My Solution to the Financial Crisis

Here is a economic policy memo I wrote regarding the shortcomings of the bailout and the need to overhaul Paulson's plan. Enjoy...


Congress should not provide capital to banks, bur rather modify existing regulations and give the $700 billion directly to taxpayers. This would prevent socializing Wall Street and infuriating the American taxpayer, eliminate existing bad government regulatory policies, allow markets to accurately and efficiently price securities, and eliminate federal guarantees. The government’s current measures may prevent a total financial meltdown, but they are seeds of another financial crisis. Congress should be concerned about its reactionary regulatory policies because the bailout package has serious shortcomings:

• The proposed bailout has not stopped the markets from slipping; From October 6 through October 10, the Dow Jones Industrial average dropped 22%, the S&P 500 dipped over 17%, and the New York Stock Exchange reached its lowest point in 7 years.

• Other proposed government policies like the ban on short selling have only hurt the markets further, disallowing many companies’ preferred method of safeguarding their portfolios. It has disrupted the ability of institutions such as hedge funds to trade pairs, a strategy involving minimizing risk on correlated stocks by going long on one and short on the other.

• The Congressional bailout package has decreased public confidence in the markets and in Congress; the public has seen endless revisions to the proposal.

• Congressional interference in mortgage lending was the leading cause of the increase in home ownership and, by extension, the economic downturn. In an effort to increase home ownership among the lower classes, several branches of government reduced the mortgage underwriting standards, leading to an increase in housing prices and home ownership. This tempted speculators to purchase homes without putting their money at risk.

• With the bailout package guaranteeing bank loans or assets, banks have less incentive to evaluate loan applicants thoroughly, but more incentive to engage in riskier behavior than they would otherwise. If affairs were good, banks would make high profits but, in the case of today’s economic downturn, it is the taxpayers who pay. This tendency of banks to take on too much risk is exactly what caused the current crisis. Government-sponsored entities Fannie Mae and Freddie Mac guaranteed loans amounting to 50 times their net equity because they knew the Federal Reserve, Treasury Department, and Federal Deposit Insurance Corporation would step in to act as lenders of last resort.

With its recent policies, the government has bailed out guilty institutions, allowed relatively innocent institutions to flounder, and made taxpayers foot the bill.

What Should Be Done Instead

The reserve requirement for investment banks and government-sponsored entities should be raised. This would require that firms value their tradable assets at market prices and maintain a cash balance equal to a percentage of that price. Small banks have fairly high capital ratios (10%), and they have remained both relatively unaffected and innocent in the recent economic crisis. Raising the reserve level allows institutions to navigate tight credit markets by holding enough capital to face sudden increases in their default rates. The bailout bill fails to address this both for short-term economic recovery and future planning.

The federal government should foster savings and investment in the stock market by extending the capital gains and dividend tax cut. Not only would this give a strong incentive to taxpayers to invest in the market but it would also raise the rate of return on financial assets with little cost to the Treasury.

Congress should lift all Roth IRA contribution and eligibility limits for at least one year. This measure also has no immediate cost to the Treasury, since contributions to Roth IRAs are not tax deductible. It would likely pump billions of dollars into the tight market.

These measures would have allowed the market to reorganize its financial sector at no cost to the taxpayer. To stimulate the economy, Congress could authorize half of the bailout amount ($350 billion) to be given in stimulus checks of $1,800 to each of the 191 million taxpayers with the condition that the funds must be deposited into some type of retirement account or subject to the premature distribution rules the IRS has regarding IRAs. Risk-averse people would invest their money in money market accounts, thus preventing a credit crunch. Others would buy mutual funds, helping sustain the market. Investors with a high risk threshold would invest in distressed banks, profiting greatly from the low prices on Wall Street. Such a measure would undoubtedly prove popular with the electorate, even if they had to pay back the Treasury later.

Addressing Objections

What about banks? Shouldn’t we help banks out by restoring their capital?
Bailing out banks would not alleviate the moribund financial system. With unemployment rising, the housing market still deteriorating, and U.S. exports suffering, it is clear that bailing out banks such as Lehman Brothers will not avert the crisis. The government chose to take on $29 billion in risky assets from Bear Sterns in March and that did nothing to prevent the imminent freefall in the financial system. The increased investment in banks as a result of the aforementioned bailing out of taxpayers would increase the value of banks’ stocks, provide capital, and allow them to make more loans to consumers.

Should we not have more regulation in this time of crisis? Isn’t deregulation what got us into this mess?
The culprits in this crisis were not the mortgage lenders, the investment banks that created mortgage-backed securities, or the ratings agencies. The key financiers of the crisis were those who purchased contaminated mortgage products. Had they not bought them, no one would have sold them. U.S. investment banks, regulated by the Securities and Exchange Commission, and commercial banks, regulated by agencies like the Federal Reserve, were the buyers. Hedge funds, which are lightly regulated and sometimes not regulated at all, resisted buying the toxic mortgage products. Because they operate with borrowed money, though, they are still vulnerable to the credit crunch, but no one proposes bailing them out. Columbia Business School’s Charles Calomiris calculates that the over-regulated Fannie and Freddie bought more than a third of the $3 trillion in junk mortgages created during the bubble; they did so because the government push for an increase in home ownership galvanized them to allocate money toward marginal home purchasers, pouring hundreds of billions of dollars of fuel on the fire. Deregulation is not the culprit in the financial crisis.