Everyone Get Our Your Buckets and Start Bailing

The bailout.

I haven't blogged all week because I didn't know what to say about the bailout.

I am opposed in theory. But I think we all agree that something has to be done. Even Newt Gingrich has finally agreed that the government has to do SOMETHING, if for no other reason than that the government has to look like it is doing something. So much of the market is based on investor confidence - a lack of government intervention would erode that confidence, even as people in all walks of life decry a government bailout.

I disagree with President Bush's plan, even though I believe that it has gotten an unfair shake. Apparently, the plan is not to use $700 billion to buy all of the mortgaged backed securities that are clogging banks and investment houses on Wall St. To simplify the issue: mortgage-backed securities are the cause of the current problem. Mortgage companies began packaging and selling mortgages as investments. People bought the securities because it looked like the housing market would never go down. When the market did drop and people started defaulting on their mortgages, the securities on which the mortgages relied began to lose value. Now, because no one knows how many people will eventually default on their loans, no one wants to buy these securities. So banks have two problems: valuation (no one knows the value of the securities, so no one buys them) and liquidity (they can't easily sell the securities, so they don't have the necessary liquidity to give out loans, make other investments, etc.)

The basics of Bush's plan is that the government will start to buy the mortgage-backed securities through what is called a reverse auction. Basically, banks will offer the securities at a certain price and the government will buy the lowest priced securities. The point is that, once the government sets the price for the mortgage backed securities, there will no longer be a valuation problem - everyone will know what they are worth. Theoretically, once the valuation problem is gone, the liquidity problem will also be solved as people again start trading in the securities.

Another aspect of Bush's plan is that the government will actually be investing. On the whole, most of the mortgages will be paid in the long run and the government will likely make a decent return on the investment. So, it may end up having a high short-term cost, but a long-term benefit. Of course, no investment is guaranteed.

One might ask: if the government is only going to aid in the valuation of the securities, why does it need $700 billion. This seems to be the question that Congress is asking, as they have toyed with the idea of only approving $250 billion initially with the rest conditionally available. Not a bad idea, though Paulson says it's not enough.

The reason for his assertion is his philosophy that if everyone knows you have a bazooka, you might never have to use it. If investors see that the government is willing to put $700 billion where it's mouth is, consumer confidence will be high and Paulson will never have to spend all of it. That's the theory anyway.

But I disagree with Bush's plan for two reasons: first, it does put $700 billion of the tax payers' money at risk. Paulson might be a wise steward of the money, but he will not be the treasury secretary forever. The next one might not be so principled. In addition, you do not solve problems in the market by giving the players a do-over - buying up all their bad debt and letting them stay in business and go out and make other bad decisions. We shouldn't be afraid to let companies fail when they make bad decisions.

However, as I stated earlier, the government must do something. I believe the best course of action would be for the government to do two things: first, instead of buying the bad investments, set up a system to guarantee the underlying mortgages. This will basically fix the valuation problem, since the securities can once against be valued on the basis of knowledge that the loans will be paid off. In addition, the government should suspend the capital gains tax, as Newt and other have suggested. This will further encourage other to invest in these securities, especially if they know that they will keep all of the profits if the securities once again increase in value.

This idea has one huge benefit over President Bush's plan. Wall Street has to get itself out of the mess. The Government will help bu guaranteeing the mortgages, but it is Wall Street that will have to figure out the valuations and buy the bad debt. In addition, while the government will have to pay money for loans that have defaulted, most loans will be paid back and the overall cost will be much less than $700 billion. Government basically stays out of the market and saves a lot of money.

This type of plan is currently being supported by House Republicans. Some suggest that Democrats will eventually agree with this plan because they are afraid of the political fallout if they pass a bill without Republican support - and Republicans have said they will not support Bush's plan.

One other interesting note. When McCain "suspended" his campaign and went to DC to help fix the problem, Democrats like Harry Reid and Barney Frank began complaining that they basically had a deal done and that McCain inserting himself into the negotiations basically destroyed that agreement. They complain that McCain has cause more harm than good. But here is the thing, if we end up with a better plan than what Democrats would have passed, McCain will be able to take a lot of credit. McCain correctly noted that House Republicans were essentially not involved in the negotiations. He went into DC and got the Republicans to the table. If we get a better deal out of this, McCain will not be a problem, but part of the solution. This will certainly help in November, even though the last week has been very bad to McCain at the polls.

We should see what Congress comes up with by Monday.