The Main Principle for a Market Intervention

I'm a bailout skeptic.  Not because I think that nothing should be done, but because the tendency of government in crisis is to overreact in ways that cause long term problems (think WPA and price controls in the Depression, or at least 80% of the reaction to 9/11). 

But on the other hand, if a lack of action is going to trigger or dramatically deepen an unrelated recession, I'm certainly not for that either.  I thought that Congress was going to act quickly enough that I could avoid comment, but I have a bit of time so I wanted to mention an important concept that ought to weigh heavily:

To whatever extent possible, the equity and bond investors who invested in the failing companies should lose their investments. 

This is important not to 'punish' or to be mean, but because investment markets are supposed to be about weighing risk.  As such, big investors are supposed to try to find high paying investments *that are also in line with their risk*.  If you save the investments when the down side of risk pays off, they will be able to make worse and worse choices believing that the government will save them if they fail.  That is one of the reasons that AIG went under the way it did, it rejected sale offers from private companies because its directors believed that they would get a better deal from the government. 

Now it may be that it is impossible to save the system to the extent that we need to without at least partially bailing out these investors.  I'm not expert enough at the gritty details to be sure.  But I do want to know that to the extent possible, the investors who made bad decisions are being forced to pay off for their risky behaviour. 

One of the most horrible long term things government intervention did for the automobile companies under Carter was bailout Chrysler.  It was horrible because it allowed both of the other major companies to believe that they didn't have to make the tough choices to really succeed, because the government wouldn't let them fail. 

If our main concern is framed along the lines of "the sky is falling the government has to DO something", I fear that the thing the government does is likely to be counterproductive to the health of the economy in the long run. 

I'm not happy that 'a' bailout failed yesterday.  But I'm not at all sure that 'the' bailout really kept the most important principle in mind.  Especially in its original form, it looked like a just do SOMETHING bailout.  And not all SOMETHINGS are good. 

Comments

[Roger Moore]

Can I ask a stupid question?

Why is it such a disaster if folks find themselves upside down on their mortgage?

It's not so much that being upside down is a disaster. It's that it's much harder to sell or refinance a home without equity. So if some unexpected event comes along that would otherwise force you to sell or refinance- you need to move, you're having trouble making your payments, etc.- being under water deprives you of options.

[Nell]

To a post at Calculated Risk consisting of analysts ripping the proposed shift away from 'mark to market', there is a comment (from someone who also doesn't like it) that makes an effort to state the SEC's case:

let me begin by stating that I think this is a horrible idea. however, it was also inevitable.

as soon as these banks and financial institutions go bk/receivership/etc they have to sell their assets. This causes a new "mark" which causes a new wave of write downs and more firms go under. domino effect. Suspending the FASB rule is in theory a circuit breaker.

in theory suspending these rules, buys the firms time to recapitalize (using the $700b to start) so that they can absorb the writedowns later on.

Japanese system part deux.

we must remember: it is possible that our system CANNOT SURVIVE a rapid price discovery, no matter how much its needed. I'm not saying it should survive, only that it might not survive if we do no bailout and no accounting gimmicks.

I'm guessing that the foreign firms won't care much because they're gonna do exactly what we do. it's a race! and so far the US is out in front. but don't worry, the rest of world will catch up.

To add spice to that last bit: Turns out that AIG's fancy financial unit was helping European banks evade regulatory reserve requirements, and they're now in need of someone else to fill that role. Can't find link right now.

[Nell]

Paul Kedrosky:

Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered -- at triple-A, no less -- while carrying less cash than required.

I'm not suggesting that this was an outright scam. Instead, it was just another example of how an over-connected financial market with too little slack ended up being under-collateralized and far riskier than any of its participants expected. And it helped that we had been living through a period of relative crisis quiet, boosting the illusion that all was eternally well.

The upshot, of course, is that the European banks are generally more levered than their U.S. counterparts. With that coming into plain view in the absence of the regulatory arbitrage cover provided by AIG's swaps, that helps explain what we are now seeing on the Continent at present.

[Slartibartfast]

Slarti, are you still in Boston? If you're up for it, I'll buy you a beer.

I regret to say that I'm not. Free beer...I hate to miss out on that. And of course there was the missed opportunity to regret. I often wonder what other commenters are like in person, and I would have jumped at the chance.

Actually was staying in Framingham, but we made a number of trips downtown. I was there Thursday night (nominally; actually my flight was delayed by four hours and I didn't land until Friday morning) through Monday morning. Was in Boston downtown area Friday night and Sunday afternoon. Had to do the Freedom Trail, yanno.