We Deserve a Better Bailout

So there's been a rush to liquidity and a freeze of the various sources of credit that threatens the continuation of the economic life we know and the specter of a crisis even greater than the 1930s. The double bubbles bursting simultaneously in both housing and in the financial world is what broke more than 300 mortgage lenders, bankrupted Lehman Brothers, forced other banks into marriages, and compelled the government to take over Fannie Mae and Freddie Mac. And we are not through yet.

The Treasury Department's solution to this crisis had many, many problems. The idea was to buy depressed mortgage securities and other illiquid, even toxic assets. But how to figure out what to pay for assets that are so complex and so uncertain in value, particularly when many of them remain overvalued on the books of financial institutions? The likelihood is that the government will buy them at a price above market and thus provide a huge, unjustified bailout of Wall Street. On the other hand, if the government buys them at market prices, financial firms might have to take enormous write-offs that would damage their balance sheets and force them to seek billions more in private equity capital, which might not be available. Then they'd have to freeze their lending—the exact opposite of what the program was intended to induce. The above-market price would rescue the financial industry from the consequences of its own misjudgments, profligacy, and greed. Meanwhile, the average American who is forced to sell his home must do so at market prices, not above them.

Public outrage. The reaction in the public was overwhelmingly hostile to this possibility. The average American saw the government as purchasing the bad loans taken on by a reckless and greedy financial sector, transferring billions of taxpayer dollars to these very shareholders and management whose excesses created the crisis and potentially creating a great windfall for these companies and inflicting huge losses on the taxpayers. The same executives who created the problem would gain through the increased value of their stockholdings. This was seen as being contrary to the American economic premise that whoever reaps the gains also bears the losses.

The political antagonism to this perceived undeserved windfall collapsed the bipartisanl support for the plan, and it was rejected by the House of Representatives (with more Republicans voting against it than for it). Abraham Lincoln had it right when he said, "With public sentiment, nothing can fail; without it, nothing can succeed."

But stabilizing the financial markets is an imperative. A major breakdown in the financial world and the credit system would make it impossible to transfer money from those people who have it to those people who can put it to productive use. The real issue is who should bear the cost. It should not be the taxpayer. Why, then, shell out $700 billion to the foolish financiers and deal makers who led their companies into this swamp? Would this not be welfare to the financial elites at taxpayer expense and undermine the moral credibility of future government action?

There's an alternative to buying the bad loans. This would be to invest public funds in these financial institutions through the purchase of prior preferred stock by the government, which would put the government senior to other shareholders. Preferred shareholders—the taxpayers, through the government— would be the last to realize losses and the first to receive gains. This would recapitalize the banking system and give it time to dispose of bad assets in an orderly fashion.

It's the same approach that Warren Buffett adopted when he invested $5 billion in Goldman Sachs. Buffett received dividend-paying preferred stock that ultimately could be convertible into equity in one of the best-managed investment banks in the country. This is similar to the government takeover of Fannie Mae and Freddie Mac.