A Bailout that Could Fly

Personally, I’m opposed to all government intervention in the economy. After all, if we bail out the banks here, we will have a long-term bailout mentality that will impact future crises. We will create a moral hazard that encourages even more imprudent risk-taking.

On the other hand, is it possible that we could have a government intervention that does little harm, provides stability for the mortgage market, and does not let Wall Street firms take a windfall?  I dunno. Assuming that I had to propose a plan, this is what I would do:

(1) Abolish the Federal Reserve.

(2) Require all credit default hedging options to be traded in open market exchanges.

(3) Prohibit Fannie and Freddie from backing Adjustable Rate Mortgages (ARMs), interest-only loans, and balloon loans.

(4) Allow Fannie and Freddie to only back residential mortgages that are no more than triple the verified adjusted gross income of the borrowers.

(5) Allow homeowners in need of relief the opportunity to refinance with the government:

  • The loans would be fixed-rate.
  • The borrower would be liable for the balance of the loan as long as it is with the government.
  • The loan would not be dischargeable in a bankruptcy.
  • The estate of the borrower would be liable for the balance of the loan in the event of the death of the borrowers, and the government would have the priority in collecting on the loan, over other creditors.
  • In a foreclosure, the borrower would be responsible for any portion of the loan that is not covered by the “fire sale” of the house.

This would:

(a) allow distressed homeowners an opportunity to refinance.

(b) resolve the “tranch dilemma” that the government would otherwise face in the current bailout provisions.

(c) provide liquidity for the processing of distressed assets.

(d) provide a reasonable opportunity for the government to recover the costs–even make a profit–thereby minimizing taxpayer risk.

(e) does not reward Wall Street

(f) provides the market an easy way to assess current and emerging default risks, as options pricing would reveal emerging red flags and make for a more efficient market.

(g) provides a framework whereby those with good credit records can obtain loans, whereas riskier borrowers woould be a lesser threat to the system.

If I had to go with a program, it would be similar to that.

Still, I’d rather have no intervention at all. Even though that could impact me.

The Fed to Americans: We’ll Kill the Dollar!

While Congress haggled over whether to pass a $700 billion shakedown of the American people, the Federal Reserve–underneath the radar of most media outlets–dumped $630 billion into our financial system.

Congress needs to rein in–I’d suggest abolish completely–the Federal Reserve. Haven’t they done enough damage? Ever since the creation of the Fed, the dollar has lost over 90% of its value. It’s time to abolish that whole outfit.

Newsweek, Credit Default Swaps, and the Right to Fail

Credit Default Swaps (CDSs), the hedging device that has allowed banks to offload risk and obviate the need for capital reserves to cover default risk for the loans they provide, are at the heart of the debacle that threatens our financial system. Newsweek actually has a pretty good article on how CDSs came to fruition, and how they contributed to the current fiasco.

Here are some key red flags:

  • By purchasing CDSs, banks were allowed to forego the capital reserve requirements that are required to cover default risks.
  • Insurers who underwrote CDS contracts used regular insurance rules to quantify the risks that CDSs posed. In doing so, they failed to account for the effect of defaults on (a) the inclination of investors to sell their holdings of mortgage-backed securities, which would force banks to cover the loans or call their CDSs; and (b) the marginal cost of insuring the risk of future defaults
  • Whereas insurers must keep substantial reserves to satisfy other insurance policies, the reserve requirements for mortgage defaults were not nearly as well-defined.
  • Because CDSs are not traditional options–which are sold on the open market–the reporting requirements are nebulous.
  • The CDS revolution began during the Clinton Administration–which made no compelling efforts to regulate them–and blossomed even more in the housing boom during the Bush Administration, which also made no compelling efforts to regulate them.

Some might argue, “Amir…being a libertarian, aren’t you opposed to further regulation of banking?” That depends.

Constitutionally, the federal government has an obligation with respect to the handling of bankruptcies, and the cost of bankruptcies impacts all taxpayers. Ergo, there is a legitimate interest–with respect to the large swath of taxpayers–in government limiting the financial risks that people can take.

How that regulation happens is a matter of flexibility.

I would suggest that the best regulation is no regulation, provided we eliminate the Federal Reserve.

When banks are allowed to fail–and they understand that they have the right to fail–they will cover their risks accordingly. Just like the banks in Hong Kong do.

I learned about the “Right to Fail”, from–among all people–a very liberal humanities teacher.

During those days, I worked as a physics lab instructor to make extra money. In my first semester of doing this, I was known for my easy grading style. Sadly, my students did not appear to be really learning the material.

Talking with Juliet Bravo–the humanities professor–about this, she told me that she used to do the same thing I did–and with the same results–there was only one way to improve the situation.

“My students have a right to fail.”

I asked her how that worked, as I never realized how tough she was, given that I got an “A” in her writing class.

She said, “I set the standards, and it is up to students to meet those standards. If they do not meet those standards, no matter how close they are, it costs them. If they do not perform well enough to pass, they simply do not pass. It’s not personal; it’s business.”

I told her it did not seem that rigid when I took the class. Her response: “Sure you noticed. You remarked about how tough the writing requirements were, but after a couple weeks you shut up, adjusted, worked, and never looked back. But if I had easier standards, you would not have done as well as you did.”

I was floored, but she seemed to make sense. When I told her I’d be completely reviewing my approach, she said, “Just remember: give your students a right to fail.”

