A Little History: How We Got Here
The Security & Exchange Commission (SEC)
The Security and Exchange Commission (SEC) was originally setup during the Great Depression to regulate and oversee the investment firms that manipulated the market and helped cause the 1929 crash. The core purpose of the SEC is to keep an eye on the markets to ensure that market manipulation and corporate greed (the constant grasping toward short term profits) would not cause another crash (like the one we’re seeing now).
As CEO of Goldman Sachs, one of the nation’s largest investment houses, Henry Paulson (now the Treasury Secretary) was long a fan of “voluntary regulation” where businesses simply monitor their own actions without external oversight. As the Goldman Sachs CEO, Paulson also lobbied the Bush administration for a voluntary commission at the SEC that would allow the largest investment banks (the “big 5”) to oversee themselves. In 2004 they got their wish, and SEC Chair Chris Cox setup their voluntary regulation scheme, allowing the largest investment houses to avoid regulatory oversight.
More after the jump…
The Glass-Steagall Act
During the Great Depression, the government passed the Glass-Steagall Act to keep FDIC-insured banks from taking on the high risk investments of the investment firms. Under this act, when the government insured bank funds, those funds had to be invested relatively safely. Non-insured funds were understandably not subject to the same rules (rather, they would be monitored by the SEC). Former Senator Phil “mental recession” Gramm, who is now a top adviser for the McCain campaign, authored the Gramm-Leach-Bliley Act in the 1990s that repealed the Glass-Steagall Act. President Bill Clinton and his Treasury Secretary Bob Rubin promoted the legislation and successfully pushed the legislation through Congress, thus repealing the Glass-Steagall Act (and setting in motion the subprime mortgage frenzy).
The Federal Reserve Board
Meanwhile, former Federal Reserve Chairman Alan Greenspan and his replacement, current Federal Reserve Chair Ben Bernanke have both provided easy credit and interest cuts after interest rate cuts. In fact, it seems that interest rate cuts were their stock solutions for everything. Last year, as the market was clamoring about markets paralyzed by bad mortgage securities, Bernanke offered an unexpected substantial interest rate cut as the solution. Economists and market players universally panned Bernanke’s rate cut as ineffective.
Bernanke’s efforts in 2007 did not address or alleviate the core problem: Too many banks were holding too many illiquid assets (assets that cannot be easily or quickly liquidated/converted to cash) whose value could not be ascertained (most were overvalued due to poor regulation of real estate appraisals). The problem festered and grew and is no longer confined only to investors. At first, only certain markets were frozen, affecting primarily those who are in danger of losing their homes and those who hold the notes on those homes. Now the lack of liquidity in the financial markets is everyone’s problem. Market inertia is no longer confined to mortgage securities – credit has frozen across the board, markets are falling at record rates around the world, and businesses large and small are suffering through troublesome cash flow complications.
The U.S. Treasury Department
As Treasury Secretary, Paulson proposed a mortgage relief plan last year, the Hope Now Alliance that was dubbed by Harvard economist Elizabeth Warren as the ” bank lobby’s dream.” It was another of Paulson’s ‘voluntary’ programs. The Hope Now Alliance was a set of guidelines under which mortgage holders could get relief if and when the mortgage note holder found it more expensive to foreclose than to provide relief.
Paulson’s mortgage relief plan did not provide relief to the homeowners, however. Under the plan, debt relief could only be granted to those whose loan-to-value ratio (LTV) was 97 or above. This meant that only those who had no equity could get relief under the plan. In general, only if the bank would make money or break even on the foreclosure (and the mortgage holder would lose money), then the mortgage holder would qualify for relief. In short, if the bank would lose money on the foreclosure, then the mortgage holder could get relief. Paulson’s proposed plan even excluded borrowers with good credit scores from relief.
Main Street is not exactly innocent in this market failure either, though. As our markets crash and our economy grinds to a halt, pundit after pundit, economist after economist, politician after politician proclaim that the problem is a lack of available credit. Businesses will not be able to meet payroll, they say. Businesses will not be able to expand, they say. Businesses will not be able to develop or market new technologies, they say. They say a lot of things along this line. But what nobody mentions is our dependence on this dried up credit.
In 2005, we recorded the first negative savings rate since the Great Depression. What happened to saving money for a rainy day? What happened to the idea that living within one’s means is more respectable than keeping up with the Joneses. Where did these important American ideals go? Since when is it ok to borrow from one bank in order to pay off another? Since when is it ok to take out a second mortgage to buy a new car or a boat or to put in a new kitchen or a swimming pool? Since when is it ok to hire employees who depend on their wages for their family’s survival when the business does not have enough reserves to pay them?
The problem is not that the American people and American businesses cannot get credit. The problem is that Americans have come to depend on getting on credit. And while Americans were mortgaging themselves to the hilt to keep up with the Joneses, almost everything they were buying was made in a third world sweat shop by the cheapest, most exploited labor available. Consumers rush to Wal Mart for the latest “rollback” deals or to K-Mart for the latest blue light special, and virtually no one buys American anymore. Too many Americans feel it’s more important to save a buck than to save a job, and most people do not understand the connection between their own stagnant wages and the consumer dollars they send overseas every day.
It’s not popular to point out these flaws of current American culture, but we need to face our demons before it is too late.
The Big Bailout: Where We Are Now
Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and SEC Chairman Chris Cox all should have seen what was coming and should have provided Congress and the public with a timely warning of the impending crisis. Instead, Paulson unilaterally created his own bailout plan and provided Congress with only a few hours of notice before he ran screaming to the world “The sky is falling!” which set off all-out panic in markets around the world and led to the largest point drop in stock market history.
