Bailout: Conservative Republicans Offer Weak Alternative

by: Dark Wraith

After claims by Democrats that an agreement in principle had been reached on a plan to bail out the financial services industry, the Republican Study Committee, a bloc of conservative Republicans getting some interest, if not open support, from GOP nominee John McCain, has balked and offered a competing plan to stem the crisis. As a result of the conservative GOP caucus and other factions resisting the nascent agreement, talks had broken down as of Thursday evening, starting up again early Friday without the cooperation of many Republicans.

Once details of a final plan have been completed and disclosed, a subsequent article will address the economic consequences of that proposal; for the time being, however, because the alternative from the Republican Study Committee is apparently creating a roadblock to a swift conclusion to negotiations among legislators, a summary analysis of several key provisions of the Republican alternative, as 7QB20080925" title="Go to the story at Reuters" rel="external">reported by Reuters, is herewith presented.

The following are quoted provisions of the GOP alternative from the Reuters article, followed by commentary on each point:

"The conservative group called for the U.S. government to offer insurance coverage for the roughly half of all mortgage-backed securities that it does not already insure."

This is a bailout by another name. Actuarial soundness of private insurance requires, quite simply, that premiums exceed payouts. The GOP's proposed "insurance" fund, run by the U.S. government and therefore implicitly or explicitly backed by the full faith and credit of the United States, would immediately be processing claims but would not immediately be receiving premiums even close to the necessarily timely payouts. If this is, indeed, a crisis, payouts would have to be occurring quite literally within a matter of days, so premiums could not possibly catch up with payouts, certainly not for a long time. The U.S. government would have to front the payout pool, and it would have to do so to the extent of hundreds of billions of dollars to ensure that all possible, and very likely, claims could be covered before the insurees went under.

Moreover, the premiums would have to be staggering because of the near certainty of losses, which would mean one of two things: either every financial services company in the insurance pool would be paying very high premiums, thereby exacting punitive assessments on firms that had prudently managed their portfolios, or there would have to be tiered premiums, with higher risk companies bearing the brunt of very high premiums. The problem with the former solution is that conservatively managed firms would want to avoid such an insurance program and, if forced to participate, would suffer costs they simply should not bear. The problem with the latter solution is that exacting draconian premiums on high-risk companies would exacerbate their already precarious financial situations.

Unless the government is willing to heavily subsidize this insurance plan for a time long enough for the accumulated premiums net of payouts to catch up with claims, it would distort incentives of low-risk financial services companies (why should they pursue low-risk investment patterns if they are being charged for high-risk activities?), or it would serve to further weaken the cash flow situation of companies already in trouble.

"[The Republican Study Committee] also called for temporary tax cuts and regulatory relief..."

Cutting taxes is the age-old dinner bell of so-called "conservative Republicans": ring it every day, three times a day, and the voters will come running to the trough of less government and more money in the pants pocket. President Dwight Eisenhower faced down the chorus of such demands from the legislators of his own party at the end of the 1950s and even went so far as to call them out for their unrelenting refrain in his last State of the Union address. He balanced the federal budget, oversaw conservative governance, and stood like a strict school marm over the rabble of congressmen bawling for their favorite candy.

It works. It's called responsible leadership. It's easily distinguishable from craven pandering.

As demonstrated in Part 4 of the series, "The Economics of Wreckage," published here at online properties Dark Wraith Publishing, the Republican majority in Congress, with the full support of newly elected President George W. Bush, used the excuse of a "recession" in 2001 to institute "temporary" tax cuts that were nearly a decade in duration, even though no recession by technical measures was in progress. The result of the unnecessary tax cuts was a swift drop of federal tax revenues to a level below expenditures, and the growing budget surpluses that had hallmarked the final years of the Clinton Administration evaporated into huge, year-over-year budget deficits from which the federal budget has never recovered and probably will not for the foreseeable future, as seen in the graphic immediately below, which does not include the deficit of $407 billion projected for the current fiscal year.



While raising taxes in the current economic environment would be foolhardy, cutting taxes would make the extraordinary, debilitating federal budget deficits even worse, which is exactly what the $700 billion bailout plan initially proposed would do, so the Republican plan offers no clear advantage in terms of impact on the year-over-year deficits and quite transparently uses the current crisis as just another excuse to blow the urgent siren for tax cuts that have always, in good times and in bad times, been the mantra of Republicans appealing to what they perceive is an essential desire among Americans to get tax money back in their own pockets at the expense of sound fiscal management of a large, complex government.

"[F]inancial institutions participating in their proposed program would have to disclose more about their mortgage asset holdings."

In principle, thorough, exhaustive, timely disclosures of information by financial services companies about the structure and details of their asset portfolios would allow outside investors to better assess risks and therefore more accurately assign market values to the companies. Enterprises with greater portfolio risks would suffer consequential equity value discounting as investors sold off the firms' stock until the expected returns to investment were commensurate with the risks being borne. In practice, the complexity and variety of exotic financial instruments being constructed, held, and traded by financial services companies make risk assessment far less accurate even for the most astute of investors. This, in and of itself, creates risk that markets should, at least theoretically, impound in prices, but that is unlikely to hold true when the instruments in firms' portfolios have subtle features that can be difficult to describe even for a firm striving for full and complete disclosure of each and every one of its assets. Beyond this, many of the complex instruments in firms' portfolios are, or can be, very short in duration, meaning that they could come into existence and then expire within a single reporting period; overall, then, firms involved in complex, short-lived derivatives could have a flow of high-risk assets as an enduring portfolio feature, but the presence of identifiable examples would elude reporting standards.

On a more practical level, the Republican Study Committee wants "regulatory relief," again a long-standing demand of pro-business conservatives. The problem is that eliminating regulatory requirements would likely have as one facet the removal of detailed, timely, and admittedly costly reporting requirements, which is inconsistent with the stated goal of the Republican Study Committee that participating institutions "would have to disclose more about their asset holdings." It cannot be both ways: either the firms must face a greater reporting burden, which has historically been at the center of regulatory oversight of financial institutions, or they must be relieved of the burden of such reporting requirements.

More broadly, the consensus emerging is that the current crisis is the very epitome of what is wrong with the entire drive toward deregulation that has been going on for years. Rejecting this determination, as the Republican Study Committee seems to be doing, is an attempt to continue the application of a theory of public policy in government oversight of business enterprise that has failed on a massive, macroeconomic scale. To insist that the federal government remain dedicated to a largely laissez-faire treatment of companies so big that their individual failures can create cascading, economy-wide effects is to persist in ignoring the legitimate and now quite obvious role the government should have in ensuring economic stability.

In summary, the Republican Study Committee alternative is unimaginative, recidivist, and petulantly defiant; that is to say, it is most decidedly the product of a committee of Republicans.


The Dark Wraith will take a similarly dim view of the bailout proposal that emerges from the less obtuse congressional negotiators.

---