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Bill Francis
Research in the Disciplines (The Corporation)/355:301:D2
Professor Robbins
Final Paper (Final Draft)
12/09/08

$700 Billion Bailout: Government Rescue or Give-away?

The United States is currently in the middle of, arguably, the worst financial and

economic crisis since the Great Depression. Home foreclosures continue to rise,

unemployment rate is the highest it has been in 14 years, credit is still frozen, and

consumer confidence and spending have fallen dramatically. These signs, as well as

other economic indicators, all point towards a full-blown recession, and possibly worse.

In the midst of this crisis, there has been an outcry from Main Street for a firmer

government stance against financial corporations. This opposition reached its’ peak in a

late September week when Congress deliberated over the proposed 700 billion dollar

bailout package in order to stop the domino effect of failing banks by improving

liquidity. Liquidity, in this sense, is simply the ability of banks to loan funds to one

another as well as to businesses. In order to meet demands from depositors looking to

withdraw and to pay off their own debt, banks substantially raise their interest rates and

lend out only to individuals and businesses with the best credit scores. Constituents

though, have perceived the bailout as a helping hand for irresponsible “big business”,

and have responded angrily to their Congressional representatives, delaying passage of

the bailout.

This tumultuous week brought back into the national spotlight the functions and

interactions between financial corporations and government with regard to regulations.

Most notably, the 2008 Presidential race has highlighted the centuries-old divide over
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economic philosophies. Democratic candidate, and now president-elect, Barack Obama

has decried the deregulatory actions of the Bush Administration, coupled to the greed of

financial and banking corporations, as the cause of the financial crisis. Republican

candidate, John McCain, called Obama’s economic philosophy “a lot like socialism”.

Regardless, the passing of the 700 billion dollar bailout in early October, along with a

more discontented public sentiment, has been undoubtedly pushing the American

financial system from a laissez faire market to a far more regulated system. Thus, the

current state of affairs brings to mind two important questions: Should the bailout plan

have passed, and what role should the government take in the financial markets?

Drawing on numerous case studies, financial experts, and a basic economic perspective,

it will be shown that it is in the best interest of the American economy and its’ people

for the bailout plan to have passed and for stricter regulations to be placed where there

is failure in the financial markets. An understanding of the causes of the current

financial crisis needs to be gained, though, in order to grasp what regulatory actions

would be appropriate to take.

The financial crisis can, unquestionably, find its’ roots in the sub-prime

mortgage. Sub-prime mortgages are, simply put, loans with initially low interest rates

given to borrowers with a poor credit history. Also known as adjustable-rate mortgages,

following the initial low interest period, the interest on these loans begin to rise rapidly,

putting extra financial pressure on the borrowers. To sell their loans, predatory lenders

convinced borrowers that the prices of their homes would continue to rise and that their

rising property values would allow them to keep up with the interest payments. While

the loans seemed to provide an ideal way for those near the bottom of the economic
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pecking order to become homeowners and part of the “American Dream”, when

property values started going down instead of upwards, a significant number of

mortgage holders weren’t able to keep up with the rising interest payments and went

into default. David Wheelock, assistant vice president and economist at the Federal

Reserve Bank of St. Louis, points out that “as of the fourth quarter of 2007…14.4

percent of subprime mortgages, and 20.4 percent of adjustable-rate subprime mortgages

were seriously delinquent” (Wheelock 133). The exponentially increasing defaults on

the loans left homeowners homeless and began the cascading chain of events leading to

the financial crisis.

The problems stemming from these sub-prime loans can be seen with a two-

pronged approach. First, the lowered interest rate that former Federal Reserve

Chairman, Alan Greenspan, oversaw during his tenure opened the door for a housing

bubble. From 2001 to 2004, Greenspan, in an attempt to recover the economy from the

dotcom bubble and 9/11 with a housing boom, lowered the Fed Funds rate from 6.5% to

1% (Federal Reserve). The lowered rates, which economists argue were kept too low

for too long, brought in a huge influx of borrowers and, with them, a stampede of banks

and mortgage brokers. This created the boom that Greenspan had been aiming for, but

it also allowed for a housing bubble to take hold. Economic bubbles occur when a large

flood of money deceptively raises the nominal price of an asset, in this case housing.

