Special Report

In Defense of Bailout Inconsistency

Unlike Santorum, Romney understands the difference between bailing out Detroit and bailing out "Wall Street."

By 2.27.12

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Almost all rules have exceptions. This is true because the real world is a complex place, more complex than theory often allows. And this is why, to quote Emerson, "A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines." Campaigning in Michigan, Rick Santorum has sought to bolster his conservative bona fides, declaring his own ideological consistency in opposing government "bailout" plans for both the automakers and of "Wall Street," and contrasting that to the "inconsistency" of his rival, Mitt Romney, who opposed the auto "bailout" but supported the Troubled Asset Relief Program (TARP), portrayed by Santorum as a bailout for Wall Street and the big banks. In failing to understand the difference between TARP and the auto bailout, Senator Santorum betrays a foolish consistency.

All American conservatives, myself included, disdain government meddling in the private sector. From a practical perspective, it is usually counterproductive and wasteful (Solyndra, for example). From an ideological perspective, it is rarely justified as a necessary and legitimate application of government power, and is almost always a dangerous precedent, inviting ever more and greater infringements on personal liberty and the workings of a free market. But this does not mean that government intervention is never, ever an appropriate option.

The Obama administration's auto bailout plan that both Senator Santorum and Governor Romney rightly opposed is clearly an example of unjustified, dangerous, and (despite all the hoopla from the media regarding its supposed "success") counterproductive and wasteful government action. Proponents of the plan argue that without the government bailout, tens of thousands of GM and Chrysler workers would have lost their jobs, and thousands more employed by suppliers to the automakers would have lost theirs, too. Instead, all these jobs were saved, GM is now profitable, and the cost to taxpayers is minimal. The problem with this justification is that it is wrong on every point. The government bailout did not prevent GM and Chrysler from going into bankruptcy. And just as if they had gone into bankruptcy without the government plan, GM and Chrysler continued to operate while they reorganized. The essence of the bailout plan was not "saving jobs" or a portion of the dwindling U.S. manufacturing base, but rather paying off a Democratic constituency, big labor, by forcing a pre-bankruptcy deal whereby the holders of senior debt had their legal positions stripped from them so as to hand whatever value remained over to the UAW and the UAW's pension plan. Chrysler got over $10 billion in taxpayer assistance, was taken over by Fiat, who somehow then got a $3.5 billion loan from the U.S. Department of Energy. The Obama administration gave GM $60 billion in taxpayer cash -- $10 billion in a loan and $50 billion as an equity stake (at a highly inflated value) -- plus another $15 billion in tax benefits. GM has since paid back the $10 billion loan. Hurray. For taxpayers to be made whole on their equity investment, the price of GM stock will need to double.

So how much did the auto bailout cost? It's hard to say. The White House estimate is $14 billion, the CBO estimates $20 billion, but it could be $40 billion. And the benefit? According to Paul Roderick Gregory of the Hoover Institution, perhaps 4,000 auto related jobs more than what would have resulted from a traditional bankruptcy program. GM and Chrysler would still be around in reconstituted form. And the overriding imperative that demanded government intervention? Nothing more than coming to the aid of a narrow political constituency.

Is Rick Santorum right in portraying the TARP program for Wall Street and the banks as no different than the bailouts of GM and Chrysler?

Unlike the auto industry, the financial industry directly impacts almost every meaningful business enterprise in the country as almost every meaningful business relies on credit for its own operations or on the credit supplied to its customers. Whereas the auto industry bailout supporters argued about the ripple effect that auto plant closures would have had on the relatively small universe of auto parts suppliers, the finance industry is a supplier of a key component to almost every other industry in the country. As an old accounting professor of mine once put it, money and credit is the blood of the economy. You may be a great guy, but without blood, you're in some serious trouble. And that's exactly where the U.S. economy was at the onset of the financial collapse in the fall of 2008.

