US Treasury Secretary Hank Paulson’s US$700 billion rescue package has run into difficulty on Capitol Hill. Rightly so: it is ill-conceived. Congress would be abdicating its responsibility if it gave the Treasury secretary a blank check. The bill submitted to Congress even had language in it that would exempt the secretary’s decisions from review by any court or administrative agency — the ultimate fulfillment of the US President George W. Bush’s dream of a unitary executive.
Paulson’s record does not inspire the confidence necessary to give him discretion over US$700 billion. His actions last week brought on the crisis that makes rescue necessary. On Monday he allowed Lehman Brothers to fail and refused to make government funds available to save AIG. By Tuesday he had to reverse himself and provide an US$85 billion loan to AIG on punitive terms.
The demise of Lehman disrupted the commercial paper market. A large money market fund “broke the buck” and investment banks that relied on the commercial paper market had difficulty financing their operations. By Thursday a run on money market funds was in full swing and we came as close to a meltdown as at any time since the 1930s. Paulson reversed again and proposed a systemic rescue.
Paulson had gotten a blank check from Congress once before. That was to deal with Fannie Mae and Freddie Mac. His solution landed the housing market in the worst of all worlds: Their managements knew that if the blank checks were filled out they would lose their jobs, so they retrenched and made mortgages more expensive and less available. Within a few weeks the market forced Paulson’s hand and he had to take them over.
Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value but the sellers know more about them than the buyer: In any auction process the Treasury would end up with the dregs. The proposal is also rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?
Senator Barack Obama has outlined four conditions that ought to be imposed: an upside for the taxpayers as well as a downside, a bipartisan board to oversee the process, help for homeowners as well as the holders of the mortgages and some limits on the compensation of those who benefit from taxpayers’ money.
These are the right principles. They could be applied more effectively by capitalizing the institutions that are burdened by distressed securities directly rather than by relieving them of the distressed securities.
The injection of government funds would be much less problematic if it were applied to the equity rather than the balance sheet. US$700 billion in preferred stock with warrants may be sufficient to fill up the hole created by the bursting of the housing bubble.
By contrast, the addition of US$700 billion on the demand side may not be sufficient to arrest the decline of housing prices. Something also needs to be done on the supply side.
To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay.
The rescue package leaves this task undone. Making the necessary modifications is a delicate task rendered more difficult by the fact that many mortgages have been sliced up and repackaged in the form of collateralized debt obligations. The holders of the various slices have conflicting interests.
It would take too long to work out the conflicts to include a mortgage modification scheme in the rescue package. The package can, however, prepare the ground by modifying bankruptcy law as it relates to principal residences.
Now that the crisis has been unleashed, a large-scale rescue package is probably indispensable if the crisis is to be brought under control. Rebuilding the depleted balance sheets of the banking system is the right way to go. Not every bank deserves to be saved, but the experts at the Federal Reserve, with proper supervision, can be counted on to make the right judgments.
Managers that are reluctant to accept the consequences of past mistakes could be penalized by depriving them of the Fed’s credit facilities. Making government funds available would encourage the private sector to participate in recapitalizing the banking sector and ending the financial crisis.
George Soros is chairman of Soros Fund Management.
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