This causes the true value of the houses to not be correctly reflected in the pricing.

The lowered interest rates, and increasing participants, lead into the second

problem stemming from sub-primes; the lax lending practices of mortgage brokers and

lenders. From 2001 to 2003, the number of employees in mortgage banking jumped
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from under 225,000 to nearly 350,000. Naturally, the flood of brokers and banks into

the housing market led to greater competition. While basic economics teaches that this

type of perfect competition, where there are many competitors in a market, is ideal for

the consumer, this did not hold true with housing. In fact, the rise of competition led to

greater risk taking by the firms, which negatively affected the borrowers and home-

buyers. As Chief Economist and co-founder of Moody’s Economy.com, Mark Zandi

notes:

…As the market heated up, down payment requirements shrank and
documenting a borrower’s income slid from a requirement to a
recommendation. Risks were rising, but in the hypercompetitive
environment, interest rates and fees could not…Lenders let their
standards slip because if they didn’t make a loan, their competitors
would. (Zandi 98)

The slip in standards was further exacerbated by the fact that the sub-prime market was

poorly regulated. Without any type of government oversight, mortgage banks were

allowed to take excessive risks.

The economy, at home as well as abroad, however, would not be in nearly as

much trouble if the problems were only contained within the sub-prime housing

markets. While the sub-prime crisis has received much of the media and political

attention, the credit default swaps (CDS) market has been shown to be the true catalyst

for the spectacular bank failures that have hit established institutions, such as Lehman

Brothers and Merrill Lynch, as well as for the tightening of credit worldwide.

CDS are highly complex financial derivatives that are difficult for laymen, and

only slightly less hard for those with a financial background, to fully understand. To put

it briefly, a CDS is an “insurance-like contract that promises to cover losses on certain

securities in the event of a default” (Morrissey). In this case, the securities are the

packaged mortgage loans that big mortgage lenders would sell up the chain to bigger

investment banks. The CDS are then bought and sold between investment banks and

other financial institutions in order to spread the risk around. What makes the CDS

market so damaging is its’ immense size and unregulated state. The size of the market,

though hard to judge accurately, since swaps are done privately, is estimated to be over

$50 trillion dollars – far above the $7.1 trillion dollar mortgage market. The lack of

regulation on CDS essentially allows contracts to be “traded — or swapped — from

investor to investor [over-the-counter] without anyone overseeing the trades to ensure

the buyer has the resources to cover the losses if the security defaults. The instruments

can be bought and sold from both ends — the insured and the insurer”(Morrissey).

Much like the mortgage banks and lenders in the sub-prime mortgage market, the

investment banks involved in the CDS market have an incentive to take greater risks for

profits when there is little oversight on their movements. Warren Buffet, one of the

most revered and prudent investors, correctly identified the heightened risk of trading in

financial derivatives in his prescient 2002 Berkshire Hathaway annual report:

I view [financial derivatives] as time bombs, both for the parties that deal
with them and the economic system… The troubles of one [derivative
dealer] could quickly infect the others. On top of that, these dealers are
owed huge amounts by non-dealer counterparties. Some of these counter-
parties…are linked in ways that could cause them to contemporaneously
run into a problem because of one event…[Deriviatives are] financial
weapons of mass destruction, carrying dangers that, while now latent, are
potentially lethal. (Berkshire Hathaway)
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Thus, when the risky behavior of banks in the CDS market finally failed due to one

event, the burst of the housing bubble, it brought many established banks and financial

corporations to their knees and buried others.

