By Ari J. Officer and Lawrence H. Officer
September 29, 2008
The Administration and Congress have felt compelled to do something
about the "financial meltdown," so an inefficient
and inequitable "bailout plan" has been rushed
through the legislature despite harsh criticism from the
right and left. That's unfortunate. Both presidential candidates
were stalling by qualifying the plan. Whichever candidate
had had the courage to reject outright this proposal would
have had the better claim to be President.
Do not be fooled. The $700 billion (ultimately $1 trillion
or more) bailout is not predominantly for mortgages and homeowners.
Instead, the bailout is for mortgage-backed securities. In
fact, some versions of these instruments are imaginary derivatives.
These claims overlap on the same types of mortgages. Many financial
institutions wrote claims over the same mortgages, and these
are the majority of claims that have "gone bad."
At this point, such claims have no bearing on the mortgage
or housing crisis; they have bearing only on the holders of
these securities themselves. These are ridiculously risky claims
with little value for society. It is as if many financial institutions
sold "earthquake insurance" on the same house: when
the quake hits, all these claims become close to worthless
but the claims are simply bets disconnected from reality.
Follow the money. Average Joes and Janes are not the holders
of the other side of complicated, over-the-counter derivatives
contracts. Rather, hedge funds are the main holders. The bailout
will involve a transfer of wealth from the American people
to financial institutions engaging in reckless speculation
that will be the greatest in history.
Rescuing financial institutions is not the best solution.
Yes, banks are needed to provide capital to businesses. But
it is not necessary to spend $1 trillion to maintain liquidity.
If the government is to intervene, it should pick and choose
which claims to purchase; claims that are directly tied to
mortgages would be a good start.
Let financial institutions fail, merge or be bought out. The
faltering institutions will see their shares devalued and will
be likely to be taken over by stronger institutions as has
already started happening. This consolidation of the financial
sector is both efficient and inevitable; government action
can only delay the adjustment.
The government should not intervene. It should leave overleveraged
financial institutions to default on their derivatives obligations
and, if necessary, file for bankruptcy. Much of the crisis
has arisen from miscalculating the risks involved in a large
book of positions in these derivatives. It is only logical
that these institutions pay for their poor management.
Rather than bailing out Wall Street, we propose that the government
should buy up the actual mortgages in question and do nothing
else. The government should not touch any derivatives; that
is, claims that do not directly tie into the actual mortgages.
If money becomes too tight, then the Fed can certainly increase
its loans to financial institutions.
Let the poorly managed, overly risk-taking financial institutions
fail! Always remember that Wall Street and the real economy
are not the same thing.
— Ari J. Officer has completed his master of science
degree in financial mathematics at Stanford University. Lawrence
H. Officer is a professor of economics at the University of
Illinois at Chicago.
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