Tuesday, September 30, 2008

The Great Seal of the United States on a dollar bill

All eyes are on the markets' reaction to Washington's bailout. But one issue has yet to be tackled: preventing future market meltdowns. Peter A Buxbaum reports for ISN Security Watch.

By Peter Buxbaum in Washington, DC for ISN Security Watch 

The incipient agreement reached in the wee hours of Sunday morning among US congressional leaders and the White House to bail out Wall Street reflects a presumption that has remained almost constant since the beginning of the crisis: that the US government had to intervene in the financial markets.

The basic parameters of the proposal to jump start global credit markets with the infusion of US$700 billion in US treasury funds elicited little dissent among Washington insiders – that is, until a group of insurgent Republicans in the House of Representatives bolted from, but later rejoined, the congressional consensus. 

The Republican proposal would have attempted to attract capital to US markets by allowing US-based multinational corporations to repatriate foreign profits at sharply reduced tax rates. (A small group of House conservatives are still holding out against the bailout.)

The Republican scheme, if it would have worked at all, would have taken much longer to stimulate global credit markets than the immediate commitment of US$700 million from the US treasury. The fact that the Republican leadership were persuaded to abandon their proposal is a testimony to the panic that has overtaken Washington. 

The premise that underlay the negotiations was that a deal needed to be announced before the Asian markets opened for trading on Monday morning, or else the global financial markets might collapse. As a result, the core principles included in the White House plan, that the US government would be buying up bad mortgages, that US$700 billion was somehow the right number, and that the plan should be administered by the US Treasury Department, was never subjected to much scrutiny.

All of this came on the heals of the US government's takeover of AIG, the world's largest insurance company, the nationalization of mortgage bankers Fannie Mae and Freddie Mac and the anteing up of US$29 billion to finance JPMorgan Chase's acquisition of the failing investment bank Bear Stearns. 

The Federal Reserve also poured US$300 billion into global credit markets through lending programs operated by the European Central Bank and the central banks of Canada, Japan, Britain and Switzerland, depleting that institution's cash reserves.

A new gospel?

What would the leaders of emerging markets such as Indonesia, Russia and Argentina think of the US advice they received during market dislocations they experienced in the last decade? Since the end of the Cold War, Washington has been preaching a gospel of letting the market solve its own problems and getting the government out of the way, even at the expense of widespread economic turmoil.

Since the 1990s, the US Treasury and the US-backed International Monetary Fund have insisted that countries beset by economic crisis embrace market-oriented policies, slash government spending and privatize state companies, as conditions for IMF loans. 

These policies led to spiking s price in Indonesia in 1998, leading rioters to force dictator Suharto into retirement, and collapsing stock values and soaring inflation in Russia that same year. In 2001, millions of middle class Argentineans were driven into poverty.

Until recently, Washington practiced what it preached at home, retreating from regulating investment banks and financial markets. But now that the consequences of this neglect have manifested themselves, the Federal Reserve and the Treasury Department have been quick to toss aside their Bibles, and pick up another tome, perhaps Das Kapital.

The nationalization of the US financial markets could have been averted by regulations which would have curbed the excesses which led to failures. Even conservatives in Washington admit that there was no alternative to government intervention and to the need for stricter governmental oversight.

"It's probably true that something had to be done in the case of AIG," Alan Reynolds, a senior fellow at the libertarian Cato Institute, told ISN Security Watch. "But doing something could have meant doing something else, such as offering a secured bridge loan while AIG engaged in some orderly asset sales."

Risk management

The crisis in the US mortgage market, which ballooned out to global credit markets, resulted from Washington's turning a blind eye to the absence of proper risk management at the primary mortgage finance institutions, according to David John, a researcher at the Heritage Foundation, a conservative Washington think tank. 

"Most banks have one dollar of capital for every US$12 in assets," he explained to ISN Security Watch. "But Fannie Mae and Freddie Mac only have one dollar for every US$20 in assets. Congress looked at higher standards in the 1990s," but failed to enact them. 

The White House bailout proposal is best seen in the light of the Republican corporatist, as opposed to conservative-libertarian, tradition. 

The proposal of US Treasury Secretary Henry Paulson, a former chairman of the investment bank Goldman Sachs, which recently converted itself into an ordinary commercial bank in the wake of the crisis, was centered on rescuing Wall Street institutions and markets, but would have done little to avert the immediate pain of ordinary Americans about to lose their homes by providing for the widespread restructuring of troubled mortgages.

The Democrats in Congress had been pushing for relief for the rank-and-file American, primary through the reform of bankruptcy laws which would allow judges to restructure mortgages as part of a bankruptcy repayment plan. But that measure was dropped from the agreement announced Sunday morning at the assistance of Republicans.

"Paulson's draft legislation attempts to rescue the balance sheets of Wall Street but does almost nothing for homeowners on Main Street," said David Abromowitz, a senior fellow at the Center for American Progress, a left-leaning Washington think tank, before the deal was announced. "That is a fundamental flaw." 

"The US housing market won't recover without restructuring of underlying mortgages," Abromowitz told ISN Security Watch. "Global credit markets will not respond to this exceedingly expensive plan unless we get our fundamentals right. Taxpayers will be saddled with increasingly worthless paper as many of the underlying mortgages fail."

In the end, it was partisan and electoral politics that the played a dominant roll in the shaping of the agreement. The Congressional Democrats could have reached their own bailout agreement with the White House, but they needed Republicans on board for political reasons. The Democrats don't want the country to perceive the bailout as a Democratic plan but the Republican president's plan that they improved upon. To make that happen, they need some congressional Republicans to go along. Both parties have an incentive to spread the political risk in the face of meager public support for the bailout.

Although the Democrats dropped mortgage restructuring, they did insist that the bailout money be dispersed in segments, with only US$250 billion available immediately. They also won non-voting shares of stock for the government from firms benefiting from the bailout so that the Treasury could recoup some its capital if the companies revive. The agreement also includes a provision which limits compensation for senior executives of bailed-out companies. The House Republicans won a provision that requires the Treasury Department to create a federal program to insure firms against loss from compromised assets. 

Glaringly absent from the agreement was any regulatory scheme which would avert the kinds of abuses that led to the current crisis. 

"Some form of government supervision must take place, as markets, not to mention market players, sometimes do not stick to what is in the textbooks," said Alexander Mirtchev, a Washington-based consultant and an economic advisor to the government of Kazakhstan. 

"Without being too interventionist, governments should embrace the reality that they have certain responsibilities towards how market players operate, in particular, the rules of the game, and how to prepare for and mitigate the possible social fallout," he told ISN Security Watch. 

Mirtchev added that recovery from the current crisis in emerging markets could be less sticky than for the US, because "it depends a lot less on financial schemes that need to be unwound than in mature markets."

By Mirtchev's standards the current state of the Washington bailout is incomplete on a couple of counts. Presumably, regulation to prevent the excesses that lead to the near-meltdown are to come, but the current administration and Congress are content to kick that football down the field until a new government can deal with it next year.

For now all eyes are on how the markets perform on Monday. Will the commitment of US$700 million reinvigorate credit markets and calm investors? More importantly, for how long? 

We'll see.

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Peter Buxbaum, a Washington-based independent journalist, has been writing about defense, security, business and technology for 15 years. His work has appeared in publications such as Fortune, Forbes, Chief Executive, Information Week, Defense Technology International, Homeland Security and Computerworld. His website is www.buxbaum1.com.