Hitting the Limits of Governmental Action

Even as various government programs aimed at easing the recession and financial crisis are reaching the implementation stage, we are already seeing their limitations.

Bank Bailouts. Several small banks have recently repaid their TARP money, and Goldman Sachs will do so very soon. It's understandable why banks want out of TARP. No business likes the government to dictate executive compensation and other market-driven business policies and practices. But, considering that TARP was meant to stimulate lending, and do so in a way that did not make any bank look weak or endangered, action by a few stronger banks to opt out begins to push TARP down the slippery slope. For competitive reasons, other banks may decide to repay their TARP money, and rely on the FASB's recently relaxed accounting standards for toxic assets to look good while staying in business. TARP's effectiveness could be damaged in the process.

Foreclosures rising even as mortgage modifications increase. The Obama administration's mortgage modification program has officially begun, with some homeowners now receiving relief. However, banks and mortgage companies have also increased foreclosures of mortgages that aren't eligible for modification. Apparently, lenders have been holding a large number of foreclosures in abeyance will waiting to see which loans would be eligible for government subsidized relief. Now that the picture is clearer, those eligible proceed to the winner's circle and those ineligible lose their homes. Thus, while many homeowners may get to stay in their homes, housing prices may continue to experience downward pressure from the increase in foreclosure activity.

GM and Chrysler bankruptcies more likely. In any bailout situation, lenders and investors try to shove as much of their losses as possible onto the taxpayers. In the cases of the Bear Stearns, Fannie Mae, Freddie Mac and AIG bailouts, financial market counterparties and bondholders were quite successful in getting taxpayers to cover lousy bets these creditors had made. Meanwhile, shareholders took it on the chin. This precedent appears to have emboldened GM and Chrysler bondholders, leading them to take hard lines in bailout related negotiations. The Obama administration in turn is talking tough to bondholders, both to avoid yet more moral hazard and the spectacle of struggling middle class taxpayers bailing out the institutions and mostly wealthy individuals who hold GM and Chrysler bonds. If they deadlock, bankruptcy will follow. While there is a theoretical framework for a government funded restructuring of GM and Chrysler in bankruptcy proceedings, there is no real world track record. One thing that lawyers know is that when you're in court, you can't be sure of what's going to happen. One or two unanticipated rulings by the court, and the government funded restructuring could evaporate. If that happens, GM and Chrysler would almost surely be liquidated and the administration's goal of preserving jobs undermined.

Bank Stress Tests. The administration is struggling with the issue of how much to reveal of the results of the ongoing stress tests of the 19 largest American banks. Basically, these tests are analyses of how these banks would fare under various economic scenarios ranging from good to bad to ugly. Traditionally, federal regulatory examinations of banks have been conducted confidentially, to avoid precipitating runs by depositors when it turns out that a bank is in trouble. The problem with the stress tests is that they are not routine examinations, but instead highly touted elements of the administration's financial recovery program. By heightening public awareness of the stress tests, the administration is damned if it doesn't disclose and damned if it does. Not disclosing only feeds the rumor mill and fuels concerns that the entire banking sector is insolvent. That would probably freeze the still very cold credit markets. Disclosure would reveal differences in strength among the banks, and the weak would be vulnerable to funding problems and runs. Rosy disclosure would be perceived as grade inflation and heavily discounted. Investors and depositors are well past the point where they believe that all banks are headquartered on the shores of Lake Wobegon. The administration could have conducted the equivalent of stress tests through the routine bank examination process, since federal examiners pretty much continually work onsite at the major banks. But using the stress tests for public relations purposes--indeed, to raise public confidence--may easily fracture public confidence.

Today's stock market is all government, all the time. The value of stocks appears to depend almost entirely on the extent and efficacy of governmental intervention in the economy and the financial system. When the government hits the limits of its power, the stock market will squirm and perhaps swoon.