The subsequent fallout from the failure of the CDS market has been an extreme

tightening of credit worldwide; the effects of which are starting to bear down on the real

economy: Citigroup announced its plans to lay off 50,000 workers by the end of 2009,

retail sales have fallen four months in a row, economists indicates a shrinking economy

until at least the first quarter of 2009 and General Motors is facing a possible collapse,

and event that would send shockwaves throughout the economy.

Thus, the passage of the bailout is essential to keeping the economy from

completely collapsing under itself. The Troubled Asset Relief Program (TARP), which

allows the government to basically buy up the bad assets of the financial corporations,

act as a greasing agent on the lending market. While the bailout would be aiding the

corporations that have taken the needless risks, the consequences of not passing the bill

would have only exacerbated the weak economic situation even further for everybody –

the gloomy outlook of the real economy mentioned above were given after the bailout

had passed.

Much of the blame for the growth of the CDS market and other risky financial

derivatives can be traced back to the deregulatory efforts of Fed Chairman Alan

Greenspan. An advocate for the free-market, Greenspan, who was the leading authority

on the economy from the 1980’s to the 2000’s, was able to push Congress successfully

for less government intrusion into financial derivatives when they were first introduced:

“In November 1999, senior regulators — including Mr. Greenspan and [former
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Treasury Secretary] Robert Rubin — recommended that Congress permanently strip the

Commodity Futures Trading Commission, [a federal agency that regulates options and

futures trading], of regulatory authority over derivatives” (Goodman). Greenspan, in

his distrust in the ability of government to regulate efficiently, believed that the private

actors would be able to self-regulate themselves from engaging in highly risky behavior.

Unfortunately, this belief proved to be a badly founded. As Frank Partnoy, law

professor at University of San Diego, and an expert on financial regulation notes,

“Clearly, derivatives are a centerpiece of the crisis, and [Greenspan] was the leading

proponent of the deregulation of derivatives” (Goodman).

The freewheeling actions of the financial corporations, helped by the equally

culpable Federal Reserve, bring to mind the social phenomenon – the Tragedy of the

Commons. The commons dilemma, popularized by the late ecologist, Garret Hardin,

describes a situation in which a group of herders share a common plot of land. Hardin

theorizes that the herders, behaving independently in their own self-interest, will

damage the land without any regard for its long-term sustainability. When the resource

collapses, everybody loses. As a metaphor, the Tragedy dilemma applies aptly to the

current financial crisis where each of the financial actors, from the mortgage brokers to

the large financial banks, act in their own apparent self-interest. Thus, they end up

destroying the common resource that nearly everybody depends upon – money and

credit. The only, proven successful, method to avoid a Tragedy of the Commons is

through mutually agreed upon resource regulation that counters the self-interested,

resource-destroying, nature of competing financial actors.

In today’s financial Tragedy of the Commons, the case for stricter government

regulations can be seen. The role of government in the financial markets should be to

regulate industries to curb the excessive risks taken by corporations aiming to maximize

short-term gains. This much was made clear when Greenspan, one of the louder

advocates for the free market, conceded in front of the House Congress Committee in

late October that “those of us who have looked to the self-interest of lending institutions

to protect shareholder's equity are in a state of shocked disbelief” (Wall Street Journal).

The main opposition against government regulations stems from the widely held

belief that governments and their bureaucracies are detrimental to the economy and, by

extension, to society. University of Michigan Law School Professor, Steven P. Crowley,

describes this cynical view of regulations as “regulatory agencies [serving] not to

correct [market failures] but rather…to exacerbate market failures…” (Crowley 15).

The trouble with this claim is that much as shareholders and corporations concern

themselves only with the short-term bottom line, the well being of a nation’s people is

judged almost solely by an economic measure – GDP per capita. However, this has

long been an outdated and inaccurate evaluation of the general welfare of societies

throughout the world. In a 2003 lecture, British economist and founder of the Centre

for Economic Performance at the London School of Economics, Richard Layard notes,

“GDP is a hopeless measure of welfare. For since the War, that measure has shot up by

leaps and bounds while the happiness of the population has stagnated…” (Layard).

