On Friday October 3, 2008, the US House of Representatives passed the “Emergency Economic Stabilization Act” (“EESA”) which was immediately signed into law by President Bush. The measure creates the Troubled Assets Relief Program (“TARP”), intended to restore liquidity and stability to the financial system. Under TARP, the Treasury Department is authorized to spend up to $700 billion to purchase mortgage-related securities from eligible financial institutions. The bill is 451 pages long, but a clear and succinct summary of the bill’s major provisions can be found here. I encourage everyone to read this, since this is the most important domestic legislation passed in several generations.
TARP represents the biggest government intervention in our free market economy since the New Deal. The New Deal was the name President Roosevelt gave to a sequence of large government spending programs initiated between 1933 and 1936 to pull the US economy out of the Great Depression. It is highly questionable whether the New Deal was successful. Generally speaking, government intervention in the economy only makes things worse in the long run. As proof, the United States, which is the standard bearer for free markets among the world’s nations, has long enjoyed one of the most prosperous economies in the world. So is the EESA – whose laudable goal is to keep our economy from entering a depression but is a stark departure from our successful traditions - justified?
There are many ambiguities in the Act yet to be clarified, and much pork was included in the final legislation. The bill could have been better. But the overriding question on people’s minds is this: Is the average taxpayer being asked to bail out greedy, rich Wall Street bankers with no overwhelming benefit to the taxpayer? Is this Main Street bailing out Wall Street? I believe the answer is important – and it is “no”.
Why The Average Taxpayer Should Care:
People’s savings, ability to buy a house, car or pay for college have all diminished in the last two weeks. A review of recent events is downright depressing. The stock market experienced its largest weekly decline ever last week, and is down 23% over the last 10 days. Investors’ 401Ks and IRAs have declined precipitously. Many 401ks are now being referred to as 201Ks. Car buyers – with good credit - have seen loan approval rates drop from 90% a year ago to 60% in September according to AutoNation, the largest auto dealer in the country. Mortgage rates are up, even for people with good credit. Getting college loans is now harder. These were the main reasons cited by legislators in support of the Act.
But what about someone who is not near retirement, and thus can ride out the decline in her 401k or IRA? Hasn’t the stock market always recovered over time? And what about the person who can forego buying a new car (can’t we all), nor has a child going to college anytime soon? And the person who already owns a home, and continues to pay their mortgage on time every month? That’s the majority of Americans, including myself. Why should we care? Haven’t we played by the rules? Is this massive federal intervention in the economy using our tax dollars worth it, since we’re not affected?
Yes – here’s why:
The simple answer is we all are affected, and it has to do with jobs. If this plan were not passed, or if it doesn’t accomplish its goals, we are going to see jobs evaporate and unemployment rise to levels unheard of since the Depression. And the loss of jobs will effect every worker – whether or not you have good credit, bad credit, work on Main Street or Wall Street.
The vast majority of jobs in our country are created by small businesses – according to SBA statistics, more than 75% of net new jobs come from small employers. As a small business grows, it hires more workers. But not every small business grows. Some stagnate, while others shrink and lay off workers.
Historically, the small businesses that are growing hire enough workers to offset the job losses from the businesses that are shrinking. The result is an increasing number of employed people, and for the last twenty years, very low unemployment levels.
To grow, businesses need loans. This is because businesses usually incur significant expenses before they benefit from increased sales. For example, take a manufacturing company that is experiencing increased demand for its product. Let’s say this company has just received a large new order. This is very positive – but don’t start counting the profits yet. To meet the customer’s needs, this company probably has to hire more workers, purchase new equipment, and produce more inventory to fill the customer’s order. Since the company has yet to receive payment for the new order, it may not have the cash on hand to hire the workers, purchase the equipment, and produce the goods. The additional payroll, equipment and inventory must be financed, meaning the company must borrow money.
