Fair Market

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RATIONAL ARGUMENTS

A Free and Fair MarketHow do we protect the markets from their own overexuberance?With reasonable policing and a clear signal that future failures won't get government bailouts.BYMARTIN LOBEL

EVENPresident Bush now admitsour economy is in trouble, butso far his administration's. re-sponse has been one hurried bailoutafter another in an attempt to keep oureconomy from crashing. Because his-tory is a pendulum where one policycreates a problem that is "solved" bypolicies intended to correct the initialpolicy, it is important to understandwhy our current economic problemsoccurred so we can craft solutions thatdon't push the pendulum too far andcreate new problems.

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Let me first admit my bias: A freemarket is the basis for a healthy econ-omy, but a free market requires thatsomeone establish and enforce therules that provide a level playing field.At the least, that playing field shouldmake accurate information available toall who want to participate in the mar-ket and require personal responsibilityof those who participate on both theup- and the downside.Unfortunately, the Bush administra-

tion has refused to act as a policeman,apparendy forgetting the warning of the

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New York artis t Geoff rey Raymond paintedthis portrait of Bear Stearns CEO JamesCayne; after the col lapse of the investmentgiant, the painting was placed in front ofBear Stearns headquarters, where employeeswrote messages, expressing their anger.

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longest-serving chairman of the FederalReserve Board, William McChesneyMartin, that the function of the Fed isto "take away the punch bowl" whenthe party gets too exuberant. Instead,the administration has been a bartend-er who allows his customers to get so

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drunk they need to be hospitalized.Whether the Bush administrationreally believed the economic lunacy ofthe Laffer Curve or Grover Norquist'stax-cutting solution to all problems is aquestion for historians. What is impor-tant is the impact such policies had onthe economy. They were summed up forme the day after the 2004 elections by avery drunk and prominent Republicanlobbyist who staggered over to my tableand proclaimed, "I'm going to get rich.My clients are going to get richer, andthen we'll have a one-term Democraticpresident because she'll have to cleanup the (mess) we leave behind."

Knowing there was no policemanon the beat, Wall Street threw cautionto the wind and developed all sorts ofways to generate income, whether theymade economic sense or not. The in-

gage-based derivatives inside specialpurpose entities called special invest-ment vehicles. The role of special pur-pose entities in the collapse of Enronis well-known and well-documented.That the Comptroller of the Currencyallowed Citibank to hide some $81 bil-lion of derivatives in an SlY is both anabrogation of responsibility and a clas-sic example of this administration's re-fusal to govern.Long before the crisis struck, the

consequences of the administration'sactions were apparent to anyone whocared to look. Then the market worked,and they became real. People whocouldn't afford their homes because ofinterest-rate increases or inadequate in-come stopped paying their mortgages.Foreclosures rose; housing prices fell.By one estimate, 1 in 10 homeowners

$29 billion of taxpayer money and giv-ing investment bankers access to theFed's money for the first time.Though needed to forestall a global

credit crisis, the Bear Stearns bailouthas many ramifications, some perhapsnot foreseen; for example, will the Fed'spriority be fighting inflation or bailingout Wall Street? Paulson also workedwith Congress to pass legislation tohelp homeowners in trouble throughno fault of their own and, of course, tohelp the homebuilders and banks.

But these are stopgap measures. Weneed to institute longer-term solutions.It is clear that we need to rethinkthe role of the government and, in par-ticular, the regulatory agencies in thefinancial system. The Securities andExchange Commission and the FederalReserve were developed in the first half

