A Rational Market?

Who noticed when the titans of finance proclaimed absolute mastery over risk? Who stayed up late at night worrying about the outrageous levels of borrowing needed to feed our profit-hungry investment banks? And who noticed when the markets stopped behaving rationally?

Markets are supposed to rely on buyers’ and sellers’ complete understanding of the consequences of their actions. High risk investments, like subprime-mortgage-backed securities, are not supposed to be as safe as low risk investments, such as municipal bonds. That’s why their returns are much higher. And since the economic world is supposed to work in a rational and predictable way, high risk investments should fail more often than low risk investments. Yet, when homebuyers, mortgage brokers, lenders, credit rating agencies and investors all stop understanding the risk behind what they are buying and selling, rationality flies out the window.

The market failed to warn investors, homebuyers and everyone else about the complexity and risk of these investment schemes. Everyone was happily making money when the bottom dropped out. Along with it went the confidence of the investment bankers, the commercial bankers, the re-insurance industry and the credit rating industry; just about everyone’s jaw hit the floor. And once confidence was eroded, the flow of money through borrowing and lending seized up, causing the current credit crisis.

When the market fails to account for the irrational behavior of its participants, economists try to find alternatives to market solutions to correct the situation. The recently passed $700 billion financial rescue package includes many of the typical symptom remedies: tax cuts, unfettered access to cheap money, and overt guarantees of a firm’s asset base. But when the market has so fundamentally failed, relying on these common policy tools won’t address basic market flaws.

Two structural failures describe the market’s current collapse: erosion of psychological confidence and inadequate understanding of risk. While the financial rescue package will help restore some of the lost confidence of the finance industry, it does nothing to elevate the public’s confidence in the financial system. Furthermore, it burdens the federal government with the same inherently confusing and risky assets that brought the system down in the first place.

Yet, Treasury Secretary Henry Paulson assuages the public by stating that the U.S. government might actually make some money on these investments over time. Isn’t that the same logic subprime mortgage brokers delivered to uninformed homebuyers? Is that more than simply pawning this unknowable risk off on the federal government and leaving taxpayers holding complex, unpredictable assets?

How better to deal with an irrational market than deliver a stunning counter? Instead of buying up hundreds of billions of dollars worth of these toxic securities, the Treasury ought to take a significant portion of its authorized bailout money and buy equity positions in struggling commercial banks and insurance companies. These investments will infuse corporations with sorely needed capital, and while stock prices will decrease for a time, it is a small price to pay in comparison with bankruptcy or buyout. Furthermore, regulation of rescued firms will come with fewer complicated strings attached than will be necessary to oversee the purchase and ultimate sale of these bad debt assets.

Government regulators already have most of the fiduciary authority granted to corporate directors, such as the right to inspect the firm’s books, approve major contracts, and oversee mergers and acquisitions. Should the government take an equity position, federal regulators would be in a better position to guide decisions on executive pay and overarching investment strategies as well as review accounting irregularities, which are among the public’s main concerns. Otherwise, a new bureaucratic structure will be required to ensure that the government handles these financial transactions fairly and to the benefit of both the taxpayer and the finance industry. Such complex conflicts of interest can only hinder the government’s ability to efficiently steer the country out of the crisis.

Meanwhile, the government can use the opportunity to push economic growth through much needed infrastructure repair and renovation. Rebuilding roads and bridges, developing new mass transit projects, and laying the foundation for a new sustainable energy grid all deserve attention and all have been constantly under-funded. With the cash infusions from equity investments, commercial banks will be able to lend to private construction companies seeking to finance work on government-sponsored infrastructure projects. With significant guaranteed construction projects in the pipeline, employment levels would again rise, commercial banks would develop streams of cash flow necessary to remain solvent, and economic gains would push the national economy back into motion.

By now you’re asking, how do you pay for this? A very rational question, but did Congress ask this question before it passed its sweetened-up bailout package last week?

Maybe the simplest answer right now is: no one knows how we’ll pay for it. But America will know what it got for its money; at the end of the day, the taxpayer is left holding billions of dollars of public goods that didn’t exist before, rather than a bunch of unpredictable assets that brought down the entire investment banking industry.

That seems to me a pretty rational investment.

Barksdale English

Barksdale English is a student at the LBJ School of Public Affairs with an expected graduation date of May 2009. He is currently serving as the Internal Financial Director for the Graduate Public Affairs Council.

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