Misrepresenting the Financial Crisis: It is not Lack of Liquidity; it is Insolvency and Lack of Trust

A major problem with the bailout scheme is that it misrepresents the ongoing credit crunch as a problem of illiquidity, or lack of cash. In reality, however, it is a lack of trust that has been created by the widespread insolvency in the financial market. In such an environment of widespread insolvency and lack of trust, owners of cash rush to safety: buying treasury bills, investing abroad, or hoarding their cash, thereby creating something akin to a black hole for cash—or a "liquidity trap," as John Maynard Keynes called it.

The "lack-of-cash" premise has been successfully promoted to justify extraction of more than a trillion dollars of taxpayers' money in the vain hope that it will free the "troubled assets" and create liquidity in the financial markets, thereby triggering a much-needed wave of lending, borrowing and expansion.

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Ismael Hossein-zadeh is the author of The Political Economy of U.S. Militarism

There is strong evidence, however, that the amount of junk assets is simply too big to be rescued by the bailout giveaway. Wall Street banks and other financial gamblers are, of course, aware of this. And that is why they have lost faith in credit markets and in the business of lending, including lending to each other.

The fact that we now have a perfect case of a liquidity trap is explained (among others) by Professor Peter Morici of the University of Maryland: "At the banks, the national officials have provided liquidity, injected equity and guaranteed overnight and other short-term borrowing. However, large money center banks simply are not interested in using the massive funds provided them to make sound loans to consumers and businesses on the scale needed to get the economy going. These money center banks are no longer interested in providing liquidity to regional banks by bundling their loans into bonds for sale to insurance companies, pension funds and other fixed income investors that sit on vast pools of capital."

Despite all the evidence that the bailout giveaway would simply fall into the liquidity trap, the Treasury Department and the cringing congress chose not to address this problem. Yet, even the beneficiaries of the treasury loot have acknowledged that they will most likely hoard the money to protect themselves. For example, John A. Thain, the chief executive of Merrill Lynch, admitted, "At least for the next quarter, it [the bailout money] is just going to be a cushion" (as quoted by the New York Times, 17 October 2008, P. B1).

Despite the clear evidence that major Wall Street gamblers will hoard the bailout giveaway (instead of injecting it into the credit market), the bailout plan offers no written requirement abut how or when the bailout beneficiaries must use the loot. "There is no express statutory requirement that says you must make this amount of loans," said John C. Dugan, the comptroller of the currency (as quoted in the New York Time, 17 October 2008, P. B5).

Unless the issue of solvency, or lack thereof, is addressed and faith and trust in credit markets are restored, any amount of taxpayers' money bestowed upon the Wall Street gamblers would be tantamount to sending good money after bad money, as the beneficiaries would simply grab the loot and hoard it.

There is, however, another alternative that would not only help troubled homeowners to meet their mortgage obligations and stay in their homes, but also help create trust and liquidity in credit markets. That alternative would focus on owner-occupied real assets, not phony or fictitious assets built on hot air—that is, on victims, not perpetrators.

The masterminds of the bailout scheme recklessly avoid addressing this core problem: inability of 5 to 8 million homeowners to pay their fraudulently inflated mortgage obligations. Homeowners' inability to meet their mortgage payments, in turn, triggered a reverberation of insolvency throughout the vast bubble of mortgage-based claims and obligations that had been accumulated on a narrow base of real assets.

A logical and responsible solution would have started with homeowners, not predatory lenders and financial fraudsters. This would have been much cheaper and more effective. "Instead of trying to salvage a mountain of soured assets and prop up bankrupt institutions," as pointed out in my previous essay on this topic, "the government should allow for a market cleansing, or destruction, of such worthless assets by purchasing the threatened mortgages not at their inflated face value but at the current, depreciated, or market value."

There is, indeed, a successful precedence to this alternative: the FDR administration's response to the housing crisis of the Great Depression. That administration created a credit agency for the financially distressed homeowners, Homeowners' Loan Corporation, which bought mortgages from private holders at prices that reflected realistic or going market values that eased their terms and allowed homeowners to meet their affordable obligations and stay in their homes.

Despite this relatively successful precedence (of course, in conjunction with the rest of the New Deal reform package), the current bailout scam follows the failed model of Herbert Hoover of the early 1930s. In the face of the Great Depression, Hoover created the Reconstruction Finance Corporation that showered the bankers with public money in an effort to bail them out. All it did, however, was to buy him a few months (perhaps that is also the goal of the current Bush administration, as it will soon be leaving the crime scene), but eventually led to the failure of almost all the banks within two years.

There is also the failed policy of Japan in trying to bailout its giant financial institutions in the face of that country's housing crisis of the late 1990s. In 1998, those financial institutions were facing huge losses following the bursting of the housing bubble in Japan. Similar to Herbert Hoover's administration, the Japanese government has since poured enormous amounts of public funds into the coffers of those institutions in the hope of "creating liquidity" and "revitalizing credit markets."

The results have been disastrous: the enormous amounts of bailout giveaways of public money have not been able to rescue the troubled financial institutions. Accordingly, the distrust of the credit markets continues, and the economy has been mired in a long, protracted recession, with no end in sight.

So, the undisclosed, tightly-kept-secret mountains of toxic assets simply cannot be bailed out. Not only will the efforts to do so fail, they are also bound to drain public finance, accumulate national debt, weaken national currency, and prolong an economic crisis.

By contrast, the homeowner-centered alternative would have a number of advantages. First, and foremost, it would help citizens facing the specter of homelessness stay in their homes by allowing them to pay affordable mortgage installments based on reduced or realistic home prices.

Not only will this method of asset evaluation (called mark-to-market assessment) rescue the vulnerable homeowners, it will also cost taxpayers much less money than bailing out the enormous amounts of the Wall Street gamblers' phony assets.

Furthermore, this solution would also allow the government to gradually recover the market-based home prices it would be paying the failed commercial mortgage holders in order to replace them as the new mortgage holder.

By cleansing the market of the dead-weight of tons of junk assets, and allowing threatened homeowners to pay affordable mortgage installments, this bottom-up solution would also help restore faith or trust in the financial system and the credit market—thereby also mitigating the liquidity crisis.

Ismael Hossein-zadeh, author of the recently published The Political Economy of U.S. Militarism (Palgrave-Macmillan 2007), teaches economics at Drake University, Des Moines, Iowa.