Three years have passed since I wrote the "Atlas Bailed" piece. Today I read that the FDIC has finally hatched a plan to deal with failures at large-scale financial institutions. Click here for the WSJ article.
While people with a deep understanding of the matter see that allowing failures to occur is clearly the "right" policy to foster properly functioning capital markets, the general public has been snowed into the belief that the bailouts were a success. Few realize that we can trace our moribund economy, zombie banking institutions, fragile and inefficient capital markets, as well as the exploding federal reserve balance sheet directly to these bailouts. They also don't realize that the story is far from over. We will revisit these issues again - the underlying problems were never addressed.
Thursday, May 10, 2012
Tuesday, March 10, 2009
Atlas Bailed - An Argument for Controlled Failure of Insolvent Financial Institutions
The financial rescue package’s $1.5 trillion price tag (including the proposed budget) is pretty astonishing but what's even more amazing is how few are questioning it. Sure, we hear grousing about the lavish pay packages and junkets the banks are paying for with taxpayer money, but our politicians and the mainstream media are not questioning the basic idea of the bailout nearly to the extent that they have opposed parts of the stimulus package. Instead we're relying on the "expert" advice of many of the same people that got us into this situation in the first place - the thought being that if we don't listen to them our financial system may collapse. But we're missing something big here. A bailout is an ineffective use of our money. It not only perpetuates a broken system and rewards those who abused it most but it also amounts to a large transfer of wealth from the middle and lower income masses to the better-off few. Moreover, if the crisis runs as deep as many prominent economists fear, the rescue package won't work; it will just forestall failure and promote "zombie" institutions, delaying our recovery.
As complex as the financial crisis can sound with all of the different instruments and interrelationships, the most important aspects of the problem are not all that difficult to comprehend. Low interest rates and lax regulation allowed our society to rapidly expand the amount of debt we use. Not only did we consumers take on more debt but so did many financial institutions. Abundant money at low rates created a money- making machine for these institutions which borrow at low rates and lend money at higher rates, pocketing the spread. While the money-making machine was functioning and the margins were large, these companies were motivated to borrow larger and larger sums to boost earnings. Unfortunately this created a dynamic where too much money was chasing too few opportunities and loans were made that shouldn't have been - thus the saying "risk was mispriced." Financial institutions financed purchases of these risky loans almost exclusively with debt, which means they simply didn't have much cushion to protect themselves or their lenders in the low probability event that these loans would go bad. So when a few over-extended borrowers could not pay some highly levered lenders, the disaster began. Fear and deleveraging are bringing us close to a self-feeding deflationary spiral which threatens our financial system.
Now the financial institution managers representing lenders, stock holders, and employees come to us with one outstretched hand asking for money while the other wields a hammer, ready to bludgeon us with the threat of system-wide failure. The hammer makes it difficult to press the matter but we need ask the question more forcefully, “why should we taxpayers bail out lenders and what happens if we don't?” Understand that a bailout in any form essentially involves giving taxpayer money to lenders who made bad loans. Taxpayers, who on average are not particularly well-off, will be rescuing relatively wealthy people who lost money buying securities that carried some risk. If the taxpayer doesn’t comply, these managers tell us that the entire financial system is at risk.
But is that really the case? If it is, what does that mean to the average taxpayer? Because financial institutions engage in many transactions with one another, there is the potential that a couple large failures could bring down many more banks - the domino effect. While this is a serious concern, we've had many bank failures in the past (534 in a single year - 1989) and this didn't destroy our financial system. So what would mass bank failures mean? Is the answer so awful that taxpayers should write a blank check to the financial industry to avoid it?
The federal government can allow banks to fail in a controlled manner. Equity holders would be wiped out and creditors would divvy up the remaining assets. The FDIC would be named a receiver and the insured depositors would keep their money. Most front-line employees could keep their jobs, and the bank could be run by the government until a private buyer is found. The federal government could even take care of deposits that are over the insurance limit – recognizing that doing so would be much less expensive than pumping enough new capital into these institutions to keep them solvent. Although mass failures would be disruptive, they wouldn't necessarily be disastrous to most taxpayers. The people who would suffer most are the equity and debt holders of these institutions.
Failure is part of capitalism. It’s the free-market's "self cleaning" function rewarding smart risk-takers at the expense of those poorly positioned. Letting institutions fail means that the government will not have to decide winners and losers -- or help manage solvent institutions. And just as weeding out the weak wildebeests keeps the herd healthy, so it goes with financial institutions. On the other hand, a bailout can prolong the economic downturn as strong institutions don't want to lend because they don't know who is solvent and the "zombie" banks the bailout has created won't lend because they're too precariously positioned.
The biggest irony, and one that seems to have escaped notice, is that the "Masters of the Universe" from Wall Street are asking us to take leave of free markets and capitalism because the markets have moved against them. Indeed, these "sunshine capitalists" scoff at the notion of nationalizing the banks as anti-free-markets while supporting financial "handouts" as a means to rescue ailing institutions. They've become confused (it probably has something to do with self-interest) but the (temporary) nationalization we're referring to is just the end result of market forces. When a large bank fails, the government can intervene to calm fears before reconstituting the institution and privatizing it with new owners. But what the Masters of the Universe propose is truly offensive to any real free market proponent: lenders enjoy the benefits of taking risks while the economy is humming but taxpayers bear the downside when the environment turns ugly.