Knowingherewasnopolicemanonthebeat,WallStreetthrewcautiontothewindanddevelopedallsortsofwaystogeneratencome,whethertheymadeeconomicsenseornot.vestment bankers ignored or hid risk.They encouraged unregulated mort-gage brokers to make subprime loansthat made no sense and, in some cases,were fraudulent. The mortgage brokersdidn't care; they "sold" the mortgages,transferring the risk to Wall Street firmsthat packaged the mortgages into de-rivatives that were sold, along with therisk, to investors, based on ratings byrating agencies that apparently believedthat the housing market could only goup. Then the derivatives were sliced anddiced until, in many cases, it was impos-sible to tell who really owned a mort-gage, but each time these instrumentswere transferred, someone earned a feethat went directly to the bottom line.Eventually, these derivatives became

so complex that no one really under-stood the risks they presented. But, solong as they generated fees, no one ap-peared to care. To take the lack of polic-ing to almost ridiculous extremes, thegovernment let banks hide their mort-

with mortgages was either three monthsbehind in payments or in bankruptcy; 1in 9 houses was worth less than its mort-gage. Other lenders stopped lending tobanks and investment banks because noone knew what the derivatives they heldwere worth. The economy froze.T HE ADMINISTRATIONad to dosomething. Letting the free mar-ket correct itself could no lon-ger be the administration's mantra. Andits options were limited by the decline inthe value of the dollar and a looming fed-eral deficit caused by its policies.Fortunately, Henry Paulson, theformer head of Goldman Sachs, had

agreed to become Treasury secretary.If anyone could fix the problem, hewould. He knew the consequences ofremoving failure - or moral hazard,as it is called - from the market. Buthe needed to insure market liquidity,so with the Federal Reserve, he engi-neered a bailout of Bear Stearns, using

of the last century to cope with the fi-nancial system as it was then. The fi-nancial system has changed significant-ly, and the regulatory agencies need tochange, too. The Fed has always beenknown as a cheerleader for the largebanks, not a law enforcement agency.Yet, when the banks got in trouble, theadministration decided to share re-sponsibility for the banks between theFed and the SEC. What it really meantis that it was taking responsibility forregulating bank stocks away from theSEC, which, at best, is a feeble law en-forcement agency, and handing it overto the Fed, which is essentially not alaw enforcement agency.Then, when the investment banks

complained to the SEC about shortsellers who had the audacity to pointout their economic problems, the SECprohibited the "naked" short selling ofinvestment bank stocks to protect themfrom the market. The best that can besaid about these actions is that the ad-

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L_____ --- - - -RATIONAL ARGUMENTS

Thosewho sat by and watched while untrammeled greed causedtoo many people to take too many risks need to be replaced by thosewho believe that government has a necessary role in makingsure the free market can work.ministration is protecting Wall Streetand the big banks against moral hazards.As some would say, the government is"privatizing profit and socializing risk."

And that's the best gloss on the situa-tion. Ifthese policies are continued, theywillcreate future financial disasters.

T o MAKESUREthe Americanpeople aren't expected to bailout Wall Street for the rest oftime, government must be populatedby people who believe that they havea responsibility to enforce the law.Those who sat by and watched whileuntrammeled greed caused too manypeople to take too many risks needto be replaced by those who believethat government has a necessary rolein making sure the free market canwork.We can no longer afford to havegovernment officials who feel their re-sponsibility is not to keep the financialplaying field level for all but to keepthe rich (or, as Bush referred to them,his constituents) happy.

The administration's opposition tobankruptcy reform that would allowbankruptcy judges to modify a mort-gage on a primary residence to make itaffordable is a good example of govern-ment behavior aimed at aiding one classof Americans - the extremely wealthy.That bankruptcy judges can cram downamortgage on a second home or a yacht- both most likely owned by a rich per-son - but not on a primary residencemakes no sense. If a bank knew that abankruptcy judge could cram down amortgage, it would have more incentiveto negotiate with a borrower in troubleand share any losses.

We need to increase transparency inthe market. The credit market seizedup because the derivatives that gener-

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ated so much income for so many onWall Street were too complicated foranyone to value, so lenders had noreal way to determine the solvency ofborrowers. We should require that de-rivatives be openly traded on a market.That way they can be priced quicklyand often. It would probably requireWall Street to have standard forms ofsuch securities, but that can certainlybe accomplished.

