I’ll state up front that while I can toss numbers like nobody’s business, I’m not an expert on Wall Street economics. Like Shoebox, I don’t know which way, if any, is the right way out.
First, we have to remember why we are where we are, with an effectively-frozen credit market and the largest of the financial institutions teetering on the brink of collapse. It is because of an insistence by the federal government that the financial institutions lend to the credit-unworthy, combined with the gusto with which the financial institutions did lend to the credit-unworthy with the beliefs that housing prices would perpetually increase and that the federal government would step in if they got into trouble, that we got to a point where a correction in the housing market would threaten to bring the entire system down.
Compounding that is the Red Chinese factor. They hold a lot of debt, and the word is they’re calling it in right now.
There are essentially three things that can be done. The first is to essentially do “nothing”. The reason why I put that in scare quotes is that there are mechanisms in place to bail out individual financial institutions that fail, like Washingon Mutual. Indeed, I have to point out that the FDIC didn’t have to use any of its funds to complete that transaction. However, the fact that there is somewhere between $1.7 trillion and $7 trillion in “distressed” loans out there (or if one prefers, between 11% and 46% of the total value of the real estate) makes it improbable that, if a significant portion of those loans were to default, the current mechanisms can deal with that. True, not all of that is truly bad, but if even half of that is bad, it will make the S&L crisis look like a blip. It also does not address the immediate lack of liquidity in the markets in general and in the credit market specifically.
The second is the Paulson Socialism plan (the government buying that 11%-46% in value of the real estate) or the current Democratic Takeover of the Financial Sector alternative (the feds buying controlling stakes in the form of preferred stock in certain companies holding mortgage-backed securities). The model for the former is the successful Resolution Trust Corporation’s disposition of the assets of failed savings and loans at the end of the 1980s and the beginning of the 1990s. The main reason that worked in the long term is that the RTC actually sought to get rid of those assets when the private market was able to reabsorb them. That is something I am not at all confident the government will be able to do so this time around for two reasons.
First, we’re talking trillions of dollars now instead of a few hundred billion dollars then. The RTC took 6 years to get rid of just over $300 billion of assets. While inflation makes a straight ten-fold increase in the time for the market to recover sufficiently to reabsorb this not quite accurate, it is fair to say it would take far longer than 6 years to reintegrate the “distressed” mortgages into the private sector.
Second, we’re within 120 days of potentially having both the executive and legislative branches of government in the hands of the Democrats. The fact that the RTC existed for several years before the election of Bill Clinton, and then the Democrats only had total control of government for 2 years, had something to do with the ability and indeed the willingness of the RTC to actually return the assets to the private sector.
I will stipulate to the likelyhood that injecting that money will have the effect of at least temporarily restarting the credit market. However, what happens when that money is burned through, especially with more social economic engineering likely in the bill and almost certainly no fundamental fix of the governmental demands that caused this? The lack of long-term positive effect the similarily-sized economic stimulus return of welfare package earlier this year had ought to provide a clue.
There is even less of a guarantee that government will get rid of any stake in financial companies. Given that government policy played a very large part in this mess, and given that this approach is being pushed by those that are at their core anti-business, I do not want the government in complete control of those companies.
Finally, there is the House Republican plan, which Shoebox and I briefly touched on. It would make it easier for Wall Street to heal itself without the takeover of either real estate or corporations by the government, but there wouldn’t be a lot of immediate relief to the credit market. Whatever direct savings in tax and regulatory breaks the financial sector would see would flow back to the federal government in the form of insurance for the half of the MBS that aren’t already backed by the feds. Depending on the range of tax and regulatory breaks, there would be a lessening of the pressure on the credit market from businesses who, with additional cash in their pockets, wouldn’t be as dependent on the credit market to operate.
It also isn’t what Wall Street is looking for; they have their own immediate self-interest at heart. They like “free” cash like anybody else, and they like not having to take responsibility for their role like anybody else.