In normal times, if the company is creditworthy and needs cash to finance growth, banks would be happy to oblige. But these are not normal times. Credit markets are “frozen” meaning that banks are not lending – neither to other banks nor to the bank’s customers. It is very hard to get credit. Thus, good companies who would normally be growing are not.
So we have a situation where good companies cannot grow, and thus cannot hire more employees. And we have other companies that are stagnant or declining, who are laying off people. The net result – which we are just starting to see – is a sharp drop in the number of people employed.
And when people lose their jobs, they cut back on spending, and stop being customers of the remaining businesses. This creates a negative cycle in which all businesses and their employees are negatively affected. This is typical of a recession. The only question now is how deep and long this recession is going to be.
The longer credit markets stay frozen, the more layoffs there will be, and the longer and deeper will be the recession – for all Americans. All of us must batten down the hatches, whether or not our actions have helped cause this problem or not.
So how does the TARP help?
Right now, banks are not lending to each other. No one knows what toxic mortgage securities another bank holds, nor what their true value is. The securities are very complex, and there’s no active buying and selling of these securities. Thus, no one can tell what any bank’s assets are really worth. Because of this, it’s a guessing game as to which bank might be next to succumb to insolvency. So no bank is lending to another – or doing so only at exorbitant interest rates. And few banks are lending to businesses. Banks need to hoard their cash, because they don’t know if their depositors will pull their cash out, and banks can’t count on other banks to lend them necessary funds. Thus, there is only very limited lending occurring.
The core of the problem is the toxic mortgage securities held in the investment portfolios of many banks. If these were removed, banks and other investors could tell what a bank’s assets were really worth. And then we could tell which are the healthy banks and which are the insolvent banks. The healthy banks could freely lend to each other knowing they would be repaid, and those banks would once again feel comfortable making loans to customers. Companies could get the credit they need to grow, and job losses would be averted. Confidence – in the healthy banks and in their customers – would return to the system.
The heart of TARP is the government’s purchase of mortgage securities from banks. Will this stop the economic slide? I believe so, but can’t guarantee it. We’re in unchartered waters. But if we don’t implement this plan, we would likely slide into the worst recession of our lifetimes. I believe the EESA, as distasteful as it may be, is a much better alternative than doing nothing. We are in a crisis, and the ramifications of doing nothing would simply be too much to bear. I’m willing to suffer some pain in the long run caused by EESA to avert a total meltdown now. A total meltdown would cause incredible hardship for millions of American families, and could last a decade.
Why This Is Not a “Bail-Out”, But A “Buy-Out”
A bail-out means the government gives away taxpayer dollars with only a faint hope of getting something in return. A buy-out means the government gets something of reasonable value for its expenditure. In this case, the government will be receiving assets that have an intrinsic value - a value that has a decent chance of being above what the government pays for the asset. This is a “buy-out”, not a “bail-out”.
If so, one might argue, why isn’t a private individual or institution stepping in, doing what the government proposes to do? The answer is there is no private entity large enough to make an impact. The last two weeks proved that point. Warren Buffet, the world's richest man and most astute investor, made a $5 billion investment in investment bank Goldman Sachs and a $3 billion investment in the largest American company, GE. Normally, an $8B vote of confidence from Warren Buffet is enough to move markets. Not this time. The stock market and economy continued on its downward path despite Buffet’s actions.
I am strongly in favor of the EESA. Though I am a strong free-markets proponent, the risk to our society is too high to not proceed with a massive Buy-out plan.
Here are some final points to consider:
1. This is not a "bail-out" plan. It is a "buy-out" plan. The difference is significant.
2. The government will be buying the assets at much less than face value. The sellers of the assets will not be getting out "whole".
3. In several years, the mortgages the government owns will be repaid, refinanced, or if stability has returned, the government can sell them to other investors. Thus, the government will start receiving back the money it has expended.
4. We won't know whether the government will lose money, break even, or make money on this endeavor for 3-5 years. My gut is it will be fairly close to breakeven.
