The bailout package is likely a done deal now. I oppose this package for a number of reasons, which I will outline below. From a financial perspective, the current deal is significantly better than the original proposal by Paulson. Still, there are too many flaws to list all of them.

The Premise

The premise of this bailout is: If the government does nothing, financial Armageddon will occur, which will devastate everyone. The government can take action that will prevent this Armageddon.

I first would like to dispute the belief that financial Armageddon will occur. While the large banks that have almost all made ridiculous bets would collapse, WaPo reports that Smaller Banks Thrive Out of the Fray of Crisis:

Banks throughout the United States carried on with the business of making loans yesterday even as federal officials warned again that their industry is on the verge of collapse, suggesting that the overheated language on Capitol Hill may not reflect the reality on many Main Streets.

What a grandiose statement. Care to back it up?

Dunkelberg, a professor of economics at Temple University and chief economist for the National Federation of Independent Business, added that a recent survey of that group’s members found that only 2 percent said getting a bank loan was the great challenge facing their businesses.

No, that’s impossible. Lending has frozen. Banks can’t afford to make loans. Right?

[…] many smaller banks said they were actually benefiting from the problems on Wall Street. Deposits are flowing in as customers flee riskier investments, and well-qualified borrowers are lining up for loans.

And the choice quote from the article:

“We’re drowning in liquidity because people are pulling money out from other places and depositing it with us,” said Peter Fitzgerald, chairman of Chain Bridge Bancorp in McLean. “Our bank has benefited tremendously.”

“Drowning in liquidity” is the exact opposite of what is being reported to our politicians by Paulson and Bernanke.

My argument for this is one of diverted economic resources. Bailing out the larger, troubled institutions will cost these smaller, local banks. The true economic cost will not be measured because the alternative will be an alternate future that wasn’t allowed to happen. Money that would have flowed to these careful lenders will stay with the large, reckless institutions that helped cause this mess. This is moral hazard and opportunity cost at their finest.

The second part of the premise is that the world’s largest government intervention will prevent financial Armageddon. For this, I’ll point out that the Bear Stearns, Fannie and Freddie, and AIG bailouts didn’t work, so there’s not a lot of reason to expect this to work either. In fact, I believe that this plan may actually cause the Armageddon it is trying to prevent.

There are two possible bad scenarios that I see:

1. Flooding the market with treasuries will cause interest rates on those treasuries to rise. Right now, the market has had an insatiable appetite for treasuries. The yields, particularly on the 3 month, have dropped to their lowest since World War II. Dumping a few hundred billion dollars worth of treasuries, or the amount of treasuries that China currently owns (how’s that for perspective?), will help these rates rise. That only makes them more attractive. This will help speed up the flight of money from stocks to treasuries. Remember, money invested in treasuries is money not invested elsewhere.

2. The plan causes the dollar to fall. This causes foreign investors to be unhappy with their treasuries, which now have negative returns in their own currencies. Foreign money pulls out, and interest rates rise to the point where nothing is as attractive to domestic dollars from a risk/reward perspective.

Of course, those two scenarios are not mutually exclusive. I will grant that there are many positive scenarios that are plausible, at least for the short term.

The Plan

I found a nice summary from Reuters here, CNNMoney here, and a copy of the bill via the LA Times here

The plan itself consists of a few key items, and numerous “improvements” that once again demonstrate that our elected officials would fail even the most basic economics courses. The key items:

1. $700 billion, spread over 3 payments of $250 billion, $100 billion, and $350 billion. The first payment would be immediate, the second would require the president to notify congress, and the third requires notification of congress with a 15 day chance to have congress veto the effort through super-majority vote.

2. The money is spent at the discretion of the Secretary (Paulson), who will consider negotiating a good price and equity stake for the bad assets.

