Re: A Study in Contrasting Responses

UPDATED ON SEPTEMBER 8 & 9
Incentives drive human behavior but, especially in government where there are no market forces, rarely does anybody pay attention to the impact of the incentives created by laws, regulations or government actions. Which is why government actions will always create “unintended” consequences and less than efficient solutions.
There is a concept called “moral hazard” in the finance world which one source defines as:

One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE…Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

What both Palin and especially Obama are missing in the Freddie and Fannie bailouts/takeovers is the larger issue of moral hazard. These bailouts/takeovers are signaling to the marketplace that nobody in the future will suffer meaningful adverse economic consequences as a result of their bad decisions.
As a first step into the moral hazard world, the federal government enabled this situation by not officially giving its full faith and credit guarantee to backstop any future defaults by Freddie and Fannie, as government-sponsored enterprises…but then winking at investors, as if to tell them that the government would step up if they had to.
Now think of how a bailout works, about what incentives and rewards it dishes out:

    Investors have generated greater than T-bill rates of return on Freddie and Fannie debt investments in past years while really only having marginally more risk than T-bills, which are explicitly guaranteed by the federal government. So investors have made out by generating a higher rate of return.
    Who paid for giving investors that higher rate of return? The American taxpayers. By now bailing them out, American taxpayers – who never contributed one iota to the misdeeds of Freddie and Fannie – are forced to pay billions of dollars of their hard-earned monies toward the bailouts. Said another way, taxpayers are being forced to make a payment for a past-due risk premium which is the difference between a T-bill level of risk and the Freddie and Fannie risk actually taken.
    The government says that the bailout proceeds will be repaid, while adding that it will be up to the next administration and Congress to decide the particulars. The players committing publicly today to a payback won’t be around to ensure it happens so their words are meaningless. The government players who could be responsible for repaying taxpayers in the future have no obligation to do so and the government world provides them with no incentives to do so. Which, I predict, will yield a not-surprising indifference to paying back American taxpayers.
    Meanwhile, the people in Freddie and Fannie who actually made the bad decisions (including, it sounds like, aggressive accounting practices) that led to the bailout have no incentive to moderate their risk-taking behaviors because they have learned – just like children learn from bad parenting practices – that they will get away with acting out of line. Sure a few top executives lost their jobs but what else has changed? So the bailout/takeover has largely rewarded bad behavior and even those who lost their jobs have not suffered consequences anywhere near the magnitude of the actions they took or allowed under their watch.

Lovely.
The only genuine solution to stop the stupidity of incentivizing bad behavior that costs taxpayers money is to let something fail completely. Yes, it would be painful and that is never pleasant. But if anybody had the courage to do it, the proper alignment of incentives, of risk and reward, would ensure organizations rapidly returned to paying attention to their business fundamentals.
This is yet another example of what happens when government gets too large and when big business can buy favors from government.
ADDENDUM
See, once it starts, it just keeps going.
Don’t lose sight of the obvious: It’s big government and big companies doing corporate welfare OR it’s big government doing other forms of undeserved welfare.
Meanwhile, average working Americans have no such welfare options. Nope, the government just takes more of their hard-earned monies via taxation to fund everyone else’s misbehavior.
Call it justice, big-government style.
ADDENDUM #2
With a H/T to Ramesh Ponnuru, the Wall Street Journal weighs in:

…Treasury Secretary Henry Paulson wants to prop up the walking dead so the world keeps buying their mortgage-backed securities. His action may calm jittery credit markets, and it may get the companies through the current mortgage crisis — albeit at enormous cost to American taxpayers. The tragedy is that he and Congress didn’t act 18 months ago — when the cost would have been far less — and that he still isn’t killing the Fannie and Freddie business model that has done so much damage. These corpses could still return to haunt us again…
At least Mr. Paulson has finally figured out he’s been lied to…[previously] saying that the battle over the two government-sponsored enterprises (GSEs) was nothing but a scrap between “ideologues.” So he bought the Congressional line that Fan and Fred weren’t a problem and would help financial markets through the housing recession…
This weekend’s formal rescue puts an end to those illusions…
The new federal “conservatorship” is a form of nationalization that puts regulators firmly in control. The feds fired the company boards and CEOs, though the clean up needs to go further to change the corporate cultures. Both companies remain Beltway satraps that hire for reasons of political connection, not financial expertise.
The taxpayer purchase of preferred stock means that the feds will own about 80% of the companies if all the warrants are ultimately exercised. The feds also stopped dividend payments, saving about $2 billion a year. This amounts to significant dilution for current Fannie and Freddie shareholders, and it offers taxpayers some return on their bailout risk if the companies recover.
We only wish Mr. Paulson had gone further and erased all private equity holders the way the feds do in a typical bank failure. Fan and Fred holders had profited handsomely for decades by exploiting an implicit taxpayer guarantee that their management claimed didn’t exist. Now that the taxpayers are in fact stepping in, the current common and preferred holders deserve to lose everything. Mr. Paulson apparently wanted to dodge that political fight…
The Treasury chief also gave a free pass to the holders of some $18 billion in Fan and Fred subordinated debt. He did so even though these securities were understood not to have the same status as mortgage-backed securities or other Fannie debt, and even though this will set a bad precedent for other bailouts. Watch for Citigroup’s subordinated debt to jump in price as investors conclude that the feds would do the same thing if Citi needs a rescue.
By far the biggest risk here, however, is that the companies could still emerge with their business model intact. That model is the perverse mix of private profit and public risk, which gave them an incentive to make irresponsible mortgage bets with a taxpayer guarantee.
Mr. Paulson could have ended that model immediately by putting the companies into “receivership.” Both companies could have continued to securitize mortgages, even as their riskiest businesses were wound down…And in any case, had Mr. Paulson acted sooner and given markets time to understand that receivership doesn’t mean immediate liquidation, the risk of a run might now be far less.
The Treasury plan does at least put some useful limits on Fan and Fred risk-taking, albeit starting only in 2010…
Treasury says all of this will provide a motive for Congress and the new President to change how Fan and Fred do business, and in the meantime the conservator has also ordered a stop to their political lobbying. It’s also nice to see that on this point Mr. Paulson has found religion. In his statement Sunday, he blamed the need for a bailout on “the inherent conflict and flawed business model embedded in the GSE structure.” Welcome to our merry band of “ideologues,” Mr. Secretary.
The Treasury chief has nonetheless decided to leave the hardest political choices to his successor, who will have to face down the usual phalanx of Fannie apologists: Democratic barons Barney Frank and Chuck Schumer, the homebuilders, various Wall Street sages and left-wing journalists…
…who knows how the political mood will have shifted once the housing slump passes. It’s easy to imagine the next Treasury Secretary concluding that he also thinks the fight for permanent reform is too difficult. Then we are back to the same old stand.
The Fannie-Freddie bailout is one of the great political scandals of our age, all the more because it was so obviously coming for so long. Officials at the Federal Reserve warned about it for years, only to be ignored by both parties on Capitol Hill. The least we can do now is bury these undead monsters for all time.

