Treasury Secretary Henry Paulson, left, and Federal Reserve Chairman Ben Bernanke at a Senate Banking Committee hearing September 23rd. (AP Photo)
Long-range issues in resolving the financial crisis
COMMENTARY | September 24, 2008
Among the questions: Who exactly needs to be bailed out; are state pension funds damaged in your area; will programs be cut and taxes raised; will mortgages be modified so that people stay in their houses?
By Martin Lobel and Henry Banta
Here are some of the longer range issues the press needs to look at.
Although the Administration claims that the government needs to take immediate steps to free up the flow of capital so that people can borrow and invest, we need to know more about who needs the bailout, what each step is likely to cost and what the likely consequences are.
Treasury Secretary Henry M. Paulson, Jr.’s, request for $700 billion (plus the $85 billion to bail out AIG, plus the $29 billion to bailout Bear Stearns, plus....) to “solve” the problem without any supervision is, quite justifiably, dead on arrival. First, the $700 billion request may not be enough because it is apparently based on the hope that housing prices will stop going down. But housing prices are likely to decline by another 15 percent as measured by most traditional indices. Second, we need to balance the cost of the bailout against our other economic issues, such as fighting inflation, protecting the dollar, providing for necessary governmental services, etc. Finally, we must weigh the risk that decisions will be made for political not economic reasons.
A central problem is valuing derivatives. If the taxpayers buy derivatives, how do we value them? If they are undervalued, the banks won’t have the capital they say they need to lend. If they are overvalued, the taxpayers are stuck with even higher losses than projected. Industry is trying to use this difficulty of valuing derivatives as a justification for not having to value them on their books at market prices (“mark to market”). They argue, incredibly with a straight face, that their computer models, which got us into the current problem, are more accurate. Some sort of auction is probably the best solution to valuation, but there are lots of technical issues that are unresolved.
More importantly for the economy is reformulating the underlying mortgages so that we don’t have wide swaths of abandoned houses. The best way to do this is to allow bankruptcy judges to modify mortgages that are in bankruptcy or, alternatively, the government could be authorized to buy homeowner mortgages either from bankruptcy or foreclosure, modify them so that homeowners who live in the house can continue to do so at a price they can afford and the government could recoup its investment when the house is sold later.
What the Administration has not discussed is the real derivative problem: credit default swaps (CDS), which one of us wrote about earlier for Nieman Watchdog (click here). A CDS is nothing more than a naked bet that a financial instrument will not decline in value. There are approximately $62 trillion of them floating around internationally. In the past, they generated huge fees as the market went up. Now that the market is going down, they are generating even larger losses. AIG is a very solid insurance company. Unfortunately, one of its units issued so many credit default swaps that it faced bankruptcy—and confusion trying to determine what the losses were. Credit default swaps should either be traded on an open exchange so they can be valued by the market daily or treated as insurance policies. Does anyone know what the Administration’s plans are for them?
We have already seen that the crisis has resulted in mergers that have created a few financial institutions that are now “too big to fail.” Although it is clear that we need to recast our financial regulatory agencies to comport with the financial world as it is today, not as it was in the 1930s, it is also clear from the regulatory failures that led to this crisis that we need additional supervision of the financial institutions. We should not allow financial problems to be “solved” behind closed doors by federal officials who come from the financial industry and who go back to it without at least understanding the competitive consequences of those “solutions.” That means we need an invigorated FTC and Department of Justice Antitrust Division to blow the whistle on anti-competitive solutions because neither their competitors or the public interest groups have the resources to enforce the antitrust laws. We also must make sure that the SEC can supervise their stock offerings because neither the Federal Reserve Board or the Controller of the Currency have either the desire or the ability to properly supervise them.
We need to see what the impact of the financial meltdown is on pension funds. Apparently, a lot of the toxic waste from Wall Street was sold to pension funds, but it is unclear what the impact is likely to be on the pension funds’ obligations to their pensioners or to state taxpayers who stand behind the state pension funds. This also raises the question about whether the trustees or employees of these pension funds violated their fiduciary obligations by buying too risky derivatives in an attempt to avoid fully funding these pension funds.
We need to enforce the fiduciary obligations of members of boards of directors. It is fairly clear that some members and, indeed, in some cases, all the members of the boards of directors of some of these financial firms apparently slept through board meetings. Did they just make bad business judgments or were their failures to act such that they are individually liable for the financial consequences of their actions or inactions?
The current financial regulators likely will argue that we need a clean slate to move forward and that we ought not hold the directors liable for their actions. But, if we are going to justify spending such unprecedented amounts of taxpayer money, we should also hold those who cost us that money responsible for their actions. Then there is the question of executive compensation. In light of the need for a taxpayer bailout caused by the executives’ actions, shouldn’t the executives be required to either disgorge their excessive compensation or, at the very least, work for more reasonable wages?
Since most of the burden of this bailout will fall on the middle class, whose income has failed to grow with increases in productivity, excessive executive compensation has become a paradigm of the problem of income inequality. The massive redistribution of wealth since 2000 to less than 1 percent of the public has many causes: the breakdown in corporate governance that resulted in an explosion in management compensation, an inequitable and essentially unenforceable tax code, and a host of deliberate government policies. The result is a middle class whose spending cannot be expected to sustain the economy. In short, we are going to have to live within our diminished means and make some hard choices. We have to decide what government programs will be cut and what tax increases are going to have to be imposed.
Not to be too pessimistic, the crisis could have a silver lining. We could be forced to really reform government programs to make them more efficient. We could simplify the tax code by eliminating eliminate unjustifiable subsidies, raising more revenue. Congress really only reacts to the general public when there is a crisis—a storm of public opinion. Normally all they hear from are the lobbyists whose employers can afford to buy access. Why else would they allow the tax code to benefit multinational corporations at the expense of domestic corporations?
These are just a few problems that the media need to examine and explain if we are to have real reform.
Henry M. Banta is a partner in the Washington, DC, law firm of Lobel, Novins & Lamont.
Martin Lobel is a partner in Lobel, Novins & Lamont, a Washington, DC, law firm, and chairman of the board of Tax Analysts (www.tax.org), a source for journalists.
Sue Golden Lerner
09/25/2008, 02:29 AM
This should go out as a 1-page point sheet to TV talk shows, news shows
and journalists who have to make a deadline and rarely have time to do a full read to pick up major points. I listen closely to the 'talling heads' and hear little reference to much of what you report.