Tag Archives: Financial Crisis

The Housing Crisis and the CDS problem

This American Life is an award-winning radio program. Each episode focuses on a theme and usually covers it with stories about ordinary people. But every once in a while the stories are about something else. In May, they covered the Housing Crisis and this weekend, Collateralized Debt Securities, the financial items which almost caused a meltdown in our credit markets. Most of the coverage of the crisis has amounted to either a repetition of some summary (since most journalism isn’t focused on understanding) or people twisting themselves into contortions to prove their political viewpoint.
As the second program points out, the CDS market has been completely unregulated. This state of affairs was fixed in 1998 by agreement of the Clinton Administration and a vast majority of the members of both parties in Congress. The belief was that those buying and selling CDS instruments were sophisticated investors (aka really smart big boys) who didn’t need oversight. Clearly, they were wrong.

I suspect that over the next few years we will see new regulations designed to address a series of problems, including bringing transparency and sanity to the CDS market.

The more interesting point in that program, for my purposes, was a comparison of the core solution in the plan Congress passed and the President signed with one that most Economists the program talked to favored.

In the official plan, money will be used to buy something that is very difficult to properly price: toxic assets. In a very real way, the Banks in question will not pay the price for their bad decisions. In economic terms, they escape the moral hazard of their choices.

The contrasting plan is termed stock injection. In essence, we would buy stakes in the Banks in what amounts (in many cases) to a Government takeover. Upper management would pay for bad decisions by loosing their jobs. The Stockholders, who are culpable because they typically approve the hiring of management and the broad direction that management takes a company, would pay by seeing most of the value of their stock disappear. Like anyone else coming to the rescue of a company, we would get to call the shots and we would expect to be rewarded for keeping the company alive.

This is actually the model that was applied to AIG. The value of the existing stockholder’s stock disappeared and upper management lost their jobs. But, the company was saved and the feared economic meltdown was avoided. At the same time, the return for the money we invested (at least according to what I’ve read) looks like it will actually be quite good.

Economic Conservatives often have a philisophical problem with government ownership of a company. And, to be honest, in general I do, too. But, the ownership is not intended to be long term. The company will leave government hands in a reasonable period of time. In essence, the government is acting as temporary caretaker until new, presumably more responsable, owners can take over the company (that the previous owners ran into the ground).

I would propose that, going forward, that this become the standard model that is followed for a government rescue of a company. A company’s stockholders and management will be very motivated to not put themselves in the position to be rescued. If they need to be rescued, they’ll be very motivated to find another solution to their problems. And, if government involvement becomes necessary, the people paying for it (us), have a good chance of getting a good return on the investment we make.