ADDENDUM #3
More from Jim Rogers:

Has America created its own variety of communism with the U.S. Treasury Department’s bailout of two beleaguered government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac? According to Rogers Holding CEO Jim Rogers, the answer is yes.
“America is more communist than China is right now,” Rogers told CNBC Europe’s “Squawk Box Europe” September 8. “You can at least have a free market in housing and a lot of other things in China. And you can see that this is welfare for the rich. This is socialism for the rich. It’s bailing out the financiers, the banks, the Wall Streeters.”
Rogers…said the bailout was not benefiting homeowners or helping average citizens improve their standing for a home mortgage.
“It’s not bailing out the homeowners who are in trouble, by the way,” Rogers said. “It’s not bailing out people who want a mortgage – it’s just bailing out financial institutions…I think it’s a mistake.”…
“This is a big huge mess and neither [Obama nor Palin] has a clue as to what to do next year,” Rogers said. “Bank stocks around the world are going through the roof, that’s because they’ve all been bailed out. You don’t see the homeowners in Kansas going through the roof because they’re not being bailed out.”
Rogers had previously called for Fannie and Freddie to be allowed to go bankrupt…
“Let the patient go bankrupt,” he said. “We have courts in America; they will be reorganized.”
Fannie Mae and Freddie Mac were “wove a mantle of invincibility” through lobbying according to a September 8 Wall Street Journal “Deal Journal” blog post. According to the Journal’s Heidi N. Moore, the mortgage giants had $170 million in lobbying bills in the past decade and spent $3.5 million on lobbying just in this year’s first quarter, spreading their largesse among 42 outside lobbying firms.

Yep, big government works for the powerful who can buy favors. Now if the less powerful only had some more community organizers to help them out…
ADDENDUM #4
McCain and Palin weigh in with a WSJ editorial.
Corruption. Politicians and former politicians scratching each other’s backs, getting wealthy at the expense of average Americans while not serving the public. Where is the outrage?

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George Elbow
George Elbow
12 years ago

Just another extension of the Nanny-state that Americans, led by the Entitlement-minded mentality fostered by the Unions, have come to prefer over the individualism that made this country great.
Our founding fathers came here, and ultimately rebelled for independance, to get away from Gov’t interference, to have the very freedoms that are trampled via Gov’t interference.
Indeed, our founding fathers would shake their heads in disgust if they could see what we have done with the gift they gave us.
When a limb on a tree breaks in a storm, what do you do?
Do you stand out there in the rain holding up the broken limb, supporting indefinitely hoping it heals itself?
Do you tie a rope around the broken limb to support it, while tying the other end of the rope to another otherwise healthy branch, only to have the rope strangle the healthy branch, stunting it’s growth?
The obvious common sense answer is that you trim the tree and cut off the deadwood so that the rest of the tree survives and thrives.
But alas, common sense has no place in an Entitlement-minded Nanny-state.

Monique
12 years ago

This one, however, is an alarming step beyond the other welfare excesses we have witnessed.
1.) The consequences of bad decisions are foisted not upon the people who made those decisions but upon those who did everything right.
2.) Where exactly does this end? For example, what about all the eight cylinder vehicles languishing unpurchased in car dealers across America? Why should all those dealers and manufacturers suffer?

George
George
12 years ago

Editing error in my last. [AR: Now deleted] Here is how it should read….
It ends when the enablers are replaced. Someone at Ford/GM/Chrystler gets replaced when they fail to anticipate or plan for movement in the markets. They get fired when they wrecklessly and greedily play a self-interested numbers game at the expense of their company, its shareholders their fellow employees.
Murphy/Montalbano/Fox/Paiva-Weed/Costantino/Lima… ALL 100 of them need to be replaced for their complicitous enabling of public sector union greed at the expense of the taxpayers, our futures and our children’s futures.
We need leaders who have the guts to say: No! You are going to pay 1/3 of your health insurance. No! You will contribute to your pension plan. No! You will not be eligible for retirement until 65 (…since most of you have such easy jobs, lets make that 70). We will not place your interest above that of the people.
Same goes at local levels… there has never been a better time than now to just replace every single incumbent.
…and keep replacing them until we get leaders with courage.

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