Bailing out Wall Street

There’s something un-American about the government rescuing private companies that made bad bets in a competitive marketplace. It runs counter to the mythos of this land of opportunity, where the freedom to fail goes hand in hand with the freedom to succeed. It also violates our sense of fairness: Why should the reckless get help when the prudent do not?

That’s why so many people objected to proposals earlier this year to help homeowners who were defaulting on their mortgages in record numbers. And now, as Washington prepares what may be the largest bailout in history, there may be as much resentment about the proposed lifeline for Wall Street as there is fear of the financial system collapsing. Being politicians, presidential candidates John McCain and Barack Obama have given voice to that anger. But McCain skewed his analysis of the situation in a clumsy effort to link Obama to the problems. And Obama placed too much faith in regulation to protect taxpayers.

Rather than looking backward for someone to blame, McCain and Obama should be focusing on the problem in front of us. Financial institutions are buckling under the weight of hundreds of billions of dollars in investments that have lost their market value. The main question for politicians isn’t whether to act -- the comments Friday by congressional leaders and top administration officials made it clear that Washington will undertake something extraordinary -- but what to extract from the companies that are helped and how to prevent the problems from recurring.

The year-old credit crunch grew out of the housing bubble, whose roots lie in the low interest rates that the Federal Reserve maintained after the 2001 recession. An array of factors combined to turn the Fed’s spigot of cheap money into a stream of increasingly risky mortgages and related securities, including poor underwriting, financial incentives that promoted predatory lending, inaccurate risk estimates by ratings agencies and new credit derivatives that spread the exposure to bad loans.

The messy history of the crisis makes for a poor stump speech. Yet McCain missed the mark almost completely last week when he blamed the problem on “lobbying and influence-peddling” by Fannie Mae and Freddie Mac, two firms with close ties to Obama and other leading Democrats. That’s not to defend the sorry record at Fannie and Freddie, or the companies’ efforts on Capitol Hill. But Fannie and Freddie came late to the subprime mortgage party and played no role in the exotic derivatives that helped sink Lehman Bros. and endangered American International Group.

McCain was on much more solid ground when he called for the Treasury Department to adopt a consistent framework for helping troubled financial firms, rather than developing solutions on the fly. In particular, he called for a federal trust to help failing financial institutions early, to minimize the cost of the intervention. The idea is similar in principle to the effort Treasury Secretary Henry M. Paulson and Federal Reserve Board Chairman Ben S. Bernanke have discussed with congressional leaders -- a taxpayer-funded entity that buys distressed investments from lenders, just as the Resolution Trust Corp. took over properties from failed savings and loan corporations in the 1980s.

The next steps

Obama gave the Paulson and Bernanke strategy a cautious thumbs-up last week, but like McCain, he cast his stance in populist terms. There must be no golden parachutes for executives, he warned, and no support for “those who are ruthlessly foreclosing on American families.” And if Washington is going to extend a hand to Wall Street, Obama said, it should also enact another stimulus package to help families, schools, local governments, homeowners and the auto industry.

Aside from the fact that the crisis has nothing to do with high executive salaries, and that piling all the blame on bankers ignores the culpability of irresponsible borrowers, Obama’s chicken-in-every-pot demand overlooks the best reason for the Wall Street bailout: If it’s done right, the benefits will spread far beyond the financial industry. If banks refuse to lend, and money-market funds run out of cash for short-term business loans, the economy will grind to a halt. Ultimately, a bailout could aid those Obama seeks to help more than his cherished stimulus package.

The immediate question is how to help Wall Street while still penalizing firms for their mistakes, so as not to encourage the recklessness that fueled the current crisis. A good suggestion, floated months ago by Moody’s Economy.com, is to have the government buy the troubled mortgages and other securities through a reverse auction that drives down prices. That limits the benefit to the sellers and gives taxpayers, who can afford to hold on to the securities until the market rebounds, the best chance of recovering their investment.

Both Obama and McCain have called for tougher regulation, arguing that lax oversight helped cause today’s problems. It’s easy to call for more scrutiny; the tougher question is what to scrutinize. It’s clear in hindsight that Wall Street underestimated the risk of many mortgage-related securities, but it’s naive to think regulators would analyze risk better. Nevertheless, there are some clear shortcomings for policymakers to address in the months to come, including the lack of information about the contents of complex securities, the dangerously small cushions to protect against certain types of losses and the different levels of regulation applied to similar types of securities.

The long-term fix will await the next administration. It’s probably too much to ask McCain and Obama to lay out, in chapter and verse, how they’d like to restructure the financial regulatory system. But they could start by zeroing in on the real sources of today’s problems, not the aspects that play best to their constituencies. And they can help make today’s bailout expensive enough for Wall Street that it won’t seem so costly to Main Street.