God Save Us From Wall Street

The idea is good but the method chosen by Paulson is crazy: to make taxpayers pay for the errors of those who made faulty investment decisions.

We have been saying for a while that the situation of American financial institutions was dangerous. Unfortunately in the last couple of weeks this situation has gotten out of control. The origin, as everyone knows, is in the large losses on real-estate loans. But the biggest problem is not the size of these losses. When the Internet bubble broke, more than 3 trillion dollars went up in smoke, but the American financial system did not feel it. Today the losses on loans are “only” a trillion but then why is the financial system on the brink of collapse?

The principle difference lies in who is undergoing these loses. The stock losses fell primarily on pension funds. We all became a little poorer but no institution finished in bankruptcy. On the contrary, the losses on mortgages now are falling on financial institutions that are the primary investors in this market. By their nature, these institutions operate with very little of their own capital and a lot of debt. Even limited losses are enough to make them bankrupt even if their underlying business is profitable. This is the case of Lehman, which went into bankruptcy two weeks ago, in spite of solid business.

If the problem is the shortage of venture capital, why is it so difficult to resolve? You just need to recapitalize the banks. But who should do it? When the situation seemed less serious, sovereign funds were rushing to invest. The price that they paid, however proved to be too high and they suffered large losses. Now no one wants to put themselves forward. In a situation of deep uncertainty, which is that in which we find ourselves, it is almost impossible to determine the fair price of an increase in capital.

The only one to propose it would signal to the market that a bank is worth less than was estimated, reducing the price of the stock exchange. If the bank does not stop and decides to go ahead with a capital increase, in spite of the smaller price, then the market deduces that the bank is desperate. And the price decreases even more. At this rate, the bank fails even before it is able to collect new capital.

If it were one or two banks, it would not be a problem. But when it is almost the entire financial system, the risk of a collapse is very high. The same banks refuse to lend to each other for fear of losing money. This paralizes the entire financial system. This is the reason that the Bush administration, through Minister of Treasury Paulson, has presented an unprecedented rescue plan. Paulson’s idea is to re-capitalize banks buying the indicted loans. For this purpose it has asked Congress for the possibility of using up to 700 billion dollars (more than the cost of the war in Iraq).

The idea of a radical intervention is good but the method is crazy. The Paulson plan includes the purchase of hundreds of billions of loans of doubtful worth on the part of the State. At what price? The reason why the private sector does not want to buy is because it is not able to evaluate these loans. What expertise does the U.S. government have to do better? In order for the plan to work it must overpay loans, recapitalizing banks at the expense of taxpayers. It is the most expensive welfare plan ever conceived. But welfare for the rich: taxpayers are taxed in order to protect investors. As I have explained in a brief pamphlet available on the Internet (http://faculty.chicagogsb.edu/luigi.zingales/Why Paulson is wrong.pdf), an alternative exists; to force a reduction of the debt of financial institutions. This alternative does not tax taxpayers but requires sacrifices to those who made faulty investment decisions. But from a political point of view, this is its Achilles heel. The interests of investors is much better represented in Washington than those of taxpayers and Wall Street loves the idea of a rescue at the expense of the taxpayer.

But this is not only a question of justice. Socializing losses (while the profits remain private), the Paulson plan undermines the base of the functioning of the market economy. The moment has come to save American capitalism from Wall Street.