5. Many market pros believe that mortgage securities are trading at prices far below their intrinsic value, even using fairly dire assumptions on default rates and recoveries. But no one is willing to step in and start buying because of the negative psychology - why buy today when there are a ton of desperate sellers with huge amounts of securities to sell just chomping at the bit to unload their holdings? And even though the few buyers who actually transacted knew they were getting a good deal when they made their purchase, they could have gotten an even better deal if they had waited. So no one is buying because prices are likely to keep falling. And thus the prices keep falling.
6. In orderly markets, the market price of a security hovers near its intrinsic value - sometimes a little above, sometimes a little below, and that's how investors make or lose money when the price returns to its intrinsic value. Occasionally, a security or a market decouples from its intrinsic value. But now we have a very large swath of mortgage securities that have decoupled from their intrinsic value. Quite simply, the market is not working. Prices are being driven by psychology, not fundamentals. The risk is that, over time, negative psychology does impact the fundamentals - it becomes a self-fulfilling prophecy. For example, if everyone thinks a company is going bankrupt, no one will buy or sell with that company, which will force it into bankruptcy, even if the original fears were baseless. Fear rules, and unless that fear is broken, fear can become reality.
7. Eventually, market forces will work. Prices could drop incredibly low so that buyers would be willing to step in even in the face of the negative spiral. But that means many families' savings and assets would be wiped out. The pain our society will endure during this process is almost unfathomable. We're talking a real risk of a global Depression as market forces work themselves out. We can't allow that to happen. The cure is not worth the price.
8. I believe there is a ton of money on the sidelines just waiting for the negative psychology to lift. Once it lifts, the buyers will return. If the government plan is credible, and once we start seeing results, I believe buyers will flock back into the market, alleviating the need for further government intervention.
9. Paradoxically, the bigger the government's plan, the less likely it is to lose money. The Treasury Department needs to restore confidence in the markets. If it goes in with the equivalent of a pea-shooter, people are likely to believe it won't work, and thus it won't. But if it goes in with a bazooka, then people will believe that this will work, confidence will be restored, and the government will likely not need to fire all the
ammunition in the bazooka.
10. To further the analogy, this is equivalent to fighting a war. In war, there are two strategies: a) apply "overpowering force" to quickly break our opponents' will, or b) use as few soldiers as possible to try to minimize losses, sending more if the first batch of soldiers doesn't get the job done. As we found in Iraq, “b” is a sure way to suffer lots of American casualties. The same is true in this war against fear.
Generally, I never want to see the government interfere in markets. Very little good comes of it. But we are in a crisis of enormous magnitude. And the government is the only player big enough to make an impact. There is no private market participant that has the firepower to solve this problem. The problem is simply too big.
There have been other proposals for government action. The one most contemplated calls for the government to “insure” mortgages held by banks, rather than buying them outright. I’ll save extended comments on that plan for another day. Let me say, however, that as a taxpayer advocate, I’d rather see TARP than an insurance plan. Under the insurance plan, the taxpayer is on the hook for any losses on the mortgage securities, but the gains go to the security holder. Under the TARP, the taxpayer is also on the hook for any losses, but at least any gains will accrue to the taxpayer. That’s a better deal for taxpayers.
These are perilous times. American taxpayers face an uncertain future. I believe the coming recession will be less negative because of the EESA. Perhaps The Economist magazine, a staunchly free market journal put it best. In its October 4th edition, it wrote: “Financial markets need governments to set rules for them; and when markets fail, governments are often best placed to get them going again. That’s pragmatism, not socialism. Helping bankers is not an end in itself. If the government could save the credit markets without bailing out the bankers, it should do so. But it cannot. Main Street needs Wall Street; and both need Washington.” Amen.
And a little prayer wouldn’t hurt either. As for me, I’m buying stocks this week.
Rich Sokol, the author, graduated summa cum laude from Yale University with a BA with distinction in Economics. He also has an MBA from Harvard Business School.