as with Failed Savings & Loans
By Tom C. Schock
Our best course of action likely would be to handle this debacle as was done with the failed Savings & Loans: Sell the loans for market value and then, due to the implicit guaranty attendant to “Fannie” and “Freddie” securitized loans, have the federal government (in reality, taxpayers) make the mortgage holders whole by covering the shortfall between the amounts owed and the amounts the loans sell for. In this manner, taxpayers end up “stuck” only for the spread between fair market value of the loans and the balance owed on them. This, as opposed to picking up the tab for the entire amounts owed.
Applying this methodology would result in the mortgagees getting “bailed out,” not the Wall Street gurus with latent liability after monumentally profiting from securitizing and selling substandard loan packages.
I understand the Fed and Treasury’s concern regarding getting liquidity into the system as quickly as possible. However, it’s well known that vast sums are sitting on the sidelines; money that will come back into the financial markets once a plan is in place and which would be available to purchase packages of mortgage-backed securities at their current fair market value.
The other inevitable result of the current plan on the table, as noted by another author in this American Experiment series, will be inflation due to “monetizing the debt.” This is an economist’s term for printing money. In addition to the methodology I just described for liquidating troubled assets, I would suggest the Fed now look to increase interest rates and decrease the money supply in order to keep inflation in check and to ward off further declines in the value of the dollar.
Tom C. Schock is a developer with Capital Growth Real Estate in St. Paul.
Don’t Give into a Protection Racket
By Gordon L. Anderson
The first American Revolution was fought, in part, because the British wanted to control our money. Ben Franklin is reported to have once said that the economy of the colonies was so prosperous because the colonies issued their own money, “colonial scrip,” issued in proportion to the level of goods and services in the economy. No interest was paid to anyone for it. The result was that the British declared the use of colonial scrip illegal.
Consolidation of money accompanied the consolidation of Federal power over the states with the Civil War, with the National Banking Act of 1863 and the two revisions which followed in 1864 and 1865. This legislation promoted currency notes issued by nationally chartered banks rather than state banks. The Act imposed a 10 percent tax on state banknotes, effectively eliminating non-federal currency from circulation.
The control of federal money was largely taken away from the government, with the Federal Reserve Act and secrecy following later.
It isn’t that we weren’t warned by the founders about the consolidation of power and credit. The request by Fed Chairman Bernanke and Secretary of the Treasury Paulson was delivered in the form of a Mafia protection racket: “Give us your money now or something bad will happen.” No serious explanation, no attempt at accountability, no willingness for transparency.
It may be that some type of bailout by the government is called for under the premise that the role of government is to protect innocent people from harm by others. And that mandate refers to financial harm as well as physical harm. But the bailout as requested does not sufficiently meet this basic test. Who is innocent and who is culpable must be established, and any bailout should be accompanied by protection of the innocent from financial harm and punishment for the guilty. If Congress does not proceed in a way that protects the innocent and simply pays extortion, they will only be compounding the problem.
Gordon L. Anderson is general secretary of the Professors World Peace Academy in St. Paul.