Last week the government took extraordinary measures to restore calm to the financial markets. Besides the takeover of insurer American International Group, the government banned short-selling of 799 financial stocks and floated a plan to buy up risky mortgage-backed assets. These actions, unfortunately, may prove incredibly costly to the taxpayer, and delay recovery of the credit markets.
The costs of the massive bailouts are not known, because the taxpayers have essentially acquired a large stake in the nation’s mortgages and assets tied to them. If the real estate market recovers, the government might actually make money on its takeover of Fannie Mae and Freddie Mac, as well as its purchase of mortgage debt outright. On the other hand, if house prices continue to plummet, then the taxpayers could stand to lose more than $1 trillion over the years.
The worst news, however, is that these costly government measures will actually prove to be counterproductive. The government’s actions have encouraged institutions to shield their balance sheets as much as possible, to hide how much they are exposed to “toxic” assets. This lack of transparency is why banks are reluctant to lend, even to each other, and why struggling institutions cannot raise outside capital.
The government itself has made it rational for each bank to continue stringing along its investors. After all, why should an investment bank announce the full extent of its shoddy mortgage-backed assets before its competitors do so? For the past 13 months, the government has been announcing steadily more generous measures to resuscitate Wall Street. The largest holders of these toxic assets played a game of chicken, betting that they could survive long enough to get a massive bailout from the government. And last week, Treasury Secretary Henry Paulson rewarded their foot-dragging with the promise of hundreds of billions in taxpayer dollars.
The ban on short-selling is also counterproductive. First of all, speculators perform a vital service by signaling to the public which stocks are overvalued. The reason the “vultures” attacked Bear Stearns and Lehman Brothers was that these firms were heavily leveraged in dubious mortgage derivatives. Not even New York State Attorney General Andrew Cuomo – who is making a big fuss about market manipulation by short-sellers – would suggest that Exxon could have been brought to its knees by mere rumors.
As in the animal world, vultures target sick prey. The ban on short sales now deprives investors of a key source of information about which firms are healthy. This will lump in the responsible financial institutions with their profligate, overleveraged peers, making recovery all the slower. And it gets even worse.
Speculators aren’t the only ones who short stocks. Other firms engage in the practice as well, but for hedging purposes. For example, some firms (such as AIG) issue “credit default swaps,” which are basically insurance contracts promising to pay the buyer of the swap in the event that another corporation defaults on its bonds. Normally, the firm issuing the insurance could hedge itself by shorting the stock of the insured firm, because if a firm defaults on its bonds, its share price would plummet, too. But now the Securities Exchange Commission has taken away this option for the very financial institutions most in danger of defaulting on their bonds.
This will make it less attractive for insuring firms to sell credit default swaps on vulnerable financial corporations, meaning the SEC’s move will make it harder for outside investors to buy insurance against bond defaults by these companies. Perversely, the SEC has made it riskier for investors to lend capital to the financial sector.
Whatever the intention, last week’s historic interventions in the financial market may end up costing taxpayers hundreds of billions. In exchange for this immense price tag, the measures will paradoxically reduce transparency and make it harder for cash-strapped financial institutions to raise private money.
Americans rightly want the credit crisis to go away, but it will continue to fester so long as the government keeps changing the rules and throwing tax dollars at the problem.
Murphy is a senior fellow in business and economic studies at the Oakland-based Pacific Research Institute. He is author of “The Politically Incorrect Guide to Capitalism” (Regnery 2007) and “Ending the Revenue Rollercoaster: The Benefits of a Three Percent Flat Income Tax for California.” Contact him at [email protected].