It appears that Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have persuaded congressional leaders to support a new government agency, modeled on the 1980s' Resolution Trust Corp. and the 1930s' Home Owner Loan Corp. Both agencies absorbed bad debt, then eventually sold off the collateral and went out of existence. House Financial Services Committee Chairman Barney Frank called for such an agency earlier in the week, and so it seems very likely that this will pass before Congress leaves on its fall recess. As I write, the stock market is up sharply; investors seem to assume that this is going ahead.
What are we dealing with? A very interesting New York Times blog provides a primer on what has been going on. And my American Enterprise Institute colleague Peter Wallison has been on top of the issues involving the government-sponsored enterprises Fannie Mae and Freddie Mac for years. As I see it, the root cause of the crisis was that the rating agencies that rate bonds were improperly incentivized under the regulatory framework established by the Securities and Exchange Commission; they were paid by the sellers and not the buyers of securitized mortgages. Hence, they had an incentive to give those securities unduly high ratings. Just about everyone in the financial markets seems to have taken these ratings seriously. Now that it has become clear that the ratings vastly underestimated the risk of mortgage default, everyone has realized that financial institutions have vast amounts of securities in their portfolios that are worth much less than they thought—and no one has any clear idea of how much less. All of which led to the collapse of Bear Stearns, the government takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the absorption of Merrill Lynch by the Bank of America, and the government loan to AIG.
Here is another interesting piece on how the Wall Street "quants" underestimated risk: They assumed nothing could get much worse than it had in the past two or three years. And they evidently took at face value the bond ratings of securitized mortgages. In retrospect, it's clear now that regulators need to set up a system where buyers of such securities pay for the ratings firms through something like a tollbooth. It may be difficult to set up, and it may be hard to incentivize the ratings firms to provide more stringent assessments, but it should be possible. One step is for the SEC to change its regulations to encourage, rather than discourage as it does now, other firms to enter the ratings business.
The presidential candidates have been slow off the mark on all this. Barack Obama has still not weighed in on whether the AIG loan was the right move, while emitting largely content-free populist rhetoric. John McCain did not do much better earlier in the week, though he gave a reluctant endorsement of the AIG loan. But on Thursday, he spoke up and called for a new Resolution Trust Corp. before Paulson and Bernanke acted:
I am calling for the creation of the mortgage and financial institutions trust—the MFI. The priorities of this trust will be to work with the private sector and regulators to identify institutions that are weak and take remedies to strengthen them before they become insolvent. For troubled institutions this will provide an orderly process through which to identify bad loans and eventually sell them.
This will get the treasury and other financial regulatory authorities in a proactive position instead of reacting in a crisis mode to one situation after the other. The MFI will enhance investor and market confidence, benefit sound financial institutions, assist troubled institutions and protect our financial system, while minimizing taxpayer exposure.
He might have added (but didn't, in his desire to keep a distance from George W. Bush) that the Bush administration called for the same thing in 2003. McCain also called, inexplicably as far as I am concerned, for the firing of SEC Chairman Christopher Cox, which was the lead on the McCain stories in Friday's morning papers. At the same time, the McCain campaign finally noticed what David Frum blogged about on Wednesday, that McCain himself had in 2005 cosponsored a bill to impose tighter regulation on Fannie Mae and Freddie Mac. McCain spoke about that in his speech Thursday, and the campaign put out ads linking Obama to former Fannie Mae CEOs Franklin Raines and Jim Johnson. And the latest ad hits Obama for not taking a stand on the AIG loan. Pretty hard-hitting stuff but justified on the record.
Finally, here's an interesting question. Was New York Attorney General Eliot Spitzer's successful drive to oust Maurice Greenberg from control of AIG a good idea? Some think not. There's no telling whether Greenberg would have disentangled AIG from the credit default swaps that seem to have undermined its creditworthiness and led to its collapse and government takeover. But there's at least the possibility that Greenberg would have kept AIG out of this mess—and the certainty that its current management, essentially installed by Spitzer, failed to do so. That counts as something like 85 billion reasons why Spitzer's move was bad public policy.