E pluribus hokum or
When the gamblers bail out the casino
Why should American taxpayers give US Treasury Secretary "Hank" Paulson a blank
check to bail out the shareholders of busted banks? Why should the Treasury
turn itself into a toxic waste dump for their bad loans? Why not let other
banks join the unlamented Brothers Lehman in bankruptcy court, and start a new
bank with taxpayers' money? Or have the Treasury pay interest on delinquent
mortgages, and make them whole? Even better, why not let the Chinese, or the
Saudis or other foreign investors take control of failed American banks?
They've got the money, and they gladly would pay a premium for an inside seat
at the American table.
None of the above will occur. America will give between US$700-$800 billion to
the Treasury to buy any bank assets it wants, on
any terms, with no possible legal recourse. It is an invitation to abuse of
power unparalleled in American history, in which ill-paid civil servants will
set prices on the portfolios of the banking system with no oversight and no
threat of legal penalty.
Why are the voices raised in protest so shrill and few? Why will Americans fall
on their fountain-pens for their bankers? If America is to adopt socialism, why
not have socialism for the poor, rather than for the rich? Why should American
households that earn $50,000 a year subsidize Goldman Sachs partners who earn
$5 million a year?
Believe it or not, there is a rational explanation, and quite in keeping with
America's national motto, E pluribus hokum. Part of the problem is that
Wall Street, like the ethnic godfather in the old joke, has made America an
offer it can't understand. The collapsing the mortgage-backed securities market
embodies a degree of complexity that mystifies the average policy wonk. But
that is a lesser, superficial side of the story.
Paulson's dreadful scheme will become law, because Americans love their
bankers. The bankers enable their collective gambling habit. Think of America
as a town with one casino, in which the only economic activity is gambling.
Most people lose, but the casino keeps lending them more money to play.
Eventually, of course, the casino must go bankrupt. At this point, the
townspeople people vote to tax themselves in order to bail out the casino.
Collectively, the gamblers cannot help but lose; individually they nonetheless
hope to win their way out of the hole.
Americans are so deep in the hole that they might as well keep putting borrowed
quarters into the one-armed bandit. They have hardly saved anything for the
past 10 years. Instead, they counted on capital gains to replace the retirement
savings they never put aside, first in tech stocks, then in houses. That hasn't
worked out. The S&P 500 Index of American equities today is worth what it
was in 1997, after adjusting for inflation (and a pensioner who sells stock
purchased in 1997 will pay a 20% capital gains tax on an illusory inflationary
gain of 40%). Home prices doubled between 1997 and 2007 before falling by more
than 20%, with no floor in sight.
As it is, many of the baby boomers now on the verge of retirement will spend
their declining years working at Wal-Mart or McDonalds rather than cruising the
Caribbean. Some of them still have time to tighten their belts and save 10% of
their income (by consuming 10% less), plus a good deal more to compensate for
the missing savings of the 1990s.
Altogether, they'd rather gamble, and if that requires a bailout of the house,
they gladly will chip in to pay for it. After all, today's baby boomers won't
pay for the bailout. The next generation of taxpayers will pay for Paulson's
$700-$800 billion. If that enables the present generation to keep borrowing
rather than saving, it is no skin off their back. If home prices continue to
collapse, the baby boomers will die in debt anyway, working at low-paying jobs
until the day before their funerals.
The homeowners of America hope against hope that somehow, sometime, the price
of their one only asset will bounce back. The character of Mortimer Duke in the
1983 film Trading Places comes to mind. After losing his fortune in the
frozen orange juice futures market, Duke screams, "I want trading reopened
right now. Get those brokers back in here! Turn those machines back on! Turn
those machines back on!" If a reverse takeover of the US government by Goldman
Sachs is what it takes to turn the machines back on, the American public will
support it. Sadly, there is no reason to expect the bailout of bank
shareholders to have any effect at all on American home prices, which will
continue to sink into the sand.
