Here's a Better Bailout Plan

By Joseph Stiglitz, TheNation.com. Posted October 1, 2008.

The champagne bottle corks were popping as Treasury Secretary Henry Paulson announced his trillion-dollar bailout for the banks, buying up their toxic mortgages. To a skeptic, Paulson's proposal looks like another of those shell games that Wall Street has honed to a fine art. Wall Street has always made money by slicing, dicing and recombining risk. This "cure" is another one of these rearrangements: somehow, by stripping out the bad assets from the banks and paying fair market value for them, the value of the banks will soar.

There is, however, an alternative explanation for Wall Street's celebration: the banks realized that they were about to get a free ride at taxpayers' expense. No private firm was willing to buy these toxic mortgages at what the seller thought was a reasonable price; they finally had found a sucker who would take them off their hands -- called the American taxpayer.

The administration attempts to assure us that they will protect the American people by insisting on buying the mortgages at the lowest price at auction. Evidently, Paulson didn't learn the lessons of the information asymmetry that played such a large role in getting us into this mess. The banks will pass on their lousiest mortgages. Paulson may try to assure us that we will hire the best and brightest of Wall Street to make sure that this doesn't happen. (Wall Street firms are already licking their lips at the prospect of a new source of revenues: fees from the US Treasury.) But even Wall Street's best and brightest do not exactly have a credible record in asset valuation; if they had done better, we wouldn't be where we are. And that assumes that they are really working for the American people, not their long-term employers in financial markets. Even if they do use some fancy mathematical model to value different mortgages, those in Wall Street have long made money by gaming against these models. We will then wind up not with the absolutely lousiest mortgages, but with those in which Treasury's models most underpriced risk. Either way, we the taxpayers lose, and Wall Street gains.

And for what? In the S&L bailout, taxpayers were already on the hook, with their deposit guarantee. Part of the question then was how to minimize taxpayers' exposure. But not so this time. The objective of the bailout should not be to protect the banks' shareholders, or even their creditors, who facilitated this bad lending. The objective should be to maintain the flow of credit, especially to mortgages. But wasn't that what the Fannie Mae/Freddie Mac bailout was supposed to assure us?

There are four fundamental problems with our financial system, and the Paulson proposal addresses only one. The first is that the financial institutions have all these toxic products -- which they created -- and since no one trusts anyone about their value, no one is willing to lend to anyone else. The Paulson approach solves this by passing the risk to us, the taxpayer -- and for no return. The second problem is that there is a big and increasing hole in bank balance sheets -- banks lent money to people beyond their ability to repay -- and no financial alchemy will fix that. If, as Paulson claims, banks get paid fairly for their lousy mortgages and the complex products in which they are embedded, the hole in their balance sheet will remain. What is needed is a transparent equity injection, not the non-transparent ruse that the administration is proposing.

The third problem is that our economy has been supercharged by a housing bubble which has now burst. The best experts believe that prices still have a way to fall before the return to normal, and that means there will be more foreclosures. No amount of talking up the market is going to change that. The hidden agenda here may be taking large amounts of real estate off the market -- and letting it deteriorate at taxpayers' expense.

The fourth problem is a lack of trust, a credibility gap. Regrettably, the way the entire financial crisis has been handled has only made that gap larger.

Paulson and others in Wall Street are claiming that the bailout is necessary and that we are in deep trouble. Not long ago, they were telling us that we had turned a corner. The administration even turned down an effective stimulus package last February -- one that would have included increased unemployment benefits and aid to states and localities -- and they still say we don't need another stimulus. To be frank, the administration has a credibility and trust gap as big as that of Wall Street. If the crisis was as severe as they claim, why didn't they propose a more credible plan? With lack of oversight and transparency the cause of the current problem, how could they make a proposal so short in both? If a quick consensus is required, why not include provisions to stop the source of bleeding, to aid the millions of Americans that are losing their homes? Why not spend as much on them as on Wall Street? Do they still believe in trickle-down economics, when for the past eight years money has been trickling up to the wizards of Wall Street? Why not enact bankruptcy reform, to help Americans write down the value of the mortgage on their overvalued home? No one benefits from these costly foreclosures.

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Joseph Stiglitz, a Nobel laureate, is a professor of economics at Columbia University.