Today, I went to see Michelle Obama speak at CU in Boulder. It was a long line, and in that line, I got to talking with lots of fellow progressives. The topic turned to this bailout quickly, and I was surprised to learn from them that they seriously thought there is no bailout necessary. I think a lot of people do not understand the trouble we’re in, and don’t get the proposed solutions. It’s a complex subject, but we must understand the problem if we are going to have any hope of fixing it.
Now, let me offer some background. While, I’m a progressive, I also have a unique perspective on this here bailout. You see, back in the dark days, say, 15 years ago, I was a mortgage-backed securities analyst on Wall Street. In fact, I was one of the guys who helped get us where we are.
At the time, mortgage-backed securities were not even remotely considered evil, as they are today. They were lauded for helping enable more people, and more diverse and first-time borrowers, to buy homes. Being a mortgage-backed securities analyst, and creating and selling mortgage securities, was a good thing.
What went wrong? Well, if you’re looking to fix blame, the answer is that Phil Gramm repealed the Glass Steagall Act, which was a depression-era rule set up to keep banks, who tend to be conservative, separate from investment banks, who are engaged in a highly speculative business. He did other great things too, like enabling Enron to game the energy market. He then reaped the rewards for all his great work by getting a cushy sinecure at UBS, the Swiss Bank, which he has to this day. Great guy. No other single American is more responsible for what’s gone wrong. They had a good thing, and they went too far. Changing the rules, and then not enforcing any oversight, were big reasons we’re in this mess.
But what exactly is this mess. I think a lot of Americans, like the folks I stood with in line today, do not understand the exact nature of the mess. Because of this lack of understanding, they’re left with platitudes, like "We shouldn’t spend what we don’t have". And they begin to come under the sway of some ridiculous arguments. There is a lot wrong, but let’s at least understand the nature of the crisis, before coming up with solutions. What you will find is that this latest bailout bill is actually worse than the old one. You will also find that there’s lots of potential to get out of this without a Great Depression, if we just do the right thing.
So what’s the problem, again? Mortgage backed securities, and derivatives, are bonds, or revenue streams, which use large pools of U.S. mortgages as assets. So let’s say you take a thousand mortgages and put them in a "pool", or trust. You then carve that pool up into different pieces, and sell the pieces. You can carve the revenues from those thousand mortgages any way you like, depending on your buyers. Some buyers will like to get just the Principal, others want just the Interest. You make certain assumptions, like assuming an acceptable rate of refinancings, etc., and you sell the pieces for more than what the whole was originally worth. Make sense? It did, and it worked brilliantly for three decades.
So what finally went wrong? When the U.S. housing bubble finally burst, the underlying assumptions which allowed traders to price these securities were called into question. Suddenly, no one knew exactly how a specialized Interest-Only security would behave, exactly. Derivatives still had value, but because no one knew how to set that value, no one would buy one. Suddenly, whole multi-billion dollar markets dried up. Once again, the securities still had value, but they could not be sold. That’s illiquidity, and that’s the crisis we’ve been in over the past few weeks. That’s the reason that Bear Stearns collapsed, and then the rest. Two of the six bulge bracket banks have collapsed, and we are staring a worldwide credit market collapse in the face.
So what’s the answer? Much as it pains me to say, Secretary Paulson’s approach would have addressed the problem. By setting a floor of 20 cents on the dollar for any mortgage-backed derivative, the plan would have provided immediate liquidity. There was no bureaucracy. Just a simple price, and a fund. It would have worked. In fact, it could have made the American taxpayer some money. How? These securities, once brought together in a gigantic pool, would once again have the risk profile of their underlying U.S. mortgages. In other words, acceptable risk. By putting Humpty Dumpty back together again, the U.S. Treasury would be buying securities at 20 cents on the dollar which would eventually very likely be worth more than that. Only the U.S. Treasury has the size, and the long-term horizon, to see these through to a profit.
So that’s what was right with the old plan. Now to what was wrong with it. What was wrong with it was that it was fundamentally unfair, and profoundly arrogant. Unfair, because it would bail out investment banks, but do nothing to help homeowners. Arrogant, because it allowed for no oversight, and forced us to trust another of Bush’s cronies. Add to that the notion that foreign banks would be bailed out too (did you know that Phil Gramm is the Vice Chairman of UBS?). Most importantly, it did little to put us back on the right track, and to provide real fixes to this mess.
So it was a problematic bill.
The problem now is that this new bill is far worse. Rather than address the weaknesses of the old bailout, this new one adds whole new weaknesses. It is, literally how the Congress works. Something hard to swallow? Just add enough sweetener. Now we get more tax breaks, and we get to force health care providers to not deny mental health patients coverage for their preexisting conditions. Are you kidding me? Either of these may have been good ideas. But they have exactly NOTHING to do with the bailout. If anything, they make our problem worse, by extending the deficit even further. Of the sweeteners, only a third, raising the FDIC insurance limit to $250,000, has anything even remotely to do with this crisis. It’s a fine idea, though tiny in its scope.
You want to improve a bailout? How about addressing the fundamentals? How about making it fairer by providing direct relief to homeowners who can’t pay their mortgages? How about foreclosure relief? How about reinstating Glass Steagall? You want CEOs to pay? How about taxing golden parachutes and stock incentives as income? It’s not rocket science, really. It just boils down to two things. First, are we willing to be fooled, and second, are they willing to fool us. Check that. It boils down to one thing.