Strategic Needs – Why Congress Is helping the Financial Markets

Through the first half of this week, I have been explaining why the Congress is right to decline granting the demands of the three major US automakers. Having done so, it seems appropriate to consider why the government was willing to spend so much more to address the crisis in the financial sector. There have been complaints that it appears to make no sense to agree to spend 700 billion dollars on one sector, but deny 50 billion to another that needs it just as much. To understand the decision, we must sort out the relevant conditions and probable effects of any money applied to the sector.

There are significant differences between the financial and automobile manufacturing sectors, so that is where we begin. With over a half-million employees directly impacted by a possible failure of the major automakers, plus as many more possibly affected by the supply chain effects of such a failure, there is clearly a great impact from the decision to assist or not. However, there is no compelling evidence that the manufacture of automobiles is a strategic asset for the United States, nor that the requested assistance would address the fundamental forces causing the crisis. If GM, Ford, and Chrysler were all to fail, the ramifications would be serious but not catastrophic. The domestic auto industry has not been shown to be strategically different from the American companies involved in consumer electronics, textiles, mills or ironworks, indeed it appears to be of a lower priority than several industries which left the country in the past several decades. This is not to say that a federal response would not be needed, but that the requisite actions by the government should focus on a different goal than perpetuating an inefficient system which cannot promise a reasonable return for the investment.

Before considering the financial sector, it is important to note that although the word “bailout” has been in common use by the media regarding each industry, its application to the different crises is not consistent. In the case of the automobile industry, company executives are asking the government to give money directly to the companies, to use as they choose, without credible guarantees of performance. In the case of the financial sector, the money granted by Congress went to the Federal Reserve Board, not directly to the banks, and the Fed will decide how to apply the money on a case by case basis. Further, there are significant assets now in the control of the Fed, which justify the limited risk being taken despite the size of the action. For instance, the combined assets of Fannie Mae and Freddie Mac are over five trillion dollars; in even a worse-case scenario less than a third of those mortgages would fail, meaning that for a commitment of approximately one trillion dollars, the Fed controls guaranteed assets of at least 3.35 trillion dollars, and which under good management could appreciate to over six trillion dollars. When you step away from the panic dance being spun by the media, the two truths about real estate and home mortgages are that some properties are worth nothing close to what they are selling for, but also that many home mortgages have a floor value that will eventually bring back the market. In other words, what is needed in the case of the mortgage crisis is a short-term solution to protect the liquidity of banks and support confidence in mortgage viability, because in the long term prices and purchasing will inevitably return to nominal performance. While it will not be like the heady days between 1995 and 2006, prudent supervision by the Fed could potentially improve President Obama’s re-election chances, as the Fed may be able to release some acquisitions back to private ownership and show a respectable profit in doing so by mid-2012. Certainly, there is every reason to expect that the Fed’s actions with regard to mortgages will be repaid in full in the long term. Therefore, the risk in relation to the money entrusted to the Fed is effectively low with relation to the likely results of not acting, and the prospect of full recovery of costs makes the action even more attractive. In practical terms, the Fed action is a set of loans, not a bailout in the true sense.

It must also be understood that the financial sector is in fact a strategic necessity to the United States. Evidence of this was made apparent with foreign reaction to Treasury bills, notes, and bonds. When the liquidity of the U.S. banking system became unstable, foreign confidence in U.S. Treasury securities also fell, indicating that failure of major U.S. banks would lead to collateral failures of government resources. The scale of this risk made government intervention in the financial sector a critical necessity. Where failure of the major automakers could worsen a recession, failure of the U.S. Treasury would create unprecedented economic conditions, which could not be controlled or corrected by the United States. The closest example would be the collapse of the Argentinian economy between 1998 and 2002, with the distinction that the U.S. economy could not expect effective IMF assistance.

In the case of the financial markets, the government assistance was built in three stages – first, the Fed received approval to spend approximately 700 billion tax dollars in cash infusions, commodity purchases, and other discretionary expenditures. The 700 billion dollar figure was not a specific amount planned to be spent, but an agreed ceiling for indebtedness at any one time. People who claim that Paulson did not understand the amount or know what he wanted to do, simply misunderstood the plan’s framework. It should also be noted that the 700 billion is made available in stages, with 250 billion immediately and the rest made available at a later date, to protect Congressional oversight in the main. Also, the bill included creation of a Financial Stability Board (similar in concept to the RTC) and a Congressional oversight panel.

The second stage is the hiring of asset managers by the Fed to select and acquire the appropriate instruments, which could range from specific mortgages to companies, but which would prohibit acquisition of hedge instruments and insure viable plans of recovery and coordinated actions.

The third stage would be the direct acquisition and direction of the purchased assets and instruments. The significance of this three-stage approach, is that each level has its own oversight and coordination, without becoming overly unwieldy.

The reason for laying out this framework, is to understand that the action is neither haphazard nor careless; the revenues used in this initiative are specific, planned, and accounted for. In comparison, the bailout request by the automakers lacks all of these safeguards, amounting to no more than a desire for the government to simply hand over billions of dollars to men who have shown neither the aptitude to protect assets, nor the proper moral priorities needed to keep their companies solvent.