We Deserve a Better Bailout

In the boom years, the financial world, which we still call Wall Street, reaped rewards to satisfy King Midas. In just one recent year, 2006, its firms paid out an astonishing $62 billion in bonuses (no, this is not a typo).This was a manifestation of a trend in which the financial services industry's share of total American business profits grew from approximately 10 percent in the early 1980s to an incredible 40 percent at its peak last year. These were years of astonishing, almost obscene, multimillion-dollar salaries and bonuses to the denizens of finance.

The public came to think of these firms and markets as the brains of our economy. There's some truth in that. Wall Street allocated both cash and credit more productively than any central planner ever could, and the credit enabled people to invest in the future, to run businesses, and to buy homes. The prestige—and rewards—of finance attracted elites from our best universities and, indeed, the rest of the world.

But the financiers were too clever by half. The "masters of the universe" created not one bubble but two—a housing bubble and then a credit bubble. Now that both have burst, we face a growing danger of a global financial panic. Every day that passes without a remedy multiplies the risk that we might see a complete freeze-up of the financial and credit markets. This would cause a flight from the system that finances all our activities into safe but less productive havens like U.S. Treasury securities. Such a move could cause an economic crash of horrible consequences.

That's why the administration and Congress have no choice but to try to fix things. Unfortunately, they fumbled the first time round. The idea that greed and carelessness might be condoned, much less rewarded, rightly brought an explosion of public anger. Now they're trying again. But the insistent question in the public mind, one to answer before looking for an exit strategy, is how we got into this potentially lethal maze in the first place.

First, housing. People with no credit history and insufficient income were enabled to buy homes with no money down—often at ridiculously high prices. How come? The immediate cause was as much political as financial. In the early days of the housing boom, members of Congress won votes by pressing for "affordable housing" for everyone. Community organizers were eager to get on the bandwagon and round up likely buyers. The money often came from Fannie Mae and Freddie Mac, which both parties protected by allowing them to run with artificially loose rules. Of course, everyone assumed houses would go on appreciating way beyond the value of any collateral, so that somehow it would all work out. These mortgages, and others like them, became the straw out of which the Wall Street money wizards could spin gold by bundling them into bonds and securities to be sold to institutions like banks around the world. The banks bought them because they were highly rated by credit agencies that didn't actually know what they were rating.

Money everywhere. The result was the greatest housing boom in the country's history. Home values appreciated from 2002 to 2006 at the extraordinary rate of 16 percent a year, compared with 3 percent annually in the prior 55 years. But at a point, it became impossible for the typical American family to buy an average-price house using a conventional 30-year mortgage. Those who used so-called teaser mortgages found their payments ballooning. People defaulted, lenders foreclosed, and house prices started falling. Prices are still 60 percent above their value in the year 2000, when they began to go crazy. If they continue to fall, there will be more defaults on mortgages and mortgage securities—and increased personal bankruptcies and credit card defaults.

No one knows what the mortgage securities and the fancy derivatives that emerged out of them are worth, and which firms might fail, since so much was based on the assumption that housing prices would not go down. Nobody knows who owes what to whom and whether borrowers at any level have the ability to pay. Investors have lost the confidence to trade with one another. And confidence is the essential ingredient in the world of finance. Without confidence, the markets stop functioning. We saw that when stock prices of financial firms, especially those that were massively leveraged with excessive debt, plummeted.

Even worse was the run on money market funds after one announced it would give investors less than 100 cents on each dollar invested. By "breaking the buck," this provoked a stampede out of these funds. That, in turn, shrank the commercial paper market, which corporations use to fund their operations, and provoked a sharp rise in the London Interbank Offered Rate, or Libor, the benchmark rate that banks charge to lend to each other.

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.

Why should the public get a worse deal when asked to use its dollars to help lesser-quality financial institutions that have a higher risk? The existing shareholders should be at risk, with their value extinguished or diminished, before the taxpayers are asked to bear the burden of the likelihood that the securities the financial companies hold will further decline. Otherwise, the executives who did so well on the way up will not be responsible for their losses incurred when their business decisions turned out to be flawed. The first description of the plan as a bailout was right: It would bail them out of their mistakes and pay a reward for failure. If there were profits to be made from spending money to shore up the banking system, it should be made by the taxpayers and not just by the political and financial elites who created this mess.

That is why Americans have been furious at these proposals, as they had every right to be. Congress needs to modify the way any rescue effort is executed. The outline of the new effort looks too much like the failed one, but Congress maintains oversight and the ability to influence the execution. Wall Street must be seen to bear responsibility for flawed business decisions. The role of markets to reward success and punish failure should not be undercut.

Congress should get it right the second time around—and quickly.