Better Than A Bailout

The most depressing thing about Reason’s analysis of the financial meltdown? This:

No one fully understood how exposed the mortgage-backed securities were to the rising foreclosures. Because of this uncertainty, it was hard to place a value on them, and the market for the instruments dried up. Accounting regulations required firms to value their assets using the “mark-to-market” rule, i.e., based on the price they could fetch that very day. Because no one was trading mortgage-backed securities anymore, most had to be “marked” at something close to zero.

This threw off banks’ capital-to-loan ratios. The law requires banks to hold assets equal to a certain percentage of the loans they give out. Lots of financial institutions had mortgage-backed securities on their books. With the value of these securities moving to zero (at least in accounting terms), banks didn’t have enough capital on hand for the loans that were outstanding. So banks rushed to raise money, which raised self-fulfilling fears about their solvency.

Two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (using a five-year rolling average valuation instead, for example) would have helped shore up the balance sheets of some banks. And a temporary easing of capital requirements would have given banks the breathing room to sort out the mortgage-backed security mess. Although it is hard to fix an exact price for these securities in this market, given that 98 percent of underlying mortgages are sound, they clearly aren’t worth zero.

So instead of simply tweaking the regulations, the government decided to spend great flipping wads of cash. I realize that Washington’s solution to everything — education, healthcare, terrorism, etc. — is to spend money. But this is ridiculous. We could have apparently literally saved tens of billions with a rule tweak.

But, of course, tweaking rules doesn’t make you look glorious for suspending your campaign.

5 Responses to “Better Than A Bailout”

  1. rpl says:

    The solutions described in the Reason article are overly simplistic. Mark-to-market accounting came about as a reaction to the S&L fiasco, where more lax accounting standards (pejoratively termed “mark-to-fantasy”) allowed the S&Ls to mask weakening balance sheets far longer than they should have been able to. The result was that the reckoning, when it finally did come, was a lot more painful than it might have been.

    Relaxing capital reserve requirements might have helped somewhat, but many of the failed institutions were bitten not by regulatory reserve requirements, but by contractual reserve requirements (as I understand it, this is what got AIG). Still more suffered credit rating downgrades as a result of their deteriorating reserves. The result in these cases was that those banks could no longer get credit at the low interest rates required to make their business models work, and they started bleeding cash or going into default. I don’t see how regulatory relief could have avoided either of these calamities.

    Finally, neither of these regulatory tweaks would have solved the liquidity problem. If you’ve got a payment due, and you need to sell off assets to raise the cash, and nobody is buying the assets, then you’re busted, no matter what the model says the assets are worth.

    None of this is intended to defend the bailout. I think rebuilding banks’ capital reserves at taxpayer expense creates a terrible moral hazard and subsidizes a bloated and unproductive sector of the economy. However, the solution to that is bankruptcy and liquidation, not regulatory voodoo.

    Incidentally, Arnold Kling has some of the best commentary going on this subject. He blogs at EconLib (

  2. Mike says:

    This entire thing is just confusing. I tend to grasp at whatever makes sense. As PJ O’Rourke said, it’s hard to figure out what’s going when someone default on his mortgage and Iceland goes bankrupt.

    I do think one big problem is that Paulson and Bernake are too close to the industry to see the larger picture.

  3. rpl says:

    I agree with that. It’s hard for Paulson to conclude that a lot of investment banks need to go out of business and a lot of investment bankers need to lose their shirts when Paulson made his career until recently as one of those very same investment bankers. It would be like admitting his entire life’s work was a fraud. There aren’t too many people out there with that kind of courage.

  4. rpl says:

    Incidentally, here is a great quote from one of Arnold Kling’s posts:

    “I think that the way that capitalism wants to solve the problem of mortgage securitization is to stop doing it. My conjecture is that if there were a level regulatory playing field, then old-fashioned mortgage lending would win and securitization would lose.” (

    Kling makes a convincing case over a long series of posts that the securitization that contributed to the subprime disaster was driven by the regulatory environment rather than by market forces. It’s a theory that deserves a lot of scrutiny, in light of how widely the meltdown is being interpreted as an indictment of “laissez faire capitalism” (in quotes because we are talking about one of the most heavily regulated segments of the economy after all).

  5. Mike says:

    Thanks for tipping me to his blog. My RSS feed is overpacked already but I think I can make room for one more… maybe.

    I think it’s telling that (I’ve heard .. and experience in finding my own loan) the small community banks are in better shape. They were much more interested in just making some damned loans instead of using them as vehicles for high-wire financial gymnastics.