Alternatives to the $700 billion financial bailout

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Despite all the politicking this week, it looks like a bipartisan deal on the $700 billion bailout package (now titled the Emergency Economic Stabilization Act of 2008) has been reached. In the revised approach the government immediately provides $250 billion to start buying the MBS and CDO clogging up the credit markets. Another $100 billion could be used at the request of the president, while Congress would have to review the expenditure of the remaining $350 billion. It also includes finer points to resolve some the party specific differences like preventing golden parachute provisions for failed CEO’s, government ownership (via warrants) of bailed out companies and sufficient oversight of the treasury (and Hank Paulson) in the expenditure of taxpayer funds.

The common slogan from both parties and presidential candidates in justifying the bailout has been about helping “main” street, rather than Wall Street. But will the mother of all bailout packages really help? I have posted two contrasting articles on the long term fallout from the bailout and also why it could be profitable for taxpayers. Based on the information to date, my view is that in the medium term we will probably stave off a recession. But a long term recovery hinges entirely on home prices and the related mortgage debt improving by 2010, otherwise the current bailout will do little do prevent a much more severe recession. So could the government have taken a different approach to resolving the current financial crisis? Perhaps and here are some of the other “extreme” economic fixes that could have been undertaken instead on this mega-bailout. Feel free to suggest any other ideas or views.

  1. Freeze all new home construction: The current crisis is primarily blamed on falling home prices which lowered the value of Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) that financial firms held. Because their risk management was so poor and the companies were so over leveraged they collapsed under the strain from falling MBS values and exposure to CDOs. Given we already have a massive oversupply of new homes, this construction freeze will quickly reduce the overhanging housing inventory. The basic laws of supply and demand will then lead to greater demand for existing homes and eventually higher prices. This will in turn restore the value of the MBS’ thereby improving the balance sheet of the remaining financial institutions we are being forced to bailout. By preventing new home construction we may put a number of builders out of business, but it will be much cheaper to bail them out than it will Wall Street.

  2. Large tax cuts: Another school of thought is that anemic consumer spending is what is keeping the economy and home prices depressed. Given consumer spending drives over 60% of our GDP, lowering taxes significantly (by up to 50%) for an interim period could really boost consumer spending and drive them to feel more confident in purchasing homes. This increased demand will support MBS prices and the financial companies that have them on their balance sheets. The issue to consider is that will the lower tax receipts be less costly to the government than the bailout costs? Perhaps, but politically this would be a sure fire winner.

  3. Keep buying companies as they fail on a “too important to fail” basis: This is an intermediate solution that would still need bailout funds, just not as much. The idea here is to support the most important companies and let the others fail. By doing this only the best and most needed companies would be left standing. I think the government was on this path with the bailout of Bear Stearns and the two GSE’s, but the complexity and interdependence of financial companies made this option untenable in the longer term.

  4. The Swedish approach.: As the NY Times reported, Sweden had a similar financial crisis in 1992 when after years of imprudent regulation, short-sighted economic policy and the end of its property boom — its banking system was, for all practical purposes, insolvent. Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government. That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well. This still requires a bailout, but ensures that the Wall Street fat cats don’t walk away with the profits when things improve. Hopefully this will be part of the final bailout plan.

  5. Free loans to distressed consumers: For folks who have lost jobs and because of the ensuing financial hardship cannot afford to keep current on loan payments, a solution could be to provide interim debt relief by providing low cost or no interest loans for a short period to allow struggling homeowners to regain their footing. Of course, they would need to be some background checks and oversight in place to ensure that people do not abuse the system. But by keeping more folks in their homes, the rate of foreclosure (or the perception of) should fall. In essence this is a direct bailout of Main Street.
  6. Do Nothing: A number of free market advocates, including some prominent Republican senators, propose that the government do nothing to help struggling Wall Street firms and let them fail. They advocate that market forces will work better than any government intervention and that the best of breed firms will survive the crisis. While this approach is the truest to our notion of free markets, in this instance doing nothing is probably not a good idea given the scale of the financial problem and the wreckage that has already been inflicted on our economy. A severe recession will cost the economy much more than a trillion dollar bailout. They key though is to ensure that government regulation is limited to the bailout and that when things stabilize the government leaves the running of our institutions to the free market with the right levels of regulation and oversight in place. Further, no firm or type of security should be able to get so big that it places out economy in jeopardy.

I am sure that the Fed and our government leaders have thought through all the solutions and consulted our smartest minds with the result being that the bailout is the best option. Still these are the very same people who through lack of appropriate regulation and as beneficiaries of all the lobbying let us get into this financial mess in the first place. So do you trust them now? To me it’s like the fox and hen house analogy – letting the fox into the hen house was a mistake, but letting the big fox provide the solution to keeping the hens safe is an even worse idea! Still the current administration was democratically elected to the lead the country in good times and bad; I just hope that this time, unlike some bad decisions made it in the past, we have picked the best path to follow – for all our futures sake.

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