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Financial Logic and Morality

Posted by Larry Doyle on March 22, 2009 12:26 PM |

I am a proud graduate of the College of the Holy Cross, a Jesuit institution in Worcester, MA. The strength of a Jesuit education lies in the principles of Logic and Morality. While I fully appreciated my classes in Economics, German, Philosophy, and others, my classes in Logic and Morality made the greatest impact on me. Those classes forced me to think, not make rash judgments, take positions, and defend them.  

Fast forward to 2009 and a banking industry facing hundreds of billions, if not trillions, of unrealized losses. How do we most effectively, efficiently, and expeditiously address the health of this banking system so that our economy and population can regain its footing and prosper?  Let me revert back to the late ’70s and early ’80s and the principles instilled in me by those Jesuits.

 My Logic class utilized “decision trees.” My Morality class was based on the principle of “the greatest good for the greatest number.”

What have we learned over the last 6 months, as well as the last 16 years, to help us chart our way forward?

 Should we nationalize certain insolvent banking institutions, liquidate assets, obliterate shareholder equity, and force creditors to take a discount on their loans? This model was utilized in Sweden and other Scandinavian countries in the early ’90s. Their economies recovered over a 2-3 year time frame.

Is our banking system so large, so globally interconnected, and so levered as to make this approach feasible? What have foreign entities who have invested in our bonds and stocks done over the last 6 months to address and mitigate this risk? They have repatriated their holdings. In the process of doing that, we saw our government interest rates move up by approximately 1% in the intermediate to long maturities. We have seen our equity markets sell off by approximately 50%.  Have our markets sold off despite our government’s actions or partially because of them? I would maintain the latter.

Over and above these moves in the markets, we have seen our largest creditor, The People’s Republic of China, jawbone our government about our honor and integrity in standing behind our markets and a number of our larger financial firms (Fannie Mae, Freddie Mac, et al). Logic tells me, the Chinese were sending our government officials a clear signal that they would further repatriate their holdings if those holdings were not protected. How did our government respond to these moves in the market and messages from our foreign creditors? Uncle Sam blinked.

Every government decision – both under the Bush administration and now the Obama administration – is defined to buy time, defer losses, and protect the very institutions that took the imprudent risks. In utilizing this approach, our officials are violating basic free market principles and enacting massive moral hazards.       

Our government also blinked in the takeover of AIG. There is no doubt that the government funds injected into AIG flowed through to the creditors of that organization. Why didn’t our government forcefully negotiate with these creditors to take a discount on their payments?

Our government is blinking again as it rolls out three programs intended to restart the flow of credit in the consumer finance markets. Each of these programs is based on similar principles of cheap government loans to investors to incentivize them to purchase stale loans and securities on bank books. In addition to the cheap loans, the government will subsidize the purchases by underwriting a large percentage of future losses on these investments. These deals are potentially very sweet and attractive for investors.

While it may seem as if the government is “giving everything away” in the midst of these programs, what is the government getting in return?

1. Don’t think for a second that the proposed legislation to heavily tax compensation of those in the financial industry is not intended to be a redistribution of wealth.  I firmly believe the administration and Democrats believe this tax and other likely restrictions on compensation within the financial community is a fair price for the government to charge for not nationalizing certain institutions. 

2. For investors in the aformentioned programs, the price the government is considering charging over and above the price of the cheap loan is:
 – inability to hire foreign workers
 – government accessibility to the investors’ books
 – restrictions on compensation

I firmly believe the Obama administration and our Democratic Congress view the capital provided to our financial institutions is an outstanding cover to allow them to promote and enact their very liberal, social agenda. We have seen this extensively already and I believe we will see much more of it in the days and months ahead. In so doing, this administration and Congress are promoting a large measure of class warfare and populist outrage.

In regard to the moral hazards playing out throughout our housing and financial industries, make no mistake these moral hazards are nothing more than the extenion of the moral hazard that was perpetrated by Freddie Mac and Fannie Mae over the last 15 years. Who benefitted from that moral hazard? The very politicians from both sides of the aisle, but predominantly the Democratic side, who are enacting the legislations promoted now.

What are the real costs of this fiasco and who pays? Well, let’s look at the movement in the Treasury Inflation Protected Securities Market (TIPS), gold and oil, and banks in the last few days. The markets (TIPS, gold, oil) are screaming that we will experience significant levels of inflation. 

Who would want to work at a well run bank or other financial institution, not in need of government assistance, but subject to government restrictions on compensation? Nobody!! As a result, those stocks led the market lower on Friday.

I accept the fact that our government needs to aggressively fill the void in consumer demand at this juncture. However, the undisciplined spending and massive deficits projected by the Congressional Budget Office will drive our interest rates and taxes higher. Who pays? 

The American taxpayers both now and, to an even greater degree, in the future.            

We should have let the market work and utilized  selected firewalls and bankruptcy procedures to manage the unwind of institutions. 

Uncle Sam’s blinking has sold out our free market principles and those in America who treasure them. Uncle Sam’s blinking will clearly prolong our economic pain and the price of that pain. I do not view that as either logical or moral!!


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