First the Bad News, and then More Bad News Posing as Good News

Published November 14, 2008

It is becoming obvious that the bailout, or “rescue” as the government wants to call it, will not unfreeze the credit market. Anna Schwartz says so. She is the coauthor, with Milton Friedman, of The Monetary History of the United States. Allan Meltzer agrees. He is a Carnegie Mellon University professor of political economy and the author of several books on monetary policy and economic history, including his multi-volume A History of the Federal Reserve. Luigi Zingales also says it will not work. He is professor of finance at the University of Chicago’s Graduate School of Business. Even Treasury Secretary Henry Paulson admits the bailout-rescue will not loosen up credit any time soon.

Unwillingness to Lend

Here is the problem. Despite the fact that the government has committed $700 billion to replace the toxic assets of investment banks and commercial banks, and ownership positions in the nine largest investment banks have been taken by the government, there remains a lack of will on the part of financial institutions to increase their lending to businesses and other banks.

What else can you expect? After suffering or witnessing the severe damage to the balance sheets of the investment banks by the defaults of the subprime mortgages, which lending institutions will want to return to a regime of easy credit? Not even banks are that foolish.

Interest on Excess Reserves

As if the credit crisis is not bad enough, some of the solutions adopted by the regulators and Congress will make it worse. One is offering interest on excess reserves held by banks. The obvious intent of the Federal Reserve is to bolster confidence in the solvency of banks. But the effect will be divert bank lending into the reserve accounts. When the choice is between risky lending and guaranteed interest by the Fed, most banks will choose the sure thing.

The Federal Reserve seems to have forgotten the important lesson of the depression of 1937-38. Despite high levels of unemployment, there were signs of recovery from the early 1930s. In 1936 the Fed discovered that banks were holding more than double the level of required reserves. Given the authority under the Banking Act of 1935, the Board of Governors of the Federal Reserve System doubled the reserve requirement of member banks between August 15, 1936 and May 1, 1937.

The feeling was that doubling the reserve requirement would generate an increase in public confidence and would not change the behavior of the banks. However, the banks responded to the Fed’s signal by sharply increasing their already-sufficient reserves. The result was a credit crisis by midsummer 1937 and the subsequent sharpest downturn in U.S. economic activity in history.

Short-Selling Ban

Another counterproductive policy is the ban on short-selling of the shares of 799 banks and financial institutions. This was imposed on September 19, 2008 and removed October 2, 2008. The action followed another ban on 19 investment banks, in effect from July 21, 2008 to August 15, 2008.

Arturo Bris studied both instances and found the bans afforded no protection. Indeed, the shares prices of banks shielded from short-selling performed worse than comparable shares. The results of the first ban were known by the Securities and Exchange Commission before it imposed the second ban.

The effect is easy to understand. When regulators identify vulnerable financial institutions, their share prices decline, regardless of whether there is a short-selling ban in effect. Apparently, knowing that a policy is ineffective is no barrier to the SEC for reimposing the policy. Actually, a short-selling ban is still in effect for 32 banks in the UK until January 2009. It was imposed by the Financial Services Authority.

This confirms another immutable law of economics. Bad policies are contagious from one set of regulators to another. It is commonly known by the euphemism “international coordination.”

Bailing out NINJAs

A new term has been added to the vocabulary for the subprime mortgage crisis: NINJA. It stands for “no income, no job, no assets,” and it refers to some recipients of subprime mortgages who did not qualify. The Treasury estimates there are three million NINJAs who are facing foreclosure, and the cost of refinancing their toxic paper is on the order of $40 to $50 billion. The total estimate (by Moody’s of households expected to default on their mortgages from now until 2010 is on the order of 7.3 million, with 4.3 million losing their homes.

The NINJA bailout is the brainchild of Sheila Bair, chair of the Federal Deposit Insurance Corporation, and has been designed by the Treasury Department. The money is to come out of the $700 billion financial bailout authorized by Congress in early October.

This funding arrangement makes it sound as if there is no extra cost in bailing out the NINJAs. This is not true; it ignores the diversion of the FDIC’s attention from its major role of insuring bank deposits, and the extra time cost of identifying the individual mortgage holders and the problem of calculating how much of the taxpayer money will be needed to refinance mortgages. This will cause substantial delay to verify the government’s (taxpayers’) portion of each of the three million modified mortgages offered by the lenders. That, in turn, will slow the unfreezing of credit to worthy borrowers throughout the economy.

Changing Bankruptcy Rules

Add to this, the grandstanding by Congress. Senator Christopher Dodd (D-CT), for example, promises new legislation to authorize bankruptcy judges to modify the terms of the endangered mortgages.

Loss Deduction

Senator Charles Schumer (D-NY) has joined Senator Charles Grassley (R-IA) in opposing the Treasury’s plan to allow deduction of tax losses when one bank obtains toxic loans in the portfolio of an acquired bank. One implication of the denial of loan loss deduction is to divert the attention of large strong banks away from acquiring loss ridden banks, to the acquisition of small sound banks that have been prudent in their lending policy.

The Solution

Eventually, the credit market will loosen up. But it will not occur because of anything Washington does. The thaw in credit will come about through actions taken by principals, namely lenders and borrowers. It is now obvious there will be unnecessary delays in this process, and the finger of blame for that should be pointed at Washington. I leave it to the reader to decide which finger to use.

Jim Johnston ([email protected]) is a policy advisor to The Heartland Institute. The views are his own and not necessarily those of The Heartland Institute.