The Government Is Contributing to the Panic; It's time to let markets do their messy work—A Commentary by Jonathan Macey ’82
The Government Is Contributing to the Panic; It's time to let markets do their messy work.
By Jonathan Macey ’82
Despite all the hard work and good intentions on the part of our public officials, when economists and historians look back on the current financial crisis they are likely to conclude that government intervention prolonged and deepened it. In particular, officials at the Federal Reserve, the Securities and Exchange Commission and the Treasury Department are to blame for publicly losing confidence in the very economic system they are supposed to protect.
The Fed, the Treasury and the SEC appear to be in a state of panic. A crisis mentality led the custodians of the U.S. capital markets publicly to jettison their lifelong commitments to the capital markets in favor of a series of short-term regulatory quick fixes. Even more troubling, for the past several months the doyens of U.S. fiscal and monetary policy have ignored the most fundamental principle of central banking, which is that the primary responsibility of central bankers is to promote stability and to maintain confidence in the capital markets. Our central bankers appear to have suddenly lost confidence both in their own abilities and in the standard tools of fiscal and monetary policy.
The original Treasury plan -- which called for the transfer of virtually unlimited taxpayer dollars and unlimited spending discretion to Treasury with no judicial or congressional oversight -- sent a very bad signal to the markets. Instead of restoring confidence, this approach to the crisis instilled more fear and panic in the markets.
The Bear Stearns bailout is another example of how the government's short-term fixes are detracting from the markets' efforts to fix themselves. To induce J.P. Morgan to swallow Bear Stearns, the Fed agreed to loan the bank $29 billion on a nonrecourse basis. Fed Chairman Ben Bernanke justified this government backstop on the grounds that a Bear Stearns bankruptcy might have led to a "chaotic unwinding" of financial transactions throughout the economy.
It was not clear why Bear Stearns and not Lehman Brothers was bailed out, but when Lehman's bankruptcy followed on the heels of the Bear Stearns bailout, it was difficult to escape the twin conclusions that the Bear Stearns bailout was done in haste, and that the Fed could not help Lehman because it had run out of ammunition. This series of events was devastating to market confidence.
The bailout of Bear Stearns contributed to the general sense of panic in the marketplace. It also hurt other banks' efforts to raise capital and was a contributing factor in the failure of Lehman, which failed to find a white knight because potential buyers (and their shareholders and directors) expected the same sweeteners from Uncle Sam that J.P. Morgan got for absorbing Bear Stearns.
On Feb. 14, just one month prior to the Bear Stearns bailout, Mr. Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. Both officials told the senators that the Fed's interest-rate cuts and the $170 billion economic-stimulus package signed into law the previous week would prevent a recession. They also testified in February that they were not concerned about bank failures because the banks were both adequately capitalized and had ready access to additional outside capital. In just over a month these regulators had completely reversed course about the state of the economy and about their own capacity to deal with the problems facing the capital markets. The regulators also changed course by losing their confidence in the strength of the free-market system and in the ability of the nation's capital markets to self-correct if provided with sufficient liquidity by the central bankers in traditional ways.
The government also wrongly abandoned market solutions when it temporarily banned short-selling. Asserting that "unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation," the SEC temporarily forbade short-selling in financial institutions. The ban lasted from Sept. 17, until 11:59 p.m. Oct. 8, and was lifted only when the Treasury bailout was passed.
By the time the bailout package was passed, market sentiment had darkened to mirror the government's own pessimism about the ability of markets to play a salutary role in repairing the fractured capital market. The notion that the government rather than the private sector can create a market for distressed bank assets seems particularly misguided.
The solutions being implemented also send the message that resources devoted to risk management are wasted. All of these plans reward the financial institutions that acted like lemmings by chasing the mortgage-related debt bubble rather than rewarding the financial institutions that exercised restraint and risk avoidance and independent thought and action. This unfortunate "heads Wall Street Wins, tails America loses" economic policy is wholly inconsistent with the principles of personal and corporate responsibility that are essential to a functional free market.
Firms like Merrill Lynch that took decisive steps to deal with their problems now look like suckers, as do banks that watched their leverage ratios and paid diligently into a deposit insurance program that offers protection on a far smaller scale than their investment banking rivals are getting for nothing.
If the SEC had done half the job in ferreting out fraud and funny accounting that short-sellers have done, our capital markets would not be imploding. Now short-sellers, like other market participants, are threatened with new restrictions on their activities as Congress begins to hold hearings on the crisis in the capital markets and politicians and regulators turn their focus to the shibboleth of market manipulation.
Of course, market manipulation does exist, but federal regulators deserve much of the blame for this form of market abuse. For years the SEC has hampered companies' ability to protect themselves from manipulation by short-sellers. The most effective way for a company to respond to an attempt to manipulate its share prices is simply to repurchase its own shares, simultaneously "squeezing" the short positions and sending a clear signal of financial health to the capital market.
However, companies have long felt vulnerable to being charged by the SEC with manipulation whenever they go into the market to make share repurchases. The SEC finally acknowledged this problem after the collapse of Bear Stearns and Lehman when it stated publicly that "historically, issuers generally have been reluctant to undertake repurchases" when faced with manipulative short-sellers because of the massive amount of uncertainty about whether the SEC would sue them for trying to manipulate the market.
The Bear Stearns bailout, the restrictions on short-selling and the government's new $700 billion commitment to buy toxic mortgage-based assets all share the same fundamental flaw: They prevent the market from imposing discipline on banks guilty of massive over-leveraging and excessive risk-taking. Moreover, they punish prudent managers who invested conservatively, kept their companies' debt at reasonable levels and worked hard to raise new capital when necessary. The SEC's attack on short-selling punishes savvy traders who invested resources and effort in identifying companies with too much debt and unrealistically valued assets.
Letting markets work is messy and costly. Nevertheless, the only sensible way to deal with the current crisis is to force the companies who created the mess to bear at least some of the costs of their mistakes. Most of all, if the markets are to get back on track our regulators must put an immediate stop to their current practice of publicly demonizing the markets and work to restore confidence in the system.
Mr. Macey, a law professor at Yale, is the author of "Corporate Governance: Promises Made, Promises Broken" recently published by Princeton University Press.