June 16, 2008

Risky Business

By: Lauren Winchester

The Frank-Dodd housing bill has been the target of ire from conservatives and libertarians alike. The bill, dubbed a government buyout by its opponents, uses the Federal Housing Administration to guarantee $300 billion in refinanced mortgages. David C. John of the Heritage Foundation called it “an extremely bad precedent” and “essentially a government buyout of problem mortgages disguised as a refinancing plan.” Tom Firey of the Cato Institute warned that many housing proposals, including the FHA provision, could “put taxpayers on the hook for billions of dollars in grants, tens of billions in tax breaks, and guarantees for hundreds of billions of dollars in mortgages.”

But for American Enterprise Institute scholar Vincent Reinhart, the bill isn’t the problem — it’s the bailout mentality it reinforces. A mentality, he says, that started with the Federal Reserve’s rescue of investment bank Bear Stearns.

Yes, the Frank-Dodd bill is an inefficient means to an end, he concedes, but the legislation could be a lot worse. He’s more concerned with how the legislation was able to gain enough public support to be passed in the House and the consequences that will result from the Bear bailout that “changed the world.”

“My fear of the Frank-Dodd bill is that it’s the first part,” he said. “If financial markets don’t get materially better and the economy does not improve, then the desire for more encompassing legislation is going to be pretty overwhelming.”

Before the Bear bailout, direct mortgage relief from the government was unpopular among the majority of those who own their houses or pay their mortgages. He cites common complaints against direct mortgage relief: Why are some households helped, but not others? Why are households who borrowed unwisely given government aid, but not those who borrowed responsibly? After the bailout, however, polls showed that public support had turned in favor of governmental housing assistance.

A Rasmussen poll in late March, just days after the bailout, showed about 54 percent of the public was opposed to governmental assistance for homeowners, but in May, a couple months after Bear was rescued, an LA Times/Bloomberg poll found that 60 percent of people supported governmental help.

“If you’re willing to help investment banking, why aren’t you willing to help households?” he asks, reflecting the new public sentiment.”Politics in the U.S. are poll-driven, and if households don’t like it, then you have to figure out a way of packaging it so they will like it, and the Federal Reserve handed them a way to do so.”

Reinhart is no stranger to the inner workings of the Federal Reserve. He held various jobs there for more than a quarter century. He left his job last year as director of monetary affairs and secretary and economist of the Federal Open Market Committee to do research at AEI. Though he charges the Federal Reserve with turning public opinion in favor of expanded government intervention, he lavishes praise on the committee members, calling them “very, very smart” and “the best staff in Washington.”

“They probably have a reason for doing what they’re doing, but sometimes I don’t agree with them. AEI is a nice opportunity to express that disagreement,” he said.

Reinhart made his disagreements public in a Washington Post column, where he criticized the Federal Reserve for the bailout and warned of government dependency to come, noting that just because something is done for the first time in 70 years, that doesn’t mean it’s going to be 70 years before it happens again.

Part of the Bear Stearns problem was that there were only two options presented: Either the Fed bailed out Bear Stearns or there would be multiple cascading defaults. Bear Stearns’ collapse, in other words, was thought to represent a systemic risk to the entire financial network.

But Reinhart says this is a false dichotomy. He questions if other options would have been effective, such as other suitors besides JP Morgan providing funding or splitting up Bear Stearns’ portfolio and dealing with the troublesome portion. The bailout was a combination of the uncertain consequences surrounding a possible default and a subsequent sense of urgency and fear, he said.

“At any crisis, you try to figure out how to solve that day’s problem,” he said. “You probably don’t at that moment internalize the medium and longer term costs of that decision. You just solve that problem because that problem just seems to be the most pressing thing in the world to you at that very moment. Sure, the bailout created some unintended consequences, but was the Fed’s help a necessary evil to prevent a severe economic disturbance from the defaulting bank?

“Boy, if that’s the case, if a middle-sized investment bank could have such a complicated balance sheet that its failure would risk the financial health of the whole U.S. economy, then we’re probably doing lots of things wrong, and we have to think seriously about regulation.”

Besides, he says, it’s not like it’s the fist time in history that a financial entity has been on the verge of failing. He points to the near-failure of hedge fund Long-Term Capital Management in 1998. To sustain the hedge fund, the Federal Reserve Bank of New York gathered 17 heads of major investment banks and told them it would be in their best interest to donate capital to LTCM so it would not fail. The bank heads, who did not want to test market resilience, provided a private capital infusion that prevented the hedge fund from defaulting.

Reinhart said that an infusion of capital is necessary for banks adversely affected by the housing crisis, but providing that capital would be an unpopular — though efficient — move. “We could just provide capital infusions to the affected financial institutions. Boy, that’s unpopular. You’re not willing to help homeowners, but you are willing to help investment banks. Politically, it’s not in the scheme of things,” he says.

When talking about help for struggling homeowners, Reinhart brings up the Home Ownership Loan Corporation, a government agency created in 1933 to refinance mortgages. He points out that at its peak, the corporation employed 20,000 people and was in existence for about 20 years.

“If the government gets into the business of supporting house prices or direct mortgage relief, it is a retail business that will involve the creation of a new agency or a considerable expansion of existing ones. It will use a lot of resources, it will be wasteful, and it will be long lasting.”

Reinhart says it’s not exactly clear if the government has to act to help homeowners, but if it does, it should follow the model of the fiscal stimulus package, approved by Congress earlier this year, which was responsible for sending out stimulus checks to help ease economic woes.

“If there needs to be a role for government intervention, I would prefer that it was targeted, timely, and temporary here too.”

Reinhart did not name dissenters, but said the criticism his argument has received regards the false dichotomy theory, mainly that allowing Bear Stearns to default would have been too risky and required wrenching market adjustments, so the medium and longer term costs of the bailout are justified. However, Reinhart said more and more people, including Federal Reserve officials, are reconsidering the bailout. He noted that Charles Plosser, Philadelphia Federal Reserve bank president, and Jeffrey Lacker, Richmond Federal Reserve bank president, very recently gave speeches in which they questioned the decision to lend to investment banks. Paul Volcker, former chairman of the Federal Reserve, also questioned the intervention on “Charlie Rose” in March, not long after the bailout.

“What happened since the Federal Reserve lent to Bear Stearns is people are thinking more about the medium and longer term consequences and saying, ‘gee, is this in the end going to be worth it?’ The answer is it’s not that clear.”

–Lauren Winchester is a reporter for Doublethink Online.

(Image of the Federal Reserve used under a Creative Commons license courtesy Flickr user Joe Hatfield.)

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