Plausible deniability?

As even the New York Times understood in 1999, as long as housing prices kept on going up there was no problem with this system. If someone couldn’t pay their mortgages, they could sell their property. There was no threat of default. However, a lack of down payments meant that people defaulted on their mortgages.

Unfortunately, these insights don’t fit the current political template. With just 43 days to the election, the New York Times and others want to be in sync with the Obama campaign’s attack on the Bush administration not having enough regulation. It particularly doesn’t fit the fact that McCain was criticizing Fannie Mae and Freddie Mac for years along the lines of the New York Times 1999 article. Ironically, in other articles, the New York Times described the Democrats as “important political allies” of these two government-sponsored enterprises.

The New York Times is right that “Taxpayers have every right to be alarmed and angry.” But they should read their old news articles to see whom they should get angry at.

Is the proposed bailout bill the answer?

$700 billion for the bailout is a lot of money. The costs so far of the Iraq war are probably even a couple hundred billion dollars less than that. But if the $700 billion wasn’t bad enough, it is on top of the giant bailout just announced a couple of weeks ago for Fannie Mae and Freddie Mac. The costs are likely to grow further when Democrats add on their demands to subsidize homeowners.

The argument is that something has to be done now. We're in a panic, and mortgages supposedly can’t be sold for what they are really worth. The fear is that with the value of assets so low, financial institutions will try to sell off their mortgage-backed securities, driving down the price of those assets and making financial institutions insolvent that would otherwise be financially viable.

What the government proposes to do is buy these assets when they are low, when people are panicking, and resell them later once confidence has been restored. Supposedly, the government could actually make money.

There are some real problems with this argument. First, even if most people are behaving irrationally and don’t understand the true long-run value of these mortgages, just like the government is proposing to do, others can make money by buying these assets at fire sale prices and reselling themselves once the crisis is past. In fact, if this panic explanation is true, there is a strong reason to believe that this desire to make money, to see the chance to buy low and sell high, would actually keep the price from falling very much.

McCain’s proposal on Friday to provide bridge loans would let the companies themselves decide whether this panic explanation is true.

If the government’s argument is right, one first has to assume that all those smart people in government are a lot smarter than people in the finance industries. Ironically, the government will be hiring private evaluators to determine how much the government should pay for these assets. Given that government regulation -- forcing mortgage companies to make loans that they didn’t want to make -- created this problem, it is not obvious why government officials should be so wise right now.

Increased stock prices after the bailout’s announcement isn’t necessarily evidence that the bailout is needed. Stock prices might also be rising simply because the government is promising to pay a lot for some worthless assets. If so, that is nice for stockholders of affected companies, but not so nice or necessary for the rest of us.

But for the sake of argument, let’s assume that only the government’s offer to purchase these mortgages can prevent panicked sellers from sending prices down. It still isn’t clear that you want to subsidize these companies. As the 1999 New York Times article noted and McCain has continued to point out, such subsidies create incentives for companies to take unjustified risks in the future. Imagine how your gambling behavior would change if the government promised to cover your losses and let you keep your winnings.

The government may also end up managing or owning these companies. Political considerations, not efficiency, will end up being the goal. A simple demand might be what company managers can be paid. But private shareholders have a lot better incentive deciding the costs and benefits of motivating managers than political constituencies who have little at stake in whether the company makes the right decisions.

Some parts of the proposed legislation released over the weekend are also worrisome. For example, at least in the first draft, the proposed power given to the Secretary of the Treasury would be unlimited and unchecked.

“Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”

It emphasizes the possible problems that can arise from drafting legislation too quickly.

Conclusion

Why do people put so much faith in government correctly solving this problem when the debate can’t even honestly discuss what caused it? With all the pressure to get things done quickly, it seems unlikely that things will be properly sorted out. With $700 billion at stake, let’s make sure that we really have a very good reason for spending the money.

*John Lott is the author of Freedomnomics and a senior research scientist at the University of Maryland.