I recently listened to a speech by Pulitzer Prize-winning historian David McCullough. You may recall that Mr. McCullough wrote the biography John Adams a few years ago as well as the excellent 1776. (I highly recommend both these books.) Mr. McCullough made the point that we often view history as deterministic, meaning we have the impression that things in the past happened the way they had to happen. We suffer from hindsight bias and often fail to recognize that nothing in the past had to turn out the way it did. Historical figures were living those momentous events in real time. Often, they didn't even know they were making history. They were simply making the best decisions they could, given whatever information they had at that time.
I believe we are living history right now. The bailout proposed by U.S. Treasury Secretary Henry Paulson last Friday represents the largest such action since the Great Depression and promises to remake the financial landscape for years to come. I spent the past few days reviewing the proposal. Here are my thoughts:
1. Its about time. This kind of government action has been a long time coming. Over a year ago we made the statement that the growing crisis was going to require a bailout a long the lines of the S&L crisis of the late-1980's. The time wasted since then has not only caused the price tag for this intervention to skyrocket, but the failed half-measures in the meantime have squandered the public trust. I hope I'm wrong, but after the initial euphoria on Friday, I expect the markets to greet this plan with skepticism.
2. This is a good first step, but more will be needed. As we have seen already, massive intervention is not sufficient to quell the storm. Additional measures, such as the accounting reform mentioned in my last post, need to be enacted in order to address the root causes of the current problem. Other actions should include establishing a self-regulatory organization (SRO) for the mortgage finance industry. Such SRO's have worked very effectively, albeit not perfectly, in other areas of financial services.
3. Oversight is essential. The initial proposal from U.S. Treasury does not contain any language to establish any kind of oversight other than quarterly reports to Congress. I am very uncomfortable handing a $700 billion blank check to anyone.
4. Taxpayers must come first. Several democratic members of Congress have made the point that taxpayers should come first in realizing any benefits from the bailout. I agree with this completely. Some have suggested that the U.S. Treasury receive warrants on the stock of companies that take advantage of the bailout fund. This could be a very effective mechanism, though I need to better understand the specifics of their proposal. A good case study for how this might work is unfolding right now with AIG. It is gratifying to see AIG's existing shareholders scramble to find a solution to their problems that will not require them to draw on the government's lifeline. You may recall that the government's bailout package for them includes warrants on 80% of the company's stock. Those shareholders stand to lose billions if those warrants are exercised.
5. Avoid regulatory over reach. Some regulation is obviously necessary. After all, we regulate all kinds of substances and activities that we deem to be harmful in our society (drugs, crime, etc.). However, not all regulation is effective or good. Watch out for demagogues in Congress (on both sides of the political divide) who try to make political hay by proposing bold new regulatory schemes.