3. The purchases made by the Treasury will be made public after a couple days.

4. Oversight of some sort.

The numerous “improvements” include:

1. Excess profits go into an affordable housing fund.

2. Sellers of Fannie or Freddie preferred stock will pay additional capital gains taxes.

3. The Treasury will try to provide foreclosure relief for mortgages it buys.

4. Mark-to-market accounting rules can be suspended.

5. Bank reserve ratios can drop to zero.

6. Limits on executive compensation for participating institutions.

Well, the Heritage Foundation reports that Latest Bailout Draft Makes Constitutional Questions Worse:

Members of Congress may think their new oversight provisions improve the bill, when in fact they move in the wrong direction. The latest House draft does not correct the old constitutional defects, and it raises new constitutional problems. These are not mere policy preferences that can be weighed against other policy preferences. These are iron-clad constitutional mandates. If they are not fixed, no Member can vote for the bill without violating his/her constitutional oath.

To me, the issues are quite simple. Congress is supposed to control the purse strings. They have given the executive branch a blank check, and given themselves strict rules for vetoing part of that check. So now the Executive branch has the purse and Congress has veto power. And the oversight issue now involves power sharing between the executive and legislative branches. That’s … interesting. The actual rules violations do not concern me as much as the economic implications (of course, if you like the Constitution, and do not approve of its use as toilet paper, you are free to feel more outraged by the Constitutional implications than the economic implications).

So, let me discuss the economic implications. The first such implication is that by passing such a large bill, the relative scale of all bills has been altered. That’s why nobody debated a $25 billion auto industry bailout.

The second implication is that the man who didn’t see this coming, and who argued against equity stakes, taxpayer protection, and limits on executive compensation, Secretary Paulson, is in charge of getting a good deal. This is a guy who thought getting nothing in return was a good deal. No actual guidelines are provided. It’s all still at Paulson’s discretion. My conclusion: Taxpayers are still going to get screwed.

The third implication is that any runs on banks will be devastating. I’m assuming that the reserve ratios will be dropped. This will allow banks to operate after they would normally be declared dead, and make them increasingly susceptible to bank runs. Worse, if nobody fixes this, then we will experience a period of hyperinflation in a couple decades, after the current unwind is over and appetite for credit increases. This is because of the money multiplier effect, that I discussed here. Essentially, lowering the reserve requirement to zero gives banks the ability to create an infinite dollar supply. Of course, I don’t actually believe this will stay this low forever, but I do expect it to last just long enough to be harmful.

The fourth implication is a more volatile market. Changing accounting rules to reduce transparency is never a good thing. Mark-to-market isn’t perfect. In illiquid markets, it can even be misleading. However, it’s better than nearly all alternatives. The argument that banks are using is that bonds were sold off at fire sale prices, and it doesn’t represent true value. Unfortunately, for fungible assets, it does. It’s true that if your neighbor’s house is sold at a distressed price, your house shouldn’t necessarily be accounted for at a lower value. However, these bonds are blendings of thousands of mortgages, not individual houses. They are as fungible as is practical. That was the point. So when a few billion dollars worth of bonds are sold at fire sale prices, that does represent the value. Not happy? Take it up with the ratings agencies for classifying your bonds as the same risk as the stuff that turned out to be dung. So, why will this lead to increased volatility? The book value of institutions will become a guessing game. To some degree, the decreased transparency will have a discount associated with the increased risk. But, the risk is hard to assess. When something blows up, it will blindside investors. There will be increased volatility in book value, and that will cause increased volatility in stock value. The larger the institution, the greater the risk of bad valuation. That’s bad.

The Behavior of Congress

I received the following in an email from Senator Dianne Feinstein:

Since this announcement, my offices have received thousands of comments from Californians like you concerned about how this action will affect them. Yet, I believe prudent action must be taken. The bill should include the following principles: a phase-in of funding; oversight, accountability and transparency; a mechanism allowing the Secretary of the Treasury to modify mortgages to prevent additional foreclosures; and a precise cap on executive compensation.

Reports are that 95% of all feedback on a bailout package have been negative, yet Congress still wants to pass this bill. In other words, “The people who elected us are nearly united in their opposition to this, but we’re doing it anyway because we think we know better.” Why do they know better? Because they are deferring to the experts, Paulson and Bernanke. The experts who never saw this coming.

The behavior of congress is atrocious. I sincerely hope that we vote the lot of them out and send a stern message to their replacements: You got elected because they screwed us, not because we liked you. You can easily be next. Our elected officials should serve us, not the other way around.