The Fate of Capitalism

In recent weeks, the soupe du jour news story is the $165 million bonus that AIG is giving out to its employees. Senators and representatives have been fighting ferociously over the legitimacy of the bonus on Capitol Hill. To tax, or not to tax? As the public anxiously awaits some kind of poetic justice on one culprit of the financial meltdown,
many economists can only sit back hopelessly and watch the politicians continue to try to appeal to the masses while letting the country sink further and further into an economic black hole.

Sure, the AIG bonus is a social and perhaps legal outrage, but when the country’s projected deficit for this year is 1.75 trillion, 12.3% of the forecasted GDP and its ability to finance its debt can be potentially crippled by China’s announcement regarding the abolition of U.S. greenback’s status as desired reserve currency, there is something to be said about the government’s priority amidst this financial Armageddon. A $165 million bonus seems like a trifle when compared to the $1.75 trillion deficit or the possibility of the nationalization of the banking system. As the call for nationalization gets louder, the government is taking its last chances with capitalism.

The Federal Reserve has recently unveiled a drastic measure in the hope to jump-start aggregate demand. Last week, the Fed announced it would purchase $300 billion worth of long-term Treasury bonds along with $750 billion worth of agency mortgage backed securities. This will allow the Federal Reserve to control long-term rates, which have previously been determined by the market. After several attempts to drive down mortgage rates to halt the housing downturn through liquidity injections, mortgage rates remained above the desired level that would effectively stabilize housing prices. The Fed hope to lower the mortgage rate through this massive purchase of agency mortgage backed securities. If housing price stabilizes, the increased in perceived wealth among households can lead to increased spending, thereby boosting economic activities.

With the Federal Funds Rate at virtually 0%, the traditional monetary policy instruments have been rendered obsolete. Previously, open market operations are designed to impact the short end of the spectrum of government securities. But the Federal Reserve is intervening in the market for long-term government securities. This action has taken quantitative easing to an unprecedented scale. Of course there is a cost associated with every economic decision. In this case, the Federal Reserve is running the risk of hyperinflation and economic collapse in the future. But in order for the economy to have a future, it needs to survive the present inferno.

Finally, the U.S. Treasury announced another plan to solve this financial conundrum of epic proportion. The plan is called Public Private Partnership Investment Program. This program is specifically designed to deal with the securitized assets, such as mortgage backed securities and collateralized debt obligations on banks’ balance sheets.

The practice of securitization has invariable lead to the current financial crisis due to the moral hazard it brought on through risk transfer. When loans can be packaged together and sold to someone else, the banks do not have to worry about default risk. Once the bundled mortgages are sold, default risk becomes someone else’s problem. However, risk transfer does not equal risk elimination, and the risk remains in the system. After subprime mortgage crisis broke out, the securitization market evaporated. Hence, massive amount of assets that potentially contain nonperforming loans are engraved onto the balance sheets of the banks. To avoid insolvency, banks horded all the capital that they have been forced into receiving from the government to cushion potential losses in the future. How can capitalism be maintained if the capital market dries up? Consequently, nationalization appeared on the menu.

Timothy Geithner seems to either think that annihilating the securitization market is too drastic a measure or the securitization process is still somewhat salvageable. Thus, the Public Private Partnership Investment Program effectively created a market for securitized assets. The purpose of setting up this market is to allow banks to dump their illiquid and nonperforming assets to free up their balance sheet so they can start facilitating capital movements in the economy.

In order for this “dumping” to take place, renaming toxic assets “legacy assets” is only a start. The necessary condition is that someone has to be willing to purchase these toxic assets. To incentivize, Uncle Sam doled out a sweet package called the Public Private Partnership Investment Program. For every dollar the private investor put down to purchase the assets, the U.S. government will match it with one dollar and will finance up to 85% of the winning bid with non-recourse loans. If the asset turns out to generate positive returns, then perhaps the worst is over. But if the assets incur losses, especially large losses, then taxpayers will bear most of the burden because the non-recourse loans are ultimately financed with taxpayers’ money. The private investor lose only what they put in.

Geithner’s system appears to be a solid market approach to get rid of the illiquid assets on banks’ balance sheets. However, the system is banking on the assumption that the auction market is capable of pricing the assets correctly. But how much are these assets really worth? The auction system through which these legacy assets will be sold is likely to push the ultimate purchase price towards to its true value. But one of the reasons that these legacy assets are toxic is the lack of uncertainty of their worth. In other words, if the auction overprices these assets, the U.S. will have to run an even bigger deficit, or simply nationalize the banks, a measure deemed inevitable by several prominent economists.

Even an investment with such high potential gain and a loss capped at 7.5%, where would private capital come from in the middle of a messy recession? With a half-dead banking sector, ailing manufacturing sector, the focus has to be on international investors. But if China does not want to buy anymore U.S. government debt that is risk-free, there is no reason for it to invest money in illiquid assets with unknown risk.

Although the prospect of running the Public Private Partnership Investment Program successful is bleak, there is a still hope. There is a way to build up capital from private sources and it has been done before. In 1907, legendary financier J.P. Morgan, along with several other tycoons, pledged their private funds to keep the banking system solvent and prevent bank runs. If there is to be a modern reenactment of this historic episode, the hope would fall on the likes of Warren Buffet. Buffet has the financial ability to back Geithner’s program. Even though the recession has taken its toll on Buffet’s assets, his company is still way ahead of the pack. More importantly, Buffet’s name will lend a tremendous confidence boost in the program and the economy in general.

So, will Warren Buffet, the great capitalist, save capitalism?