Contrary to what the Bush administration says, it is not the case that banks'
troubled mortgage assets cannot be sold in the private market. Those are the
so-called "Level III" assets that banks say they cannot value. But that is only
a dodge that the banks use to postpone taking losses. There is a ready bid for
these assets from hedge funds, in multi-hundred-billion-dollar size. The
trouble is that the market bid is 25% to 30% below the prices that banks carry
these assets on their books. Traders at Wall Street boutiques who specialize in
distressed securities say that US regional banks regularly make discreet offers
to sell private mortgage-backed securities (not guaranteed by a federal agency)
at prices, for example, of 75 to 80 cents on the dollar. Hedge funds bid, for
example, 55 to 60 cents in return.
On rare occasions, the bank seller and the hedge fund buyer will meet in the
middle, although very few transactions occur. Although many banks are desperate
to sell, they cannot accept the offered price without taking losses over the
threshold of mortality, for write-downs of this magnitude would destroy their
shareholders' capital. Investment banks typically hold about $30 of securities
for every $1 of capital, so a 3% write-down would leave them insolvent. Lehman
Brothers classified 14% of its assets as Level III at the end of the first
quarter; Goldman Sachs was at 13%. Why is Lehman bankrupt, and Goldman Sachs
still in business? If Secretary Paulson, the former head of Goldman Sachs, had
not proposed a general bailout last week, we might already have had the answer
to that question.
For the Paulson bailout to be helpful to the banks, it must buy their
securities at much higher prices than the private market is willing to pay.
Otherwise it makes no sense at all, for the banks could sell at any moment to
the hedge funds. But that is a subsidy to private banks, administered at the
whim of the Treasury Secretary, without oversight and without the possibility
of legal recourse.
Some Democrats in Congress are asking for some form of oversight, but it is
hard to imagine how they might use it, for a Treasury with $800 billion to
spend would constitute the whole market bid for low-quality mortgage assets,
and would set whatever prices it wished. Professionals with years of experience
set prices on these securities with great uncertainty. How would an overseer
determine if it had set the correct price? And if the Treasury decided to bail
out one bank (say, Goldman Sachs) rather than another, how would the overseer
judge whether that decision was judicious, politically motivated, venal, or
Opposition to the Treasury plan is disturbingly thing. Bloomberg News on June
21 quoted the Democratic chairman of the Senate Banking Committee, Christopher
Dodd, saying, "I know of nobody who is arguing over the amount of money or even
about that the secretary ought to have the authority to purchase these toxic
instruments, these bad debts."
Why the taxpayers of America would allow their pockets to be picked in this
fashion requires a different sort of explanation than one finds in economics
textbooks. My analogy of gamblers taxing themselves to bail out the casino is
inspired, in part, by a remarkable new book by the Canadian economists Reuven
and Gabrielle Brenner (with Aaron Brown), A World of Chance. In effect,
the Brenners re-interpret economic theory in terms of gambling, showing how
profoundly gambling figures into human behavior, especially in such matters as
so-called life-cycle investing. The 50-ish householder who has not made enough
to retire may take outsized chances, considering that as matters stand, he will
work until he drops dead in any case. The Brenners write:
reach the age of fifty or fifty-five and have not "made it," what are their
financial options to still live the good life? Except for allocating a few
bucks to buy lottery tickets, it is hard to think of any other option. If
people find themselves down on their luck and see no immediate opportunities to
get rich, what can they do to sustain their hopes and dreams? Allocating a
fraction of their portfolios with a chance to win a large prize is among the
options. And when people are leapfrogged - that is, when some "Joneses" who
were "below" them jump ahead - how can they catch up? They will tend to
challenge their luck for a while, taking risks that they might have
contemplated before in business, financial markets, and other areas but did not
follow up with action.
A World of Chance undermines our
usual view of "economic man" and substitutes the angst-ridden, uncertain
denizen of a world that offers no certainties and requires risk-taking as a
matter of survival. I hope to offer a proper review of the work in the near
future. As my marker, though, permit me to leave the thought that for providing
a theoretical foundation for the counter-intuitive behavior of American
taxpayers, the Brenners deserve the Nobel Prize in economics.
Alas for the gamblers of America: they will tax themselves to keep the casino
in operation, but it will not profit them. Where, oh where, is America's
Vladimir Putin, who will drive out the oligarchs who have stolen the country's
treasure and debased its currency?