$700 Billion for Disastrous Financial System Bailout

Bush is seeking $700 billion to buy “bad mortgages” in the largest bailout in history.  The proposal attempts to bail out the entire financial system, rather than individual banks.  This sweeping federal intervention will turn out to be either excessively costly, or unnecessary.  Defenders of this bailout, like Treasury Secretary Hank Paulson, claim it is needed because the mortgage meltdown and ensuing panic have led to mortgages having a market value of far less than they are truly worth, drying up markets for mortgages and resulting in “frozen” credit markets.

But even if this is true, it’s no reason for a bailout.  There are two possibilities, neither of which justifies a bailout.  Either the mortgages are just as worthless as their current market price suggests, in which case the banks that hold them, rather than taxpayers, should pick up the tab (and any insolvent banks should be closed, so that they cannot gamble with depositors’ and taxpayers’ money in the future).

Or, the mortgages are worth much more than they are currently valued — their current value being set under federal “mark-to-market” accounting regulations, which require that assets like mortgages be conservatively valued at what they can currently be sold for at the moment, rather than what they would be worth if held to maturity.  If that’s the case, then federal accounting regulations need to be immediately relaxed by federal agencies like the SEC that enforce them — as John Berlau argues today in the Wall Street Journal, and as former FDIC Chairman William M. Isaac urged yesterday in a Journal editorial attacking the federally-enforced Fair Value Accounting Rules and Basel II capital rules.  (This would also be a good time to revisit the truly senseless accounting regulations imposed by the Public Company Accounting Oversight Board, which cost the U.S. economy over $35 billion per year, and were used by sub-prime mortgage lender Countrywide Financial as a smokescreen to hide its risky business practices).

As John Berlau and Holman Jenkins have noted in the Wall Street Journal, if it were not for federal accounting regulations, the federal bailout of AIG might never have been necessary.   And banks, rather than dumping their own sub-prime mortgages at fire-sale prices to meet reserve and regulatory requirements, might instead have been willing and able to purchase or make loans to troubled financial institutions that now will have to be bailed out by the taxpayer.

As we noted yesterday, federal regulation contributed to the mortgage bubble and meltdown, as regulators encouraged and promoted risky lending, rather than curbing it.  Laws that pressure banks to engage in risky lending, like the Community Reinvestment Act, remain in full force, and the government-backed mortgage giants Fannie Mae and Freddie Mac, which failed and were taken over by the federal government, are now buying even more risky mortgage loans.  “Affordable housing” mandates continue to encourage risky lending.

But politicians, seeking to avoid any responsibility for causing this mess, are blaming the mortgage meltdown entirely on the free market and an alleged lack of regulation.  And journalists who recently (and belatedly) admitted the role of federal affordable housing mandates in causing the mortgage crisis, like the Washington Post’s Steven Pearlstein, a long-time cheerleader for Fannie Mae against its critics, are now back to their long-time role of cheerleading for more federal involvement in lending, and claiming that the massive federal bailout proposal shows the need for still more regulation of financial markets.

John Lott explains how regulators helped spawn the mortgage crisis by eroding lending standards here and here.