The Bailout Isn’t a Morality Play

If this were a movie, we'd call it "TARP, The Sequel." The Obama Administration will soon unveil its plan to bolster the nation's financial system by buying or guaranteeing banks' bad loans and securities. Given the widespread revulsion against financial fat cats, the public reception may be underwhelming. But we need to move beyond populist denunciations of "bailing out Wall Street." The fundamental purpose is more compelling. It is to reverse a massive worldwide credit contraction that is clobbering the real economy of production and jobs.

Global finance has swung from one extreme to the other. Having engaged in excessive risk taking—by misjudging the hazards of collateralized debt obligations and other feats of financial engineering—banks and investors have become traumatized by all risk, which they now seek to avoid. The result is paradoxical. As individual financial institutions try to minimize their risks, they actually increase the risk for the broader economy by denying needed credit or dumping securities (bonds, mortgages).

It's a vicious circle. Here's how it works.

With the economy weakening, more loans and bonds go into delinquency and default. Distressed households and businesses can't meet their payments. Diane Vazza of Standard & Poor's predicts that the default rate on "high yield" corporate bonds issued by smaller or weaker companies will reach nearly 14 percent in 2009—a record, and up from only 1 percent just two years ago. Some firms piled high with debt from private-equity buyouts seem particularly vulnerable.

Growing losses then make investors and creditors even more leery of risk. To conserve capital, they further curb new commitments. The consequences are global, not just local. Money flows into developing countries have collapsed. In 2009, they may be down 82 percent from 2007 levels, forecasts the Institute of International Finance, a research group. Private companies in these countries (Brazil, India, Mexico and others) have $100 billion of maturing debts in the first half of 2009. The IIF worries that much of this debt won't be refinanced. Scarce credit implies slower growth or recessions that will worsen the global slump.

So, we've gone from too much credit to too little. Surprisingly, banks—institutions that take deposits—aren't the main problem. In December, total U.S. bank credit stood at $9.95 trillion, up 8 percent from a year earlier, reports the Federal Reserve. Business, consumer and real-estate loans all increased. True, lending was down 4.7 percent from the monthly peak in October. But considering there's a recession, when people borrow less and banks toughen lending standards, the drop isn't disastrous.

The real collapse has occurred in securities markets. Since the 1980s, many debts (home mortgages, auto loans, credit-card debts) have been "securitized" into bonds and sold to investors—pension funds, mutual funds, banks and others. Here, credit flows have virtually ceased, reports Thomson Financial. In 2007, securitized auto loans totaled $73 billion; in 2008, they were $36 billion. In 2007, securitized commercial mortgages for office buildings and other projects were $246 billion; in 2008, $16 billion. There were also sharp drops for mortgages, consumer loans and other forms of securitization.

Given the previous lax mortgage lending, some retrenchment was inevitable and desirable. But what started as a reasonable reaction to the housing "bubble" has turned into a broad-based rejection of securitized lending. Creditors are so terrified that they prefer to buy "safe" U.S. Treasury bonds, notes and bills instead. The low interest rates on Treasuries (0.5 percent on one-year bills, 3 percent on 10-year bonds) simply provide one convenient measure of risk aversion.

Somehow, the void left by retreat from securitization must be filled. If it isn't, credit flows will remain moribund. There are three possibilities: (a) securitization revives spontaneously—investors again buy bonds backed by mortgages and other loans; (b) commercial banks or other financial institutions replace securitization; or (c) the government substitutes its lending for private lending. Until now, it's been mostly (c).

The federal takeover of Fannie Mae and Freddie Mac in September means they're now providing about three quarters of all new mortgages, up from about half in 2007. The Treasury and Federal Reserve, through various new and complex lending programs, are funneling funds to mortgages, student loans, small-business loans and even foreign governments. But a permanent expansion of government's lending role raises a host of practical and philosophical issues. It might politicize most lending decisions, involve ever-larger increases in federal debt and pose long-term dangers of inflation.

As proposed by President Bush, the $700 billion Troubled Asset Relief Program aimed to rehabilitate the private credit system. The Treasury would buy some of the banks' bad loans. Thus strengthened, banks could increase lending and offset some of the decline in securitization. But in practice, the Bush gambit failed. The Treasury changed course. It injected capital directly into banks after deciding that it was too hard to put a price on the banks' bad loans. Unfortunately, banks remain reluctant to lend because they still have lots of bad loans on their books.

Now the Obama administration is preparing its own program to revive lending. It's a genuinely hard problem; if it weren't, it would have been solved already. The Obama proposals will spur ferocious debate. Will the plan work? Is the cost too high—or too low? What conditions should be imposed on banks that receive federal aid?

But we should resist turning the debate into a morality play about whether Wall Street and bankers deserve to be rescued. Probably they don't. Although beating up on them may be politically and morally satisfying, it's beside the point. If the financial sector isn't revived, the economy will remain depressed.