We're in the midst of one of the more severe economic downturns in this country's history. How we respond to this crisis is a real test of our dedication to the ideals of free markets and capitalism. It is a defining moment in our history. If we continue propping up failing institutions whether auto manufacturers, insurance companies, investment banks or commercial banks -- we not only prolong our pain and weaken our future prospects, but we risk undermining investors' faith in the ability of our markets to determine economic outcomes. Economic downturns promote the reallocation of the productive factors of an economy – basically, society redirects resources into new opportunities. Let's not let our government prevent one of the few benefits of an economic downturn in the name of preserving the status quo. Let's take these awful lumps as quickly as possible and get on with enjoying the best, most flexible and responsive economy in the world.
As complex as the financial crisis can sound with all of the different instruments and interrelationships, the most important aspects of the problem are not all that difficult to comprehend. Low interest rates and lax regulation allowed our society to rapidly expand the amount of debt we use. Not only did we consumers take on more debt but so did many financial institutions. Abundant money at low rates created a money- making machine for these institutions which borrow at low rates and lend money at higher rates, pocketing the spread. While the money-making machine was functioning and the margins were large, these companies were motivated to borrow larger and larger sums to boost earnings. Unfortunately this created a dynamic where too much money was chasing too few opportunities and loans were made that shouldn't have been - thus the saying "risk was mispriced." Financial institutions financed purchases of these risky loans almost exclusively with debt, which means they simply didn't have much cushion to protect themselves or their lenders in the low probability event that these loans would go bad. So when a few over-extended borrowers could not pay some highly levered lenders, the disaster began. Fear and deleveraging are bringing us close to a self-feeding deflationary spiral which threatens our financial system.
Now the financial institution managers representing lenders, stock holders, and employees come to us with one outstretched hand asking for money while the other wields a hammer, ready to bludgeon us with the threat of system-wide failure. The hammer makes it difficult to press the matter but we need ask the question more forcefully, “why should we taxpayers bail out lenders and what happens if we don't?” Understand that a bailout in any form essentially involves giving taxpayer money to lenders who made bad loans. Taxpayers, who on average are not particularly well-off, will be rescuing relatively wealthy people who lost money buying securities that carried some risk. If the taxpayer doesn’t comply, these managers tell us that the entire financial system is at risk.
But is that really the case? If it is, what does that mean to the average taxpayer? Because financial institutions engage in many transactions with one another, there is the potential that a couple large failures could bring down many more banks - the domino effect. While this is a serious concern, we've had many bank failures in the past (534 in a single year - 1989) and this didn't destroy our financial system. So what would mass bank failures mean? Is the answer so awful that taxpayers should write a blank check to the financial industry to avoid it?
The federal government can allow banks to fail in a controlled manner. Equity holders would be wiped out and creditors would divvy up the remaining assets. The FDIC would be named a receiver and the insured depositors would keep their money. Most front-line employees could keep their jobs, and the bank could be run by the government until a private buyer is found. The federal government could even take care of deposits that are over the insurance limit – recognizing that doing so would be much less expensive than pumping enough new capital into these institutions to keep them solvent. Although mass failures would be disruptive, they wouldn't necessarily be disastrous to most taxpayers. The people who would suffer most are the equity and debt holders of these institutions.
Failure is part of capitalism. It’s the free-market's "self cleaning" function rewarding smart risk-takers at the expense of those poorly positioned. Letting institutions fail means that the government will not have to decide winners and losers -- or help manage solvent institutions. And just as weeding out the weak wildebeests keeps the herd healthy, so it goes with financial institutions. On the other hand, a bailout can prolong the economic downturn as strong institutions don't want to lend because they don't know who is solvent and the "zombie" banks the bailout has created won't lend because they're too precariously positioned.
The biggest irony, and one that seems to have escaped notice, is that the "Masters of the Universe" from Wall Street are asking us to take leave of free markets and capitalism because the markets have moved against them. Indeed, these "sunshine capitalists" scoff at the notion of nationalizing the banks as anti-free-markets while supporting financial "handouts" as a means to rescue ailing institutions. They've become confused (it probably has something to do with self-interest) but the (temporary) nationalization we're referring to is just the end result of market forces. When a large bank fails, the government can intervene to calm fears before reconstituting the institution and privatizing it with new owners. But what the Masters of the Universe propose is truly offensive to any real free market proponent: lenders enjoy the benefits of taking risks while the economy is humming but taxpayers bear the downside when the environment turns ugly.
We're in the midst of one of the more severe economic downturns in this country's history. How we respond to this crisis is a real test of our dedication to the ideals of free markets and capitalism. It is a defining moment in our history. If we continue propping up failing institutions whether auto manufacturers, insurance companies, investment banks or commercial banks -- we not only prolong our pain and weaken our future prospects, but we risk undermining investors' faith in the ability of our markets to determine economic outcomes. Economic downturns promote the reallocation of the productive factors of an economy – basically, society redirects resources into new opportunities. Let's not let our government prevent one of the few benefits of an economic downturn in the name of preserving the status quo. Let's take these awful lumps as quickly as possible and get on with enjoying the best, most flexible and responsive economy in the world.
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