The Magazine

Building a Better Bailout

It's time to reward virtue.

Dec 1, 2008, Vol. 14, No. 11 • By LAWRENCE B. LINDSEY
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The U.S. government's efforts at containing the financial crisis have to date been aimed at shoring up institutions and households that are in trouble. Several hundred billion dollars have been injected into troubled financial institutions, with more on the way, and a whole array of negotiated schemes have been created to keep people in homes for which they cannot pay the mortgage. Yet the Democrats in Congress clamor for more relief, such as bankruptcy "cramdowns," which unilaterally reduce the mortgage payments for people who can't afford them. And still more institutions are lining up for bailouts, most notably the auto companies.

It is quite natural for politicians to seek to target benefits on those that they perceive to be in need. It is the normal political response to the wheel that is squeaking the loudest. Regardless of motive, the reality is that these programs and indeed the bailout's whole approach is failing. Even Treasury Secretary Henry Paulson has now thrown in the towel on his original proposal to buy bad assets from the troubled financial firms: the Troubled Assets Relief Program (TARP). None of the $700 billion targeted for TARP will be used as originally intended. Instead most of it will prop up the capital position of the troubled financial institutions, allowing them to hold existing portfolios of questionable loans on their books. The rest will be spent on other distressed firms and troubled markets.

Recall that it was the efforts to sell TARP and the bailout that caused so much political and economic angst a few months ago. The president went on television to tell the American people that the economy, which had been holding in the relatively flat position for most of the summer, was about to collapse. Retail sales began plunging immediately after the president's speech. A majority of the Republican members of the House voted against their own leadership and the president on the plan and were blamed by the media for the 778 point drop in the Dow that day. As this went to press, the Dow Jones Industrial index stood 2,750 points below where it was the moment the bill finally passed, suggesting that Wall Street didn't think it was a panacea either.

The failure of the original plan was predictable. It contained unworkable logistical hurdles. TARP could only be run through some market mechanism, in which those who needed the relief the least would get the largest share leaving the most desperate institutions adrift, or through direct governmental targeting of those institutions most in need, which would have made a mockery of the market mechanism. The plan was rushed out to meet a perceived need to "build confidence," but the self-imposed political deadline and the need to survive the political log rolling with congressional Democrats meant that the time needed to think it through was not taken.

Hundreds of billions of dollars later, we are left with the same three underlying economic problems the economy faced when the bailout was proposed. First, the troubled housing-related financial assets that TARP was supposed to move onto the government's books are still in the private sector, while the nation's banks rush to pare down their balance sheets in the only way they can--by recouping existing loans and not making any new ones. Second, the housing market continues to fall--prices are down 22 percent from their peak and dropping roughly 1 percent per month. Housing starts are at a 17-year low, and homebuilder confidence is the lowest ever recorded. Third, with unemployment rising and consumer credit tight, household cash flow is in desperate shape. If it doesn't stabilize, the odds are high that the current recession will wind up being as bad as, or possibly even worse than, the deep recessions of 1974-75 and 1980-82.

The country faces three major economic problems: (1) making liquid the troubled housing debt that is clogging up the books; (2) stabilizing home prices; and (3) improving household cash flow. Each can be more easily achieved by rewarding virtue than by continuing down the current path.

The government should offer the option of a new mortgage to everyone now holding one, be it from a Government Sponsored Enterprise like Fannie Mae and Freddie Mac, a bank, or a mortgage broker. The principal amount would be the same as the existing mortgage. If the home-owner had two mortgages or a home equity line, they could all be rolled together into one new 30-year fixed rate mortgage. The new mortgages should have a substantially lower interest rate than existing mortgages. I suggest 4 percent, but the rate could be slightly higher without affecting the program.