Congress and the White House continue to wrangle this week over the terms of the “Wall Street Bailout Bill” as some have called it. Many conservatives who were skeptical of the plan have become livid. I believe that government intervention at this time is absolutely necessary to ensure the continued survival of the markets and American hegemony as a financial power. However, I am increasingly disappointed with Republicans, the White House, and the Treasury over what seems to be more and more a bail out, and less and less a plan designed to actually reform and recapitalize the financial system.

 I personally felt on Thursday that when Secretary Paulson made his remarks that the Government was going to intervene that was tantamount to the US Financial system standing up and saying, “Hi! I’m US financial markets, and I’m an alcoholic.” It was a relief in many ways because finally government, business, and the financial markets stopped kidding themselves and the American people and said, “Hey, we’ve got a real problem here.”

 I still believe that the United States must act, and that action is entirely consistent with conservatism, to ensure the primacy and hegemony of the United States as the world’s financial leader and to ensure that the liquidity crisis that has plagued the country for over 14 months finally comes to an end. That said, I strongly oppose, in the broadest terms possible, a bailout of Wall Street. We need market Reform… not a rescue of banks that made bad debts… we need to buy into the market in order to stabilize it… not bail out bad investments. In the end, the taxpayer should come out on top of the deal… not foot the bill for the stupidity of bad business decisions and moral antipathy of hedge funds, government officials who assisted their political contacts to getting millions of dollars in compensation, and the mismanagement of the financial “captains” who have long since departed with billions of dollars from unsuspecting borrowers.

 To put this in perspective, I think one needs appreciate exactly what has happened. If this is a “bailout” - it’s a bailout of the US Government for their collective stupidity in managing the international credit markets. Government caused this problem - but ironically, only Government is likely able to fix it. Reforming how our government manages the international financial system is the only long-term fix to ensure that this period of “financial pain” (and it will be a period of financial pain) leads to learning and improvement of the safety and health of the US (and by extension the world’s) financial system.

 First, like all disasters, we had indications that this one was coming. Back in 2003 and 2004, there was considerable concern about Fannie Mae and Freddie Mac. Both organizations had to restate their accounting for the loans that they had incurred as a result of what was largely fraudulent accounting practices on the part of both organizations. Both organizations were investigated following a report by the Office of Federal Housing Enterprise Oversight (OFHEO) finding that both organizations had manipulated their earnings statements for several years. Rather than reforming the market then - Congress (and the Fed, and the Treasury) did nothing.

 In what I’ve come to accept as an ironic historical event, the OFHEO stated in 2003 what would ultimately be the downfall that would lead to last Thursday’s announcement by the Treasury by saying, “although investors perceive an implicit Federal guarantee of [Government Sponsored Entities] obligations,” “the government has provided no explicit legal backing for them.” As a consequence, unexpected problems at a GSE could immediately spread into financial sectors beyond the housing market.(”Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO,” OFHEO Report, 2/4/03)

 When Freddie and Fannie exploded in 2008 - what OFHEO said was the risk became reality. One could no longer deny the fact that despite every effort to stop it - the USS Financial System had a massive hole below decks and was going to go down unless the flooding stopped.

 Second, the structural causes of the current world financial crisis are related to the fact that financial intermediation system that used to be based mainly on banks has been replaced by a system based on the capital markets, markets that can have their own disadvantages when they are less transparent. During the last decade, those markets did not operate transparently, and as a result, a significant amount of “bad debt,” debt on housing that even if the housing market didn’t collapse would have failed, was passed on throughout the capital system as indistinguishable as good debt.

 Fannie and Freddie’s underwriting of so much of the risky debt attached the good faith and credit of the United States to a mountain of bad loans. As a result, banks no longer faced the consequences of their actions in originating bad debts. Since no one, other than the ultimate investor, would suffer the consequences of bad loans, money sloshed around the system until eventually the game of “musical chairs,” came to a screeching halt in 2007. One by one, as the chairs were eliminated (the ability to refinance the bad paper), banks found themselves with increasing liability to shareholders with no performing assets to pay them off.

 Those two facts I believe guide what should happen now with Congress. We need to fix the problems that the GSE’s caused, and we need to focus on reforming the structural problems that lead to cheap money with no accountability.

 First, I think we need to accept the realities of the current financial situation. In the past year and a half - we have vaporized trillions of dollars of US wealth. As a result, I think recession is all but assured. Both Wall Street and Main Street are going to be forced to reconcile their bank accounts and their wealth. Thus, the goal of Government action should not be to keep these events from happening, but rather, to ensure that as we go through this transformative period, it occurs in an orderly way. Any other tact is essentially a misappropriation of the taxpayer’s funds.

