Rebuilding America: Bubbles and Panics

Member Group : Lincoln Institute

On Good Morning America, Elizabeth Warren, Chairperson of the Congressional Oversight Panel reviewing the expenditures of the TARP funds, expressed righteous indignation with the inability to track how the government funds were spent. She vowed to continue the fight to determine where the money went.

Even Fox News jumped on the bandwagon and demanded to know where the money went and how it was spent.

The collective cry from news analysts was that they believed that the funds were to be used to bailout consumers and homeowners.

Once again, a poorly designed government attempt at intervening in free markets has proven disastrous.

I would have hoped that the first recommendation that the Oversight Panel would have made in their report to Congress was that it is unlikely that a bank would accept funds in preferred stock with a direct cash cost of 5% after tax to lend out at 4% before tax. Should the bank be so inclined, it would merely reinforce my understanding of the stupidity of the mortgage crisis to begin with.

How can a bill get passed by both the House and Senate with neither body understanding that banks lend based upon the cost of funds. With the cost of the Treasury Department’s preferred stock and the related warrant costs, these funds are very expensive. Preferred stock is equity. It was not a loan by the government. It was an investment. As such, the borrowings would have been done to shore up the bank’s capital base due to losses already incurred and not solely for the purpose of lending.

By shoring up the bank’s capital base, the bank is able to stop its deteriorating capital base which was causing a further reduction in lending. Banks are by design highly leveraged. When leverage is favorable through increases in earnings, banks can expand lending. The reverse occurs though when the banks lose money. The loss of equity through mortgage losses for example requires the bank to curtail lending and even reduce loans outstanding. Recent mortgage losses had a multiplier type effect in the banking system’s ability to lend. The issuance of stock is one way for banks to stop the multiplier effect. In the current situation, the financial markets were so shaken that only the federal government was willing to put up funds.

The Treasury Departments preferred stock issuances stopped the hemorrhaging of the banking system and prevented further deterioration in the credit markets.

Bubbles and panics happen in markets. Intervention in markets by government happens occasionally. The long term effects of those interventions are not always so obvious particularly when the legislative branch does not understand how markets work to begin with.

If you examine the current panic, those with cash will reap huge rewards. Within a decade, Warren Buffett’s decisions to invest in Goldman Sacks and General Electric will be viewed as the brilliant move that it is. Mr. Buffett wisely had cash. He understood that buying just because you have cash is a silly reason to buy. He does not buy into bubbles but he invests during panics.

The Treasury Department’s investment in banks will as well be very beneficial for the treasury in the long run even though I personally do not believe in bailouts. The continued intervention in the market by the government may in fact reinflate the bubble leading to an even greater panic in the years ahead.

Until the government understands that its own policies led to an overheated real estate market to begin with, more efforts to remove the pain of economic contractions will be made with the effect of setting the stage for the next bubble.

All of us should be concerned that failing to allow the economy to stabilize through rational market forces will likely lead to an even more disastrous bubble and then deflation in the years ahead.

Properly using fiscal and monetary policy for an economy is important for any government. These tools though need to be used for legitimate roles of government as provided for in our constitution. Any efforts outside of those limited roles of government which include providing the rule of law are likely to spell disaster in the long run.

The day of reckoning is coming. Continue spending our way out of panics and the stage will be set for the next bubble. Allowing the economy to contract rationally will remove the poor practices which created the bubble in the first place.

The day is coming in which the world will no longer be able to finance our experiment. Then and only then will we deal effectively and seriously with the excesses in our markets. Unfortunately, it will be painful unless we decide to stop excessive intervention now.

Frank Ryan, CPA specializes in corporate restructuring and lectures on ethics for the AICPA. He is on the boards of numerous publicly traded companies as well as not for profit charitable organizations. He can be reached at [email protected].