Budget & Tax

Why Bailouts Aren't Enough

December 6, 2008

Tom Daxon

The financial markets have taken on a lot of water recently. Congress has been bailing furiously. But are we doing anything to actually fix the leak?

If Congress doesn’t correct the underlying causes of the current crisis, the fruits of any bailout will be short-lived.

Liberals want to lay the blame for the financial meltdown on Wall Street greed, as if greed is a recent development. This is on par with Claude Rains’ reaction when told of gambling in the back room in Casablanca. Our liberal friends even want to round up all the usual suspects: lax regulators, brazen executives, and ordinary capitalists. Yes, there is greed on Wall Street. There is also greed on Main Street and in shopping malls. And there is certainly plenty of greed in Congress. There always has been. That won’t change soon.

Meanwhile, some conservatives have fingered mark-to-market accounting as the culprit. Mark-to-market simply means that a company holding securities that decline in value must recognize the decline on its balance sheet. Mark-to-market is a good rule that protects investors—a good rule we should keep.

But some seem to think that if we would just go back to the old, more “pliable” accounting rules, the good times will magically return. The SEC properly clarified the application of mark-to-market in unusual circumstances by noting that an entity may use alternative means of valuing assets so long as it discloses the assets so valued and the alternative methods employed. Still, some grumble. But why? Because an investor might actually learn that there is rot in the balance sheet? This is called transparency—a good thing!

If someone thinks the market does not reflect the “real” value of an asset, there is a ready solution: Buy the undervalued asset. This not only bids up the price to more “realistic” levels, but also lets the buyer make a profit … if the buyer is right.

While the current financial crisis manifests itself in many ways, at its root are unsound lending practices encouraged by the federal government. Fannie Mae and Freddie Mac carried out those policies and made matters worse. These quasi-government institutions complicated the process and spread the consequences worldwide.

Anyone in a crisis needs to identify the problem and attack it. To attack this problem at its source, Congress should repeal the Community Reinvestment Act (CRA). At the same time, it should turn the assets of Fannie and Freddie over to the FDIC, just as if they were failed banks. These steps will stop the leak and help restore confidence in our financial markets.

The CRA has laudable goals, but encouraging the granting of credit to those who are not good credit risks does no favor to unqualified borrowers. Saddling the poor and sub-prime borrowers with debt they cannot handle is insane. And it is bringing disaster to many who pay their mortgages faithfully but see their home values decline due to spreading foreclosures.

We must tighten lending standards, but in a way that doesn’t further dampen the demand that helped drive home prices up in the first place. In the short term, Congress could help people buy a home without saddling them with debt they can’t service. Congress could offer help to those saving for a down payment rather than pushing borrowers into homes with zero dollars down and artificially low initial “teaser” payments. Longer term, Congress should redesign our increasingly dysfunctional safety net and quit creating new problems by meddling in otherwise functioning markets.

With regard to Fannie and Freddie, the federal government could guarantee at least most of the face value of their outstanding securities—say, 95 percent—although a number other than 95 percent may be more appropriate. This assistance to the holders of underwater securities should come with a price, an equity interest in an institution that uses the guarantee. The feds could then sell the stock in the open market.

We should take other steps to ensure sufficient liquidity for our economy. We face potential catastrophe from opposite directions. In our effort to keep our financial institutions afloat, we could pump too much money into our economy, leading to very serious inflation. Conversely, we could provide too little, resulting in deflation and a very serious recession or worse. There is a sweet spot that our policymakers should endeavor to hit.

The American people respond when our leaders tell the truth and provide leadership. We don’t need technical expertise so much as we need leaders who will own up to their mistakes and move to correct them, even if that means dismantling a popular program and looking for new, more effective ways to help the less fortunate.

The good news is that we don’t face problems beyond our collective grasp if we face them and take decisive, corrective action. With solid leadership and public support, we should find that the current crisis, while serious, will have no more long-term effect than the almost forgotten 1987 market crash, the failure of many savings and loans a few years later, or the bursting of the tech bubble. Our system can and does correct itself when our leaders face our problems and act appropriately.

While bailing water from a sinking ship is important, only fixing the underlying leak will ensure long-term prosperity.

Tom Daxon is a CPA who has served as Oklahoma’s elected auditor and inspector and as director of state finance. In 1994, he was called by Orange County, California to serve as interim treasurer and led the team that developed a financial rescue package as part of the county’s successful rehabilitation after bankruptcy. He is the author of OCPA’s “Oklahoma Comprehensive Health Independence Plan,” and his new study on government transparency is forthcoming from OCPA.