Everyone knows about bad real estate loans, securitized into pools sold off to investors as "AAA" credit investments, insured by giants like AIG (with pitifully low reserves), all of which came crashing down as the real estate market cooled and debtors in way over their heads, with no way of refinancing started to default left and right. All of a sudden banks and other financial institutions discovered that large portions of their balance sheets were made up of securitizations of unknown but dubious value, trading in some cases at 30 or 40 cents on the dollar at fire sales at distressed financial institutions, and due to "mark-to-market" accounting regulations they had to start taking massive write downs of their assets, putting their capital ratios out of whack (indeed making some institutions insolvent), resulting in not only a stoppage of lending, but the need to shrink the amount of outstanding loans (a process known as deleveraging), effectively reducing the money supply.

Less known, and what really spurred the Federal Reserve, the Treasury Department, and Congress to dramatic action, was what happened in the commercial paper market in the wake of the Lehman Brothers collapse in September 2008. Lehman was a big supplier of corporate paper (short-term loans to commercial borrowers for everything from working capital for inventory to gap lending to meet payroll when collections of accounts receivable are slow), which in turn is one of the primary assets in which money market funds invest. After the Lehman collapse, for the first time ever, people lost money in money market funds, which were supposed to be a "safe haven." A panic ensued, the electronic equivalent of a run on banks. Within days, the money market funds were hit with redemptions of $500 billion -- more than 25% of the market. As a result, for a few weeks there was almost no available supply for short term commercial paper. The market was frozen. Market theory suggests that as interest rates rose to try to attract capital, equilibrium would be achieved. But with panic keeping money on the sidelines, it is difficult to say just how long financial markets would have been frozen and just how long the U.S. economy would have been deprived of its blood. Without credible action by the Fed (supported by the Treasury) to end the panic, the damage to the economy could have been considerably worse than it was. Panic begets panic, and failing financial institutions take down other, healthier institutions, with them as the financial industry is based on leverage.

Yes, the U.S. economy has survived financial panics before (recessions and depression used to be called "panics" precisely due to their source). But all indications were that 2008 could have been as bad as anything we had ever seen. As Milton Friedman chronicled, the Great Depression was in large part the result of a similar collapse in the money supply, as the Federal Reserve failed to stop the domino effect as bank after bank failed. In 2008, the Fed took dramatic action and stopped the panic. The deleveraging process continued, and will likely continue for a while, but in a more orderly and less destructive fashion. TARP was initially envisioned as a way to buy up "toxic assets" to get them off of banks' books so that banks could start lending again with cleaner balance sheets (and the Fed possibly making money selling the assets, bought at a deep discount, as conditions improved). A big part of the plan, however, quickly turned into massive capital infusions into the banking system in the form of purchases of preferred stock. Since time was of the essence, this was seen as the quickest way to stabilize the financial industry rather than to figure out the complexities of buying and selling asset pools.

Such direct investment in U.S. companies was nearly unprecedented, and certainly scary, though not as scary as the wholesale nationalization of banks that many were advocating. Calming the markets, and even taking over unhealthy financial institutions, is clearly within the role of the Federal Reserve, but the massive interventions, including equity investments, of 2008 and 2009 were pushing the envelope. In the end, most of the direct "bailout" aid was repaid, with interest. Though it is tangled given that much of the auto bailout was allocated through TARP, the numbers are that of the original $700 billion authorized for TARP by Congress, $414 million was disbursed, $124 billion remained outstanding at the end of 2011, and the CBO estimates losses will be $14 billion, exclusive of auto bailout losses. (Though not a part of the TARP program, the Federal Reserve does currently hold $850 billion of Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securities, which could be a source of future losses, but those mortgages already carried at least an implicit government guarantee.)

Did the situation justify such action? It is a reasonable point of debate. Certainly the specifics of some of the actions taken were questionable (as is almost always the case with government actions). But in the final analysis there wasn't much of an alternative to some form of aggressive action by the Federal Reserve and the U.S. government constituting some sort of "bailout." The unique nature of the financial industry makes its rescue different in kind from the bailout of the auto industry. That may not satisfy an ideological purist, but whereas ideology can point you in the right direction, in a complex world it can also be a straightjacket if you let it, and sometimes ideological consistency can, indeed, be foolish.

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About the Author
Brandon Crocker is the chief financial officer of a commercial real estate development and management company in San Diego.