The Bailout Is A Fraud

In my last column I discussed the bailout as proposed and noted that the proposal cannot succeed if it impairs the US Treasury's credit standing and/or the combination of mark-to-market and short-selling permits short-sellers to prosper by driving more financial institutions into bankruptcy.

A reader's comment and an article by Yale professors Jonathan Kopell and William Goetzmann raise the question whether the Paulson bailout itself might be as big a fraud as the leveraged subprime mortgages.

As one reader put it, " We have debt at three different levels: personal household debt, financial sector debt and public debt. The first has swamped the second and now the second is being made to swamp the third. The attitude of our leaders is to do nothing about the first level of debt and to pretend that the third level of debt doesn't matter at all."

The argument for the bailout is that the banks will be free of the troubled instruments and can resume lending and that the US Treasury will recover most of the bailout costs, because only a small percentage of the underlying mortgages are bad. Let's examine this argument.

In actual fact, the Paulson bailout does not address the core problem. It only addresses the problem for the financial institutions that hold the troubled assets. Under the bailout plan, the troubled assets move from the banks' books to the Treasury's. But the underlying problem--the continuing diminishment of mortgage and home values--remains and continues to worsen.

The origin of the crisis is at the homeowner level. Homeowners are defaulting on mortgages. Moving the financial instruments onto the Treasury's books does not stop the rising default rate.

The bailout is focused on the wrong end of the problem. The bailout should be focused on the origin of the problem, the defaulting homeowners. The bailout should indemnify defaulting homeowners and pay off the delinquent mortgages.

As Koppell and Goetzmann point out, the financial instruments are troubled because of mortgage defaults. Stopping the problem at its origin would restore the value of the mortgage-based derivatives and put an end to the crisis.
This approach has the further advantage of stopping the slide in housing prices and ending the erosion of local tax bases that result from foreclosures and houses being dumped on the market.

What about the moral hazard of bailing out homeowners who over-leveraged themselves? Ask yourself: How does it differ from the moral hazard of bailing out the financial institutions that securitized questionable loans, insured them, and sold them as investment grade securities? Moreover, note Koppell and Goetzmann, bailing out the financial institutions puts enormous power over the economy into executive branch hands and amounts to "transition to a socialist economy."

Socializing the housing market and financial sector is probably too high a price to pay for bailing out private financial institutions. Congress should focus the bailout on refinancing the troubled mortgages as the Home Owners' Loan Corp. did in the 1930s, not on the troubled institutions holding the troubled instruments linked to the mortgages.

Congress needs to back off, hold hearings, and talk with Koppell and Goetzmann. Congress must know the facts prior to taking action. The last thing Congress needs to do is to be panicked again into agreeing to a disastrous course.