Well OK, I like the bailout (or "rescue") bill the way a medieval prisoner would like lethal injection, when the other choice is disembowelment. But here we are. We all believe we're at a point in history where a failed governing philosophy is about to be thrown out, and we need to put a better one in its place. I think this bill is a big step in that direction.
We've been treated to some great diaries by bonddad and others explaining how this financial crisis came to be and what's happening inside of it. If I could vastly over-simplify for a moment, here's what happened:
- Financial institutions sold risky mortgage-backed securities to each other. These had names like "credit default swaps" and bundles of "sub-prime mortgages." The deals appeared lucrative, but neither buyer nor seller understood the risk.
- Financial institutions sold risky mortgages to consumers. These had names like "zero-down," "adjustable rate," and "no documentation." The deals appeared lucrative, but neither buyer nor seller understood the risk.
The risk in all these deals was leverage. What that means is that if you took out a zero-down mortgage, you promised your bank a huge amount of money, but had no equity and (if you're like most people) very little cash, to back up your promise. All you had is faith that you would keep your job and be able to make the payments. Your bank also had faith that you would keep your job, and that your house would increase in value. All of the securities I listed above, even the most complicated ones, were based on the same kind of leverage and the same faith.
Of course, it turned out the faith wasn't justified. People lost their jobs and home values went down. Faith-based securities lost their value. And investors came to realize that they never really knew how much these securities were worth to begin with. Yet, they were using these securities like cash, and they were being accepted throughout the economy. So suddenly firms counting on the value of these securities weren't able to pay their bills. And that's what we call the crisis of liquidity.
How did firms develop this false confidence? We've been through this before. I work in a unique niche that is a combination of economics and bridge engineering. I have a story that will help.
Back in 1883, the longest suspension bridge in the world, and the first made of steel wires, opened in New York. The Brooklyn Bridge was a marvel, almost magic, and the first of many progressively more ambitious bridge designs.
One of these ambitious new designs was the Golden Gate Bridge, which opened in 1937. Compared to the Brooklyn Bridge, it was much longer and its deck was much more slender. It was comparatively lightweight, and therefore beautiful and affordable.
During the 1920s and 1930s, designers raced each other to come up with more and more slender and lighter designs. No one knew how slender a bridge deck could be. They didn't have computers to analyze it. They built a bridge a little lighter than the last one, and if nothing bad happened then they built an even lighter one.
In 1940 the lightest one yet, the Tacoma Narrows Bridge, opened in Washington State. The bridge had such a slender deck, that it would sway and buck in the wind. Locals called it "Galloping Gertie." On November 7, 1940, it galloped its last:
Because of Galloping Gertie and other incidents of the mid-20th century, civil engineers became a lot more conservative. Not conservative in the political sense — we have more Democrats than Republicans — but in the careful sense. We love innovation, but we've become very sensitive about risk. We measure it, analyze it, and build it into our design codes. Scientists and labs and wind tunnels and databases and computer models all over the world study structural risk.
These organizations are both public and private, but they are demanded and funded by government. They make up what could be called our risk management infrastructure. It may seem a little socialistic that we have this gigantic government-funded infrastructure that produces volumes and volumes, shelf upon shelf, of complex rules and regulations. But civil engineering is a vibrant field with thousands of competing firms ranging in size from one person to tens of thousands. It's a hotbed of entrepreneurs. I'm one of them. If anyone is hampered by these rules and regulations, you wouldn't know it. The rules make it easier, not harder, to build a firm.
Why is government the right sector to do this? For one thing, it costs too much for the private sector. If each engineering firm were required to quantify the risk of its own designs, there would be no one-person firms, probably none less than 10,000 people. Risk analysis doesn't help anyone win the next design contract, so there's no incentive and no accountability. It's a field that's constantly changing, right out in the open. Someone at a lab in Croatia collects and publishes data on flutter in cable-stayed bridges, and an engineer in Arkansas picks it up and puts it to work. We build on each other's work, we don't keep trade secrets in this area, so we learn fast.
I believe the financial markets are at the Galloping Gertie stage. Just like the early bridge designers, they've been winging it. We can't afford that any longer. We need a risk management infrastructure. In this bill, I see all the basic ingredients necessary to get it going. For example:
- On page 9, the Secretary of the Treasury is charged with publishing methods for pricing and valuing troubled assets. No such methods currently exist, which is part of the problem. It's a hard problem, but not any harder than quantifying the risk that a bridge will fall down. It could be a good example of a higher professional ethic in finance.
- On page 11, the Secretary is charged with establishing a program of insurance for troubled assets, to charge a premium for that insurance, and to publish the methodology for setting premiums.
- On page 19, the Secretary is required to publish a great deal of data concerning its transactions.
- On page 20, the Secretary is charged with submitting to the Congress a Regulatory Modernization Report, which analyzes the current regulatory environment and recommends improvements.
- Sections 109 and 110, starting on page 25, describe a whole suite of provisions for reducing foreclosure risk for individual homeowners.
- Section 113, starting on page 33, describes a suite of measures to reduce risk to taxpayers.
- Section 114, on page 39, mandates market transparency.
- Section 117, starting on page 56, directs the Comptroller General to study and report on the use of leverage in general.
- The act provides funding and an institutional home for all these activities.
- The act provides a variety of oversight mechanisms and cross-checks which, among other things, will make it difficult even for a large criminal enterprise to capture it.
I know none of us likes to be in the economic mess we're in. It's the unavoidable price of 30 years of
laissez faire that arguably constitutes criminal neglect. We need to set the economy on a better course, and clearly disavow the failed governing philosophy of the past. This bill is a great way to get that started.