March of the Bailouts: A Lesson courtesy of IndyMac

By Reuters Staff
July 12, 2008

First reported on the Implode-o-Meter yesterday, IndyMac bank’s $32 billion in assets have been taken over by the FDIC. This is the largest bank failure since the $40 billion bailout of Continental Illinois in 1984. Federal authorities estimate the bailout will cost taxpayers $4-$8 billion. (And that may be a fraction of what this down cycle costs the FDIC and, possibly, taxpayers).

It had to happen, of course. Having lost the ability to accept brokered deposits earlier this week, the bank desperately needed other sources of funding to keep its operations going. It had nothing to lose by offering the best rates on taxpayer-insured deposits, significantly higher than any other bank in the nation.

There is a lesson here, dating back to 1982, when Reagan’s Garn-St. Germain Act was signed into law. That act “took all restrictions off the interest rates S&Ls could offer for insured deposits and most restrictions off what they could do with the money” according to Martin Mayer’s definitive book on the S&L crisis. He continues:

Prior to 1983, when the act took effect, a bank or S&L that was in trouble would shrink, as depositors…withdrew money. There would be no way for such a bank or S&L to lure new money, because the government put a ceiling on interest rates. Once that ceiling was gone, a failing institution, desperate for funds and willing to take any gamble that promised a hope of recovery, would simply offer more interest than could be paid by any bank or S&L that had to earn what it paid its depositors by making normal loans and investments.

The lesson is that federal insurance of ANY kind severely distorts economic incentives. Let me explain…..

Fannie and Freddie provide the perfect example of investment incentives distorted by government. Their very existence, or, rather, the existence of an implicit government guarantee backing the majority of American home borrowers, has encouraged trillions of excess dollars to flow into housing finance. The fact that the government backstops all this debt encourages creditors to be lazy and, more importantly, to demand lower interest rates than they otherwise would. Artificially low interest rates encourage artificially high credit creation. Put simply: a credit bubble.

It’s simple to measure how much incentives are distorted by government guarantees in housing finance: interest rates on mortgages backed by Fan and Fred are lower than the rates on those that aren’t. Hell, the private mortgage market has all but evaporated since the housing bubble burst last year. Nearly all new mortgages are the kind backed by taxpayers.

This just makes the shakeout worse in the end because the presence of government insurance encourages good money to keep chasing after bad even as the market is screaming STOP.

When the market is telling savers to stop putting their funds into failed banks like IndyMac, they do it anyway because they’re protected by deposit insurance. When the market is telling investors that mortgage credit is a bad investment, they invest their cash there anyway because the bonds come with a federal guarantee.

But Mayer says it best:

“If the state takes away the market discipline that compels the recognition of mistakes…capitalism can generate losses and misallocation of resources even faster than socialism.”

If the taker of risk bears no responsibility for risks gone bad, and federally-backed companies like Fan and Fred don’t, he will take as much risk as the market will bear.  The market, trusting in the unlimited financial power of the federal government, will in turn allow virtually unlimited risk-taking by the federally-backed entity.  True for deposit-taking banks during the S&L scandal; true as well for Fan and Fred.

But the laws of probability aren’t affected by government guarantees.  Risks, by definition, have uncertain outcomes.  At a certain point, the outcome will be a bad one.  The question is, who is left holding the bag?  In the case of Fan and Fred, even if they make it through this crisis, the ultimate bagholders will always be taxpayers.  Until Fan and Fred are fully privatized, and the federal government makes plain there is no guarantee backing their debts, bond investors will continue sending cash their way.

Most people can’t wrap their head around the idea of the U.S. government not making good on a “guarantee.”

But how many bailouts can the government finance?

In a worst case scenario, it’s not a stretch to see literally hundreds of billions in bailouts coming for Fannie and Freddie, the FDIC, and perhaps even the PBGC, which backs private pension plans. Add these to the bailouts for Bear Stearns, the $100 billion bailout (excuse me, “stimulus package”) for certain taxpayers, and the housing bill currently in Congress that will permit lenders to dump $300 billion MORE of privately held problem mortgages onto the government.

All told, the above works out to perhaps $6-$7 trillion of problem debt being dumped onto taxpayers’ balance sheet. To be sure, the actual recognized losses won’t run nearly that high. But they will be substantial.  And the long-run impact is that whatever borrowing capability the government retains, it will have to devote to paying off past debts.

This is all coming at a time when taxpayers really don’t have the money to finance any more losses: we’ve yet to deal with the tens of trillions in liabilities we face for Medicare and Social Security.

A trillion here, a trillion there. Pretty soon you’re talking about real money.

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