Don't Like Bailouts? Consider the Alternatives.

By Steven Pearlstein
Wednesday, September 10, 2008

First came the rescue of Bear Stearns and the Fed loans to cash-strapped investment banks. Then the government stepped in to fill the financing gap left when private lenders retreated from the college loan business. Last weekend brought the takeover of Fannie Mae and Freddie Mac. And now the Not-So-Big Three are headed our way looking for $50 billion in retooling loans.

When is this going to end?

The honest answer: With stock markets swinging 300 points a day and the economy diving into recession, not anytime soon.

Indeed, the chances are pretty good that by year's end, Washington will have to bail out another big bank or investment house along with a bond insurer or two. And taxpayers will be called on to replenish the coffers of the federal agencies that insure private bank deposits and private pensions.

Already, there's been plenty of grumbling from editorial writers and market-oriented conservatives that the country is on a slippery slope toward socialism. They also fear that these rescues will encourage reckless risk-taking in the future, creating the expectation that if bets go bad, Uncle Sam will always be there with a bailout.

From the left, meanwhile, come populist complaints that government has committed enormous amounts of taxpayer money to bail out corporate fat cats and rich investors while ignoring the plight of millions of Americans facing personal bankruptcy and foreclosure.

While there is validity to these concerns, they are also based on a number of false assumptions, chief among them that vast sums are expended on these rescues.

History shows that rather than costing taxpayers, the rescues have often wound up making money.

That was the case with the Home Owners Loan Corp., a New Deal agency that bought mortgages from banks and wound up with a small profit by the time all the loans were paid up in the early 1950s. The same was true of the controversial loan guarantees made to Lockheed and Chrysler in the 1970s. More recently, following the Sept. 11 terrorist attacks, the government set up an Air Transportation Stabilization Board that offered loans and loan guarantees to a handful of cash-strapped airlines. The agency now expects to close out its books in the black.

In the case of the $29 billion that the Federal Reserve loaned J.P. Morgan Chase to take over Bear Stearns, the final cost won't be known until the Fed sells the asset-backed securities it took as collateral for the loan. So far, so good: As of June 30, those assets had an estimated market value of $29 billion.

It's anyone's guess what the Fannie and Freddie rescue will cost, but at this point it looks to have been structured on terms quite favorable to the government. Although the government is yet to put a dime into the companies, it has received $1 billion worth of preferred stock and warrants for 80 percent of both companies' common stock simply for agreeing to provide backstop financing.

Over the next few years, however, the Treasury will almost surely have to invest tens of billions of dollars to keep Fannie and Freddie adequately capitalized, and how much of that money will ultimately be recovered depends on how things turn out with the millions of mortgages the companies hold or have guaranteed. But if it is willing to wait until housing markets finally recover, there's a good chance the government will recoup most of its investment, along with a 10 percent annual dividend and a hefty guarantee fee.

In the end, the right way to think about these rescues is not to simply ask how much they are likely to cost, but how the rescue compares to the cost of doing nothing.

It's not hard to imagine, for example, that if nothing had been done, Fannie and Freddie would have been forced by nervous bondholders to hunker down and throttle back its housing-finance activities, further destabilizing financial markets and accelerating the housing market's downward spiral. Those, in turn, could have easily turned a short recession into one that was longer and deeper -- one that cost Americans an extra $200 billion in lost income, several hundred thousand additional lost jobs and a net loss to the Treasury of $80 billion. Suddenly, a Fannie/Freddie rescue begins to look like a bargain.

Aside from the money, of course, there is also the problem of moral hazard -- the concept that unless markets are allowed to inflict the full measure of punishment on investors and executives for their bad judgments and undue risk-taking, it will only invite bad judgment and undue risk in the future. But using moral hazard to argue against the carefully structured rescues of Bear Stearns or Fannie and Freddie is a bit likely arguing that any sentence short of capital punishment is insufficient to deter bank robbery.

Remember that even with the rescues, top executives at Bear Stearns, Fannie Mae and Freddie Mac lost their jobs, their reputations and most of their net worth, while long-term investors lost all but a tiny fraction of their money. It's hard to imagine that anyone will look back on those experiences and see anything but a cautionary tale.

© 2008 The Washington Post Company