Derivatives are not all bad. Theycan be used to shift and spread risk,allowing innovation and enterprise tothrive. But there are about $63 tril-lion of credit default swaps - a formof derivative that is essentially a nakedbet that a financial instrument willnot default - overhanging the marketright now. They need to be cleaned up;otherwise, no one can have confidenceabout the value of banks' and invest-ment banks' assets. Unfortunately, un-raveling who owes what to whom will

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not be easy and will take a long time.Since credit default swaps are essen-tially bets, they should be banned inthe future as a form of gambling. Ifwe want to treat them as insuranceagainst risk, we should regulate themas insurance policies.

We need to make sure governmentregulators do not eliminate moral haz-ard or the risk of failure from the market.That means investors need to know thatthey will lose their investment if an en-terprise fails - that the government willnot bail them out. It also means highlypaid investment bankers and CEOsneed to be held personally liable fortheir failures. No longer should we allowCEOs or investment bankers who de-stroy companies to walk away with mil-lions of dollars while all the employeesget is unemployment insurance. Whilewe're at it, we should find out why com-petitive market forces are not working tohold executive compensation at reason-able levels and correct the problem. AreAmerican CEOs really worth 100 times,on average, what a British CEO is paid?Paying top executives many times whatcould be justified by any analysis is notjust unfair to workers; it is a fraud onshareholders, too.We need to reform our tax code tomake it fairer and less complicated. Weneed to rethink whether income fromcapital should be taxed at a lower ratethan income from labor. We need toremember that the purpose of the taxcode is to raise revenue, so we need tosimplify our code by eliminating taxsubsidies and making the code enforce-able. We also need to make the tax codefairer by increasing the tax burden onthe very rich, who earn a greater per-centage of our nation's income than atany time since the 1890s, and lowering

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it on the middle class, which is strug-gling to make ends meet.

I've advocated eliminating the exist-ing corporate tax provisions and impos-ing a flat tax on the amount corpora-tions claim they earned in their reportsto the SEC and shareholders. But thereare less-drastic steps that would work tolevel the taxation field.We could requirecompanies to determine their profits andtaxes by using a unitary accounting sys-tem to eliminate the ability of the mul-tinational corporations to shift profitsto tax havens abroad. That would raisemore money for the federal governmentand help domestic companies competeagainst the multinationals. We also needto hire more people at the IRS so theycan enforce the laws we have now. Forexample, the Swiss investment bankUBS has admitted that it has 19,000U.S. taxpayer accounts that have notbeen reported to U.S. authorities. Butthe IRS does not have the resources togo after all of these apparent tax cheats,even though the IRS knows offshore ac-counts are responsible for about $100billion in annual lost taxes.

If we do not take reasoned steps tocorrect the results of the Bush adminis-tration's refusal to govern and to policethe markets, the pendulum will swingtoo far, the economy will suffer moreextreme damage - and far more dra-conian steps will be taken in response.The commodities industry is now ex-periencing just such an overreaction.Because so many traders were makingso much money, the industry wouldnot acquiesce to a closing of the Enronloophole, which allows traders to makeelectronic commodities trades thataren't subject to U.S. regulation. Manysuspect that such unreported trades inthe U.S. and in Europe have been re-sponsible for significant increases in oilprices. In the face of voter outrage athigh gasoline prices, Congress is nowconsidering legislation that not onlycloses the Enron loophole but also im-poses restraints that could have sub-stantial adverse effects on the wholecommodities-trading business.Business needs to realize that the

Lgovernment must begin regulating themarkets with an eye toward fairnessand transparency, or voter outrage willforce extreme changes that could im-pair a free market. There are only a fewissues in Congress that have such pub-lic visibility. All the business campaigncontributions and corporate lobbyingin the world will not convince taxpay-

ers that continued bailouts for largemarket players are fair. And taxpayersconvinced they have been played forsuckers can be a terrible thing forCEOs to behold. Just ask Ken Lay. 1mMartin Lobel isan attorney inWashington,D.c., who representsmarryreportersand haswritten widely about tax and media issues.

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