Take the pain to do it right

Despite the initial failure of the proposed $700 billion bailout of the financial system to win approval in the House of Representatives, the general idea continued to be tweaked by supporters and it was almost inevitable that it will be implemented after it overwhelming passed in the Senate. And the House did support it with a Friday vote. But a better course would have been for Congress to return to square one, reassess the causes of the crisis and attack them at the root.

It has become increasingly apparent that the crisis was precipitated by government actions going back many years - although there was certainly overreaching and even fraud in the mortgage lending industry and a gross failure on the part of private credit rating institutions to estimate the risks involved in exotic new investment instruments.
Thus the solution lies in ratcheting back direct government intervention into the marketplace rather than this bailout, which gives Treasury Secretary Henry Paulson broad authority to buy troubled assets from financial institutions.

Subprime mortgages were virtually invented by government, and government pressured lenders inexorably to grant them to potential homebuyers who might not otherwise qualify for mortgages. The inherent risks were "insured" by the government-sponsored enterprises Fannie Mae and Freddie Mac, with taxpayers' money at risk. In conjunction with the loose-money policies of the Federal Reserve as well as securitization of the mortgages, these practices inflated the housing bubble. So, when the bubble burst, institutions around the world were faced with money-losing investments.

These problems were compounded by the introduction last November by the Securities and Exchange Commission of what has been called fair value accounting, or mark-to-market. Under this practice, a fire sale of an unsound security requires banks and other institutions to "mark down" similar securities they hold to that sale price - mark to market - even if the market is slim to nonexistent and if the institutions intend to hold them to maturity. This paper loss in value triggers the need to sell other assets to raise capital, leading to a cascading downward spiral.

Perhaps the only constructive aspect of the bailout package that failed Monday was a provision suggesting to the SEC that it has the power to repeal fair value accounting.

Whether that would do the trick in one fell swoop or not, it would be a good start. The next step would be to announce that Fannie Mae and Freddie Mac are going to be broken up into smaller entities and sold to the private sector, with no access - zero, ever - to taxpayer funds. Operating with their own money rather than with the promise of a taxpayer bailout, these entities would be subject to market discipline and would have to operate more conservatively. Consequently, so would the lenders. If the Federal Reserve provided liquidity to banks and all concerned showed a little patience - time to evaluate the investments - a real market should emerge.

One positive aspect of the crisis is that the otherwise obscure economic term "moral hazard" has become part of the public dialogue. Moral hazard occurs when an economic entity knows that mistakes that could lead to losses or even to bankruptcy will be covered by the government.

The trouble with the $700 billion bailout proposal - besides vagueness as to just what officials planned to do with that huge sum - is that it would have increased moral hazard. There have been genuine losses as well as paper losses in this financial fiasco. Working through it will involve some pain, and perhaps more banks and other entities going under. But it would be better to take our hits now than to delay, lengthen and compound the consequences with more of what led us into this mess.