Visiting Scholar Lawrence B. Lindsey

Last Thursday night Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke stood surrounded by the bipartisan leadership of Congress to announce that a consensus had emerged that drastic action was needed to save our financial system. On Saturday the first vague details of that action began to emerge. By the time of the first hearings on Tuesday a groundswell of popular opposition produced some of the most broad-based skeptical questioning of the nation's economic leadership that I can remember. What happened?

First, it is now obvious that the Thursday consensus to pass a bill was not backed by the reality of legislation, or even a coherent plan of action. When Washington let Lehman Brothers fail (after a century and a half of operations), many in Washington said that Lehman had had six months to get its problems revolved--since being put on notice when its sister firm Bear Stearns was bailed out--and had not done so. Hence it was denied the assistance Bear had gotten. But what had Washington been doing in the intervening six months to get ahead of the developing financial crisis? By the weekend it appeared that the answer was: about as much as Lehman.

Second, when the first details emerged, the focus of the plan was for the government to buy the assets in the financial system that were not easily valued and therefore could not be sold. They were clogging up the books and thereby consuming most of the spare capital in the system. Those that could be sold were being sold out of desperation at fire sale prices. For example, Merrill Lynch had sold assets at 22 cents on the dollar, and had to lend three-quarters of that amount to the buyer. Trouble was, if the government bought at those prices, the financial industry would take massive losses and many firms might go under. That meant that the only way the plan made sense was for the government to buy assets at prices well above current market values. Not even the most talented wordsmith could find a way of getting around the word "bailout" for this type of action. This meant bailing out the same gigantic firms which government regulators and prosecutors had been saying for months had used shady accounting practices and paid their CEOs tens of millions of dollars per year. I'm just an economist, but that hardly seems like a political winner to me.

Third, to make these purchases the government would have to set a price on assets that are so opaque and differentiated that no market price had been determined for over a year. This opacity led Wall Street to employ some of the smartest people in the world to come up with computer models to determine these prices, and when they did, the prices were so subject to small changes in underlying assumptions that they proved wildly volatile. Passing the plan meant asking members of Congress, most of whom would have to ask a staffer what the formula was for compound interest, to either figure out a fair price or trust the same geeks who got us into this mess in the first place to figure one out instead.

The most likely end game of this approach is passage of a bill that hands the job over to the geeks with so many constraints and conflicting objectives that the entire enterprise runs up against Arrow's Impossibility Theorem. (Kenneth Arrow got a Nobel Prize for formalizing a way of saying "you can't get there from here.") The resulting process would be open to manipulation by private players who could hire their own geeks to figure it out, and therefore almost certain to produce instant billionaires in the process. But, this outcome will still allow congressmen to go home to campaign and tell voters that they have both solved the problem and protected the taxpayer. After the process collapses and the Congress returns in January, the blame will be dumped on the appointed officials who were supposed to oversee the geeks assigned to complete the impossible task. A new process will then be created in January by people with even less experience and with the deterioration in the system much further advanced.

One likely way the new folks could proceed is to stay away from the tar pit of trying to bail out institutions directly and instead opt for an indirect approach. Specifically, the government might choose to bail out homeowners instead. Suppose all homeowners were allowed to refinance their existing mortgage at some low subsidized rate that was also extended to all new buyers, say 4 percent. One catch--the government would have recourse to the borrower and not just the house in the case of default. This is a huge broadening of the plan originally suggested by Martin Feldstein. Not everyone would take this up because it would mean they would have to pay the money back and not just default on their mortgage. So, it would quickly separate the good mortgages from the bad ones that are creating problems in the system.

For those who did take up the plan, a wave of prepayments would begin that would trigger positive cash flow and reduce the risk to all that derivative paper the financial service industry now holds. Prices on that paper would quickly rise and firms would enjoy both more liquidity and more capital. For those who did not refinance, the expectation would be that the house was so far under water that it will ultimately produce a loss. This would help clarify precisely just how much the losses were in the system and on each of the many securitized products and mortgage derivatives as well.

But the biggest advantage is that it avoids the quagmire in which the political class now finds itself. No need for direct bailouts, no need to warehouse paper, no need to hire geeks to figure it all out, and no instant billionaires who simply gamed the system. Better yet for those up for election, no political complaints since it is the voters themselves who were being bailed out.

Lawrence B. Lindsey is a visiting scholar at AEI.