I made that adjustment in the ensuing semesters: I raised the standards, and was more rigid in my expectations and grading. I communicated that to the classes at the beginning of the semester. Some of them bitched, others didn’t. Most rose to the occasion, raised their level of performance, and did very good work.

I found that while the grades only dropped slightly, the level of performance was much higher.

When students realized that they had a right to fail, I found out who really deserved to be there. Some dropped, a few failed. Most passed. Some did very well.

If we took the same approach to business, especially the banking sector, we would see similar results.

Until every business realizes that they have the right to fail, we cannot reasonably expect them to act prudently.

GOP, DNC, and Federal Reserve Join Forces to Screw Americans

The shakedown bailout compromise, reached by congressional leaders, reminds me of something that P.J. O’Rourke once said:

In my country, we have two parties. The stupid party, of which I am a member, and the evil party, which we oppose vehemently. Sometimes my party wins, in which case we get lots of stupid legislation. Sometimes the other party wins, in which case we get lots of evil legislation. Occasionally, the parties act together in what we call ‘bipartisanship,’ in which case we get legislation which is both evil and stupid.

Ron Paul on the “Bailout”

I received this e-mail today:

Dear Friends:

The financial meltdown the economists of the Austrian School predicted has arrived.

We are in this crisis because of an excess of artificially created credit at the hands of the Federal Reserve System. The solution being proposed? More artificial credit by the Federal Reserve. No liquidation of bad debt and malinvestment is to be allowed. By doing more of the same, we will only continue and intensify the distortions in our economy – all the capital misallocation, all the malinvestment – and prevent the market’s attempt to re-establish rational pricing of houses and other assets.

Last night the president addressed the nation about the financial crisis. There is no point in going through his remarks line by line, since I’d only be repeating what I’ve been saying over and over – not just for the past several days, but for years and even decades.

Still, at least a few observations are necessary.

The president assures us that his administration “is working with Congress to address the root cause behind much of the instability in our markets.” Care to take a guess at whether the Federal Reserve and its money creation spree were even mentioned?

We are told that “low interest rates” led to excessive borrowing, but we are not told how these low interest rates came about. They were a deliberate policy of the Federal Reserve. As always, artificially low interest rates distort the market. Entrepreneurs engage in malinvestments – investments that do not make sense in light of current resource availability, that occur in more temporally remote stages of the capital structure than the pattern of consumer demand can support, and that would not have been made at all if the interest rate had been permitted to tell the truth instead of being toyed with by the Fed.

Not a word about any of that, of course, because Americans might then discover how the great wise men in Washington caused this great debacle. Better to keep scapegoating the mortgage industry or “wildcat capitalism” (as if we actually have a pure free market!).

Speaking about Fannie Mae and Freddie Mac, the president said: “Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.”

Doesn’t that prove the foolishness of chartering Fannie and Freddie in the first place? Doesn’t that suggest that maybe, just maybe, government may have contributed to this mess? And of course, by bailing out Fannie and Freddie, hasn’t the federal government shown that the “many” who “believed they were guaranteed by the federal government” were in fact correct?

Then come the scare tactics. If we don’t give dictatorial powers to the Treasury Secretary “the stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet.” Left unsaid, naturally, is that with the bailout and all the money and credit that must be produced out of thin air to fund it, the value of your retirement account will drop anyway, because the value of the dollar will suffer a precipitous decline. As for home prices, they are obviously much too high, and supply and demand cannot equilibrate if government insists on propping them up.

It’s the same destructive strategy that government tried during the Great Depression: prop up prices at all costs. The Depression went on for over a decade. On the other hand, when liquidation was allowed to occur in the equally devastating downturn of 1921, the economy recovered within less than a year.

The president also tells us that Senators McCain and Obama will join him at the White House today in order to figure out how to get the bipartisan bailout passed. The two senators would do their country much more good if they stayed on the campaign trail debating who the bigger celebrity is, or whatever it is that occupies their attention these days.

F.A. Hayek won the Nobel Prize for showing how central banks’ manipulation of interest rates creates the boom-bust cycle with which we are sadly familiar. In 1932, in the depths of the Great Depression, he described the foolish policies being pursued in his day – and which are being proposed, just as destructively, in our own:

Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end… It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.

The only thing we learn from history, I am afraid, is that we do not learn from history.

The very people who have spent the past several years assuring us that the economy is fundamentally sound, and who themselves foolishly cheered the extension of all these novel kinds of mortgages, are the ones who now claim to be the experts who will restore prosperity! Just how spectacularly wrong, how utterly without a clue, does someone have to be before his expert status is called into question?

Oh, and did you notice that the bailout is now being called a “rescue plan”? I guess “bailout” wasn’t sitting too well with the American people.

The very people who with somber faces tell us of their deep concern for the spread of democracy around the world are the ones most insistent on forcing a bill through Congress that the American people overwhelmingly oppose. The very fact that some of you seem to think you’re supposed to have a voice in all this actually seems to annoy them.

I continue to urge you to contact your representatives and give them a piece of your mind. I myself am doing everything I can to promote the correct point of view on the crisis. Be sure also to educate yourselves on these subjects – the Campaign for Liberty blog is an excellent place to start. Read the posts, ask questions in the comment section, and learn.

H.G. Wells once said that civilization was in a race between education and catastrophe. Let us learn the truth and spread it as far and wide as our circumstances allow. For the truth is the greatest weapon we have.

In liberty,

Ron Paul