Indeed, the average happiness in America today is actually below the level that it was at

in 1972 (Wolfers).
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What does this all mean? Essentially, a fundamental shift in the how societal

well-being is measured and approached would need to take place, with regulation

helping to achieve that goal. As noted earlier, corporations, CEO’s, and economists

operate under the rule that the optimal result to be gained is maximum profit. This has

led to a me-first mindset, which has placed individual financial gain over the benefits of

society and while the prospect of a monumental change in how we approach the health

of a nation’s people seems farfetched, history has shown that large swings in the public

sentiment are possible and do occur approximately every couple of generations. During

the onset of the Great Depression, the public largely denounced the free-market

approach taken by Herbert Hoover. The subsequent election of Franklin Roosevelt

ushered in a lengthy period of government reform and welfare programs, such as Social

Security, under the New Deal. The political pendulum swung back to the conservative

pillar of deregulation when Ronald Reagan popularized his brand of economic policy,

Reaganomics. Accordingly, the stage seems set for a much needed move back to

regulations of wayward corporations with the election of a Democratic President.

The corporations will unquestionably fight against any governmental actions or

social shifts that will put a dent on their profits, either by lobbying directly against

regulation or by softening it. However, there is a case to be made in the profit making

ability of acting socially responsible and the corporations that try to fight it will

inevitably find themselves in hot water. Such is the case with the Big 3 Detroit

automakers: General Motors, Ford, and Chrysler. Recognized throughout the 20th

century as stalwarts in the automobile industry, automakers have been sent scrambling

for cash as large cutbacks in consumer spending have drastically lowered their ability to
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raise revenue. GM, in particular, has found itself on the brink of bankruptcy, warning

that they might run out of money by the end of the year. While there are multiple

causes for the financial troubles of the Big 3, one of the foremost reasons has been the

arrogance of the automakers. For more than a decade, the Big 3 have put all their eggs

into the large vehicle and SUV market. To sustain that market, they lobbied Congress

and the Environmental Protection Agency (EPA) relentlessly to relax their federal fuel-

efficiency standards such as gas mileage. While this brought in increasing profits when

the economy was booming, the end result of has been three American multinational

corporations unable to adapt quickly enough to the changing times and public

sentiment. As the “green movement” began to gain groundswell and consumers

responded to rising gas prices the domestic companies began to lose ground to foreign

corporations who invested in smaller, fuel-efficient cars, the Big 3 hung onto the SUV’s

and large trucks. This is especially evident in the rise and fall of GM’s Hummer line as

a national status symbol of excess. In the early 2000’s, GM “wanted to make Hummer

a signature company brand. Instead it showed that the [corporation] was out of touch

with the needs of the 21st century” (Newman).

Given the complexities of the existing financial problems, any viewpoints on

how to mend today’s financial system will not be thoroughly complete. For instance, a

historical perspective into similar financial crises, such as the Great Depression and the

Saving & Loan Crisis, would undoubtedly aid in providing a guide to fixing the current

recession. What this case highlights, as well as other cases, are the many different ways

to approach the current financial crisis, all with their own risks. However, given the

causes of the crisis and the nature of corporations, the best course to proceed on would
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be a tightening of oversight and regulation on financial institutions. Corporations act

mainly in their own self-interest, taking risks that ultimately affect the whole economy,

and that is not likely to change anytime soon. Consequently, it is in the best interest of

the economy, as well as society, for a more strict government role in preventing the

economic engines from overheating. As the late Milton Friedman has eloquently stated,

“there is one and only one social responsibility of business–to use it resources and

engage in activities designed to increase its profits” (Friedman). It is than paramount

that government does not allow corporations to hurt itself and the larger society in this

pursuit for profits.