September 24, 2008 (Housing Market Monitor)

The Public Interest In Collapsing Investment Banks

September 24, 2008

By Dean Baker

"The bailout should be explicitly designed to punish the banks and their managers."

As Congress debates Secretary Paulson’s bailout proposal, it is worth briefly recapping what the interests of the general public in such a bailout might be. To restate the obvious, the public has an interest in keeping the banking system functioning. The jump in the LIBOR last week following the collapse of Lehman showed that a breakdown is a real risk.

The likelihood of another breakdown at the moment really cannot be determined. Nor is it possible to know for sure whether stop-gap measures by the Fed and Treasury will be sufficient to again stop a run. These factors suggest some urgency to addressing the problem, but there is almost certainly time to design a good package.

Beyond keeping the banking system running, there is absolutely zero public interest in giving a dime to either the top executives at these institutions or the shareholders. The top executives at these banks are among the richest people in the country. They are obviously incompetent, or their banks would not be sitting there with tens of billions of dollars of junk loans.

If these executives profit from the bailout, it effectively means that we will have taxed school teachers and firefighters to give money to the executives at Citigroup and Goldman, who drove their companies to the edge of bankruptcy.

Apart from the fairness issue raised by a bailout, there is also an enormous moral hazard problem. These executives profited enormously from the risky investments they made during the housing bubble. If they are allowed to walk away unscathed now that these investments have turned spectacularly sour, then we are creating an incentive structure that encourages the most outlandish form of risk-taking. In effect, we are telling these bankers that there is no downside if their gambles don’t pay off.

For this reason, the public has a huge interest in seeing the top executives at these institutions punished to the greatest extent possible. They must suffer real consequences from their mistakes.

The same logic applies to the shareholders in these firms. The firms showed huge profits during the peak years of the housing boom. Many shareholders pocketed substantial sums as a result of the banks risky bets. Therefore, they should also be forced to pay the price from losing bets.

The situation of homeowners caught in the crash is more complex. To some extent, these were people who also hoped to profit from the housing bubble, hoping that house prices would continue to rise at double-digit annual rates. But for the most part, these were families who were simply following the advice that the experts – economists, financial counselors, politicians, and community groups – gave them. They bought a home and often struggled to make the payments on their mortgages for as long as they could.

There is an interest in trying to ensure that these people do not suffer unnecessarily from the collapse of the housing bubble. While the government cannot hand them their house free and clear, it can attempt to make reasonable write-downs to allow them to stay in their homes as owners. If ownership is not a possibility, they should be given the opportunity to stay in their homes as renters. This is not a great bonanza for homeowners who will lose their home, but such a move would provide some security to families who otherwise face eviction.

Beyond keeping homeowners in their home, there is zero public interest in trying to support house prices. Housing prices are still inflated, even though they have fallen sharply from their bubble peaks. The bubble prices have resulted in a huge oversupply, which will not be eliminated until house prices return to their trend level. Furthermore, even if we could sustain high prices this would simply mean a transfer of wealth from those who don’t own homes to those who do. It is not clear why anyone would argue for this sort of upward redistribution of income.

We are more likely to see an effective resolution to the financial crisis if there is clarity on its goals. At this point, it seems there is very little agreement on the intent of the proposed bailout package.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net). CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.



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