The Problem
It’s a classic speculative bubble, this time with home prices. Jim Manzi has a superb explanation of the situation:

…As is typical in a bubble, its later stages were characterized by reckless investment, excess debt and shady-tending-to-illegal business practices. As cheap credit pushed up the market price of houses, homeowners began to incur lots of debt (i.e., promises to pay other people on Tuesday for a hamburger today), which they were comfortable doing because they believed that they had sufficient equity value in their homes to make good on the debt if required. Some of this debt was mortgage debt. Many people who previously would not have received credit for a mortgage got them. Simultaneously, many homeowners were offered and accepted mortgages that approached all-debt at floating interest rates, rather than the traditional 20% down 30-year fixed rate mortgage. In the worst instances, these mortgages had payments that were all-but-certain to rise in the future. These homeowners were betting that they would get raises, inherit money, or, more likely, would be bailed out by an increasing home price that would allow them to roll over the debt. Other debt was incurred by existing homeowners for the purpose of consumer expenditures, which had the net effect of hollowing out the equity they had in their homes. All these effects are just examples of greater levels of debt secured against the market prices of homes.

Now what do you suppose happened when home prices declined (or didn’t rise fast enough)? Exactly.

Normally this would have been bad for both the homeowner and the guy who wanted to get paid for his hamburger, which might very well be the mortgage lender, but not really a big deal for you or me. (If enough of this occurred, of course, it could lead to a general slowdown and hurt pretty much everybody.) But this impact was magnified by the fact that most of the mortgage lenders sold the right to the payments under the mortgage to third parties. These third parties broke up the rights to the payments from the mortgages into lots of little pieces, combined these pieces with the rights to payments for little pieces of lots of other mortgages, repacked these in “creative” ways, and re-sold them to fourth, fifth and sixth parties. Four, five and six then used these promises as their own equity in order to raise further debt of their own. This would be like you using an IOU from your neighbor as your down payment for a mortgage. So when lots of these over-leveraged homeowners started to miss mortgage payments, parties four, five and six had less money than they expected, and they had problems making their own debt payments if they themselves had taken out enough debt. Oh yeah, many of these debt contracts are in fact between parties four, five and six.

Unfortunately for you and me, parties five and six are the financial institutions where we have our life savings deposited.

The Government’s Solution
No matter what happens next, it’s gonna hurt. The proper response hurts the right people, and minimizes the pain on those not culpable. Unfortunately, that’s not what the FED and the Treasury Department are proposing:

This is what Paulson and Bernanke are trying to manage. They have done three big things in the past couple of days:

1. Proposed a huge RTC-like government “bad bank” that banks can dump all their bad loans into. (Apparently, though, unlike the case with the RTC, they will not need to declare bankruptcy to do it.)

2. Provided a federal guarantee on money-market accounts.

3. Promulgated a temporary ban on naked shortselling for about 800 financial stocks (in related news, the new recommended medical practice when you discover that you have a fever is to smash the thermometer against the wall, since this makes the problem go away).

All of these things are, in theory, bad. In practice, all will have very negative consequences over time. Here are some of the problems:

1. We’re getting pretty close to nationalizing (hopefully temporarily) a reasonably big piece of the U.S. housing finance market, as well as other financial sectors that are put at risk by it.

2. Time will tell, but likely medium-term implications include higher government interest payments, worse deficits and higher taxes. This certainly reduces the probability of making the Bush tax cuts permanent in a couple of years, no matter who is in the White House.

3. This is obviously unfair. It bails out irresponsible behavior, and by implication, punishes responsible behavior. Longer-term, unless there is a lot of pain felt by financial company executives – who, remember, don’t look like they have to go bankrupt to dump their bad loans on taxpayers – this creates a massive moral hazard problem. Further, if such a situation develops, it won’t be lost on voters, who will likely demand greater socialization of consequences of reasonably-foreseeable bad behavior by people who don’t make a million dollars per year. The ideological consequences of the last few weeks will take many years to play out, and conservatives are unlikely to happy about them.

4. It’s also unclear how much of the problem, and what problem, this really solves until home prices hit bottom. As the market price of the underlying assets keeps dropping, more and more debt instruments become “bad”, with cascading effects. Though not likely, it is a lot more plausible than it was five days ago that the federal government may become a buyer of the actual housing assets. In that case, welcome to the introduction of large-scale public housing for middle-class Americans.

We should not be surprised the government’s solution is, by and large, awful. The FED and the Treasury are run by Wall Street guys who are worried firstly about protecting their own. This attempted socialization of the free market economy is bad in the long run even as it potentially lessens the pain in the short-run.

A few questions
If Wall Street is clogged with illiquid (aka “worthless”) loans as Treasury Secretary Henry Paulson says, why should taxpayers foot the bill for all the bad loans that investment banks have made?

If we’re going to effective recapitalize investment banks with taxpayer money, how come taxpayers don’t get any ownership?

If the federal government is providing the financial guarantee for money market funds–and this thought applies to checking and savings accounts as well–why does the government derive zero compensation for the risk it is taking? If the government is taking the risk shouldn’t it also garner the reward, even if that means nationalizing the banks?

Can we please, please, at long last stop confusing the Republicans with conservatism? Nothing the GOP has done in the latest eight years has been even remotely conservative. This is just the latest evidence.