Let me be clear: Secretary Henry Paulson is directly responsible for the 778 point drop in the Dow. Sure, the markets were in trouble. Capital is frozen. But when the Secretary of the U.S. Treasury runs around like Chicken Little screaming about the impending doom of the world economy, it is bound to set off an instant panic, and so it did.
The Big Bailout
The bailout bill, as currently written, certainly does nothing to correct what so-called Main Street sees as the problem: corporations that have been allowed to grow “too big to fail” that have been gambling on risky investments while paying themselves unconscionable salaries and then expecting the government to prop up their opulent lifestyles while ordinary Americans suffer from rock bottom home values, skyrocketing gas/energy prices, and stagnant wages. More important than doing nothing to address the concerns of Main Street, Paulson and his cronies have done nothing to explain the problem or the solution to Main Street either.
Monday’s Smackdown of the Bailout Bill
The bill that was voted down on Monday was touted as one designed to protect the American taxpayers. But the bill falls short in every protection it tries to provide. It supposedly curbs executive pay and golden parachutes, but in reality the bill only curbs golden parachutes under certain circumstances. Executive pay is also limited only under certain circumstances and was written into the bill using tax code language that is so well known for its loopholes that the Co-Director for the Center on Economic and Policy Research said, “Any executive who can’t figure out a way around these restrictions should be fired.”
The House Republican Insurance Scheme
The insurance program, cooked up by House Republicans, is nothing more than a way for these financial firms to put their risk onto the back of taxpayers while keeping possible profits for themselves, and according to the Treasury conference call Monday evening, each company will be able to choose whether to participate in the insurance program or the asset buying program. The insurance plan currently being proposed by House Republicans would put taxpayer money at the same risk as the current bailout plan but with none of the upside – the taxpayers would not have an equity position and thus would not share in the profits after having put taxpayer money on the line. More important, the insurance plan would not recapitalize the banks, which is needed for the banks to take up normal lending again.
The proponents of the bill also touted a provision that supposedly prevents these firms from profiting on the sale of bad assets to the government, but it includes an exception for assets acquired through buyouts and mergers and an exception for companies in bankruptcy (in other words, executives may have an incentive to run their companies into the ground, depending on how heavily vested they are in worthless mortgage securities).
Conflicts of Interest, No Oversight
Under the current bailout bill, Former Goldman Sachs CEO Henry Paulson, as the current Treasury Secretary would also still have virtually no oversight and carte blanche to determine the value of worthless assets, to select which worthless assets the government should sink taxpayer dollars into, and to hire the same financial consultants that got us into this economic mess. The so-called oversight basically requires Paulson to send a report to Congress after buying bad assets.
The Law of Unintended Consequences
This bill, as it is currently written, would do more harm than good, but the worst aspect is not the bill itself. Rather, it is the rush to get it passed (a direct result of Paulson’s late-to-the-game prognostications of doom). In addition to all of the problems and loopholes that have already been laid out by countless experts, more loopholes undoubtedly will be discovered in the days ahead. Indeed, bloggers, pundits, analysts, and economists are still studying this 100+ page monstrosity, and every hour they are finding new loopholes and making other discoveries. This afternoon, bloggers at DailyKos laid out a case that this bill could enable the Feds to set the reserve requirements of zero for some FDIC insured banks.
One of the major problems with the bailout, as it stands now, is the premise that by contracting the supply of housing by buying up the bad mortgage securities and holding them, the price of housing will rise again (especially if the government overpays for these bad assets, which seems to be Paulson’s plan). The primary reason that housing prices fell and housing sales stalled is that they rose too astronomically and too fast — it became too difficult for middle class people to buy the houses on the market.
The housing prices need to come back down to affordable levels before the market will truly recover – and before the middle class will recover from the recession. Otherwise, the wealth will simply be transferred from the middle class to the rich because the middle class will be unable to afford to purchase these houses when they later come onto the market, and the wealthy will purchase them as investments, rentals, second homes, and the like.
After the dot.com crash, many of the investors who were able to hang onto their fortunes were skeptical of reinvesting in the stock market. They began investing in real estate — traditionally the safest place to put money. This along with other factors — the deregulation of investment houses and banks, the loosening of mortgage credit, and a lack of regulation of real estate appraisals — were converging to produce a new bubble — the real estate bubble whose bursting has set off the current economic crisis.
In a move independent from the bailout legislation, on Tuesday the Financial Accounting Services Board (FASB) and SEC relaxed accounting rules for mark-to-market accounting valuations. Institutions have been required to value their assets at the current market value (at the price the asset would fetch on the open market today), but investment houses have complained that they should not have to price assets at today’s values when they plan to hold those assets for years to come. The new rule allows management to use mathematical models to determine the value of illiquid assets whenever an active market does not currently exist — in other words, because the housing market has dried up, these firms can now estimate the future value of their mortgage securities and record those values in their next round of financial statements. The new rule in laymen’s terms: if the market value is too low to instill the confidence of stockholders, just make something up.
The $100 Billion Tax Break Package
Wednesday the Senate is expected to vote on a revised bailout bill. Specifically, a $100 billion tax break package has been added to the bill, and the bill now includes a provision to increase FDIC insurance on bank deposits from $100,000 to $250,000. The tax break package includes tax breaks for businesses, renewable energy (both production and usage), research and development (i.e., science and technology), an expanded child tax credit, tax relief for victims of natural disasters, and exceptions to the alternative minimum tax.