Thursday, July 17, 2008

The U.S. Government's Fight Against the Markets

America, the great bastion of free enterprise, now confronts the spectacle of its government trying to fight the markets. When the real estate, mortgage and stock markets began tumbling last year, the Federal Reserve sharply reduced interest rates in an effort to stem losses. It may have softened the blow, but the losses nevertheless remain gargantuan. When banks stopped lending to each other, the Fed stepped in with billions of dollars of loans, taking mortgage-based derivatives and other kitchen sinks as collateral. When Bear Stearns tottered at the brink, the Fed guaranteed a bunch of its hinky assets in order to induce J.P. Morgan to make an acquisition it might well not have otherwise made. When Fannie Mae and Freddie Mac's stock lost most of their value, the Fed stepped in with yet more promises of credit, and the Treasury Department announced a plan for the government to invest in Fannie and Freddie. Brilliant. Treasury wants authority to invest taxpayer money in companies that no private investor in its right mind would invest in.

The SEC made a cameo appearance and issued an order limiting the ability to sell short the stock of Fannie, Freddie and certain large financial institutions that are primary dealers of the Federal Reserve. Shareholders of these firms can momentarily wipe the perspiration from their brows. But shareholders of GM, Ford and all of the other thousands of public companies in America might wonder why firms so badly mismanaged as Fannie, Freddie and some of the primary dealers are insulated from market realities.

The U.S. government is trying to fight the markets--the real estate market, the stock market and the derivatives market. This isn't likely to be a winning proposition. The losses that have been or will be sustained in these markets are in the trillions, too great for any government to absorb or control. Governments that try to take on massive market forces eventually lose. The Communist governments of the Soviet Union and China couldn't beat market forces and wound up joining them. The U.K. government's attempt to defend an overvalued pound in 1992 against short sellers ended in failure and devaluation. The U.S. government's decades long efforts to fight market forces in the agricultural commodities markets has resulted in unjustified and irrational farm subsidies. The Japanese government's efforts to avoid recognizing the Japanese banking system's losses from the collapse of real estate and stock prices in that country in 1990 resulted in failure and stagnation that still bedevils Japan.

In its waning days, the second Bush administration appears to be placing on the federal government responsibility for all liabilities and even share values of the core players of our financial system. This is a really bad idea, not only because of the moral hazard it creates--incentivizing the financially powerful to take exorbitant risks--but also because it ultimately puts the government in the position of trying to combat market realities.

What can be done? Organize a new mortgage agency to replace Fannie and Freddie, this time with a very clear statutory articulation of the extent, if any, of the government's responsibilities for its liabilities. Then, wind down and liquidate Fannie and Freddie. This is what the government did with the bad savings and loan associations in the early 1990s. They weren't bailed out and their shareholders were wiped out. Their poorly performing managements lost their jobs. The government thrashed around through most of the 1980s, trying to avoid the reality of the S&Ls' losses in the real estate markets. During that time, the S&Ls continued on their merry way, incurring more and more losses. The price to taxpayers of all this governmental squirming was about $3,000 apiece. If the federal government thrashes around more with Fannie, Freddie and the major financial firms in an effort to avoid confronting their losses, the outcome won't be particularly different. All of this administration's principal actors will be out of office before the full implications of the current policy emerge. But we schlemiels (read taxpayers) will have a firm grip on the bag for a long time.

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