 Second, people should not be able to escape the consequences of their decisions. The greatest culprit in this crisis is both the Government and Wall Street. While the consumer did indeed take no more than they should in debts - the accountability for that action is simple, they’ve lost their homes, and lost them in record numbers. They have had to file for bankruptcy. The accountability for the Faustian bargain that Wall Street and Washington made has not been accounted for as easily. This bill needs to account for those mistakes and figure out if there is any way to mitigate the consequences of that bargain for the American Taxpayer.

 To understand why, again, I think you need to understand what lead to the inflation of the housing markets and its eventual collapse. Easy money policies that were encouraged by Fannie and Freddie increased the availability of liquidity to the originators of home mortgages. This increase in money required that banks lend more in order to increase profits to shareholders. That could be accomplished only through an increased volume of transactions. Unfortunately, the originators followed the path of least resistance by appealing to the sector of the economy that is the most vulnerable and the one with the most pent-up demand. During 1994 only 5% of total US mortgages were classified as sub-prime but by 2006 that proportion had risen to over 20%. Moreover, that process occurred not just in the United States, but as the data now shows, it also occurred in the UK as well as in much of continental Europe as their markets are now laboring under the same strains as the US markets did about a year ago.

 As a result of the cheap money - Wall Street and Washington essentially created a situation where trillions of dollars had been lent to people who were at high risk of default. As defaults increased, and the availability of money slowly evaporated, the “house of cards,” fell apart. The consequences of that collapse were far reaching - as money markets, retirement accounts, and 401k’s found they all had a piece of that deck.

 Everyone is going to pay the price - but the taxpayer should not be the one who foot’s the bill. The point Government intervention in this case is to buy into the market to stabilize it, and ultimately, reform it so that it operates in a much more transparent manner. This is not a bailout. It’s not a rescue. To that end, I think the bill needs to focus on the following:

• There needs to be a strict formula and assessment for how to buy the assets that banks have. The government should not put the taxpayers on the line for completely worthless debts. An auction process seems to be the best way to insure that the government buys debts that have a reasonable chance at recovery at a fair price.

• The operations of whatever conservatorship is set up need to be completely transparent. Both the executive branch and the legislative branches need to have access to the books of the executor of the conservatorship. Moreover, the government needs to publish, at some regular interval, what the activities of the conservator are and what it intends to do in the future. The conservator of the portfolio must also brief Congress at regular intervals to provide the taxpayers accountability for the monies spent in accumulation of these assets.

• Any assets the government buys - it receives full right of control. The government should not be an underwriter of the debt. This is a buy in - not a bail out. The government should have all the full rights an investor would normally have.

• The conservator/receiver organization needs to be able to hold whatever instruments it purchases in perpetuity, not with a sunset clause. Some versions of the various bills suggest that the government should be forced at some point to sell debts by a specific date. That plan would be a disaster. The government should sell the debts it incurs only when it feels it is most advantageous to do so.

• The conservator/receiver organization needs to be restricted in both how much it can buy, and for how long it is authorized to buy. This should not be an open ended process. Within about 6-10 months, the Government should be out of the purchasing of bad debts business. The rest of the time should be spent by the receivership organization trying to figure out how best to structure and ultimately dissolve the holdings.

• In order to ensure that taxpayers receive the best value for the funds given to the government should be encouraged to sell, restructure, or otherwise liquidate the debt it buys over time.

• There should be Bankruptcy reform as part of this effort. Judges should be allowed to reform mortgages as part of their bankruptcy process. The 2005 Bankruptcy Reform bill insulated lenders from the risks of lending to risky creditors by making it difficult to discharge their debts through anything other than foreclosure and liquidation. This fact has contributed to the swelling of inventories of homes on the market and the devaluation of prices. In order to stabilize this contributor to the market’s decline, Bankruptcy reform should allow the banks to shoulder an increasing portion of this debt, either through restructuring or court-forced discharge of portions of mortgages. Moreover, restructuring the law will actually reduce the price of mortgages for everyone, as elimination of the “pay or surrender” risk will reduce that premium cost in mortgage interest rates.

 Most importantly, again, this is a restructuring, not a rescue. It’s a buy in, not a bailout. Congress and the White House need to realize that this effort’s main goal is the stabilization of the financial markets and the recapitalization of the financial system. It is not the time to take the taxpayer’s money and give it to Wall Street. It is not the time to take the taxpayer’s money and give it to homeowners who can’t pay their mortgages. We’re taking the taxpayers money and correcting an error we should have corrected over five years ago - making the markets more transparent and ensuring that people who benefit from risky deals also assume the downside to those deals when they go bad.

9/23/08: Update -

Video from today’s hearing…

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