Toxic Assets and the Government's Web

Treasury Secretary Geithner has revealed yet another program, this time to clear out $1 trillion in toxic assets held by financial institutions. We have had the Recovery and Reinvestment Program, housing programs, capital injections into banks, Federal Reserve lending to shore up securitized student loans and consumer debt, direct purchase of securities backed by Small Business Administration loans, and purchases of Treasury securities, not to mention the provision of billions of dollars in loans to two of the domestic auto companies. This is all an attempt to correct for the result of massive government intervention in the housing market, especially that of Fannie Mae and Freddie Mac.

The great Austrian economist, Ludwig von Mises, more than eighty years ago, pointed out that when government intervenes in the economy it creates unintended consequences that lead to further government intervention and argued further that this process will eventually lead towards socialism. Perhaps Newsweek was being prescient when it ran its February 7 cover “We Are All Socialists Now.”

The new Treasury plan looks a lot like the original plan to buy up toxic assets that Secretary Paulson expounded six months ago when Congress was asked to pass the Troubled Asset Relief Program. Instead, the TARP money was used to directly inject capital into banks and give loans to Chrysler and GM. The problem, we were told, was that it is too difficult to find a price for the assets. Now there is a new Public-Private Investment Program, which, to quote the new Secretary, “will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time,” in order to purchase real-estate related loans and securities.

The difference now is not that the pricing of these assets has become clearer, but that the federal government has now become the majority owner in the world’s largest insurance company and creditor to the major banks and is reaching out for the rest of the financial community. As the Nobel Laureate Friedrich Hayek wrote, once someone else becomes responsible for your actions you will be coerced by them. Now that the government has become responsible for the debts of AIG, Bank of America, General Motors, and others, these companies are finding that the government is now telling them what salaries they may pay their executives, what kind of cars they may produce, to whom they must loan, etc.. There is little reason to believe that the government will stop here. Requirements to pay union wages, to provide specific health care benefits, to use green energy, are all only a bureaucrat’s whim away.

The new plan is meant to entice more firms into the web of government control. Hedge funds and other investors will bid for packages of loans and securities that banks are willing to sell. However, the investors will only be at risk for 7% of the price of the asset purchased should the asset be truly toxic. The FDIC will provide a guarantee of a loan for 86% of the purchase price, and Treasury will provide half of the remaining 14%. If the assets rise in value, the loan is paid off and then the private investor gets half of the profit. If the asset collapses in value, the only collateral the FDIC has is the asset, so the taxpayer can potentially lose 93% of the price.

The taxpayer risk is almost the same as the old Paulson plan, but this one draws in participation by hedge funds, insurance companies, mutual funds, and a wide range of financial institutions by providing them minimal risk on the down side and the potential for massive profits on the upside. One might ask, if the taxpayer is at risk for 93% of the downside, what is the advantage of participation from the private sector, especially when the taxpayer gives up 50% of the upside? While Treasury may argue that the competitive bidding for the assets facilitates determining a market price, the real effect of this program is to bring more private companies into “partnership” with the federal government. But “partnership” with the federal government means that the executive and legislative branch can begin to dictate the behavior of the financial institutions drawn in by the promise of a deal nearly too good to be true.

Do we really think that Congress will not impose a tax on companies, shareholders, and executives if the assets rise in value more than is deemed “fair” by Chairman Frank or Speaker Pelosi? Why won’t an insurance company that participates in the program be required at some point in the future to provide subsidized rates to certain low income individuals? The amount of government intervention will only be limited by the imagination of the majority in Congress.

A clear signal that this is more about government control than stabilization of the banking system is the testimony yesterday from Secretary Geithner that he is seeking the ability to effectively take over non-bank financial institutions using powers similar to those the FDIC and Federal Reserve have over the banking industry. The idea of limited government as envisioned by the founders is no longer part of the discussion. Institutions that choose to participate in any of these programs are likely to find themselves playing the role of fly to the spider as will our tradition of liberty and personal responsibility. Before embarking on more government intervention, market-oriented solutions such as suspension of mark to market accounting for regulated capital should be given a chance.