Confessions of a raving, unconfined lawyer

The taxpayer funds being directed to the financial industry are largely being targeted to putting liquidity back into the system — by encouraging banks to lend more, and through mortgage restructuring, allowing consumers to spend more.  (Never mind that these goals are not being achieved by the Paulson plan.)

By contrast, the auto industry is asking for funds to keep the individual firms, and the industry itself, alive in the United States despite evidence that they have made poor decisions over the years in relation to foreign car makers.  The rationale is that (a) we need these firms in the US for security reasons (they make tanks); (b) we need the many good jobs they provide directly and indirectly; and (c) eventually times will get better and they will repay us.

Right now the total value of all the common stock of the Big Three companies is probably about $13 billion (Chrysler’s figures are private).  There are lots of people around who have that kind of money.  The biggest billionaires could raid their cookie jars and buy all three for cash, right now.  But Warren Buffett chose to put his money into Goldman Sachs stock rather than a car company.  Why?  Probably because once the subprime mess passes through the python, the financial companies will do well because they are run efficiently.  By contrast, the GM execs evidently felt that a YTD loss of $21billion did not require them to lose their corporate jets or their bonuses.  They are like ship’s captains who have run out of fuel and have forgotten how to hoist a sail.

That leaves jobs and national security as reasons to put federal money into the car makers.  Both are good reasons.  But what form should taxpayer support take, given that we are not likely to get it back?  Remember that private money is not eager to fund these companies, and their execs have not seemed eager to go through Chapter 11 (even though it would permit them to leave the UAW holding the bag to some extent).  So this moment is somewhat akin to government funding of other programs that private industry is unwilling or unable to finance.

Like the space program, in other words.  That’s a program that the US taxpayers own and finance, contracting out production to private contractors (sometimes with less than optimal results).  It may never turn a profit, but we run it because it is useful.  Or like Amtrak.  That’s a government corporation that we formed to take over the hapless passenger railroads and operate them with a taxpayer subsidy that with any luck will turn into a profit over the years.  Either way, the government controls the operations, the executive pay, the perks, and the company’s priorities.  We can, and do, force them to provide the service that is needed the most, not necessarily the service they can advertise the most.

It may be that despite the ubiquity of automobiles, producing them in the US may be a luxury that we can rationalize only because in wartime we may need to produce tanks.  That may not be true in the long run, but it appears to be true now.  If that’s the case, we should pony up the $13 billion, buy every share, and run them the way we want them run — good jobs, good pensions, good fuel economy.  It’s better than paying twice as much to give the captain sailing lessons.

Let’s say you are a trillionaire with a social conscience.  You see the disaster afflicting the US economy, and spreading rapidly throughout the world.  You want to make a difference, but how?

If you’re a trillionaire, you probably have people on your staff who know something about financial markets, business cycles, and tax policy.  And you probably have some experience making deals with strong and weak businesses.

Everyone’s clamoring for help.  The banks say credit will freeze up if you don’t shell out.  The auto makers say millions of jobs are in jeopardy if they don’t get some free money.  But you know that when they get the money, they use it to pay themselves first, and then to fatten their companies by acquiring weaker players.  If there’s anything left, they might just do what they promised to do.

Surely major investors don’t put up with that kind of crap.  Venture capitalists don’t just give money away — they demand a big share of the company, seats on the board of directors, and guarantees of how the recipient of their largesse will behave.  An investment bank like, oh, say, Goldman Sachs doesn’t just drop money in the box either —  it looks at balance sheets, income projections, and detailed evaluations of how the company manages its core business.  You’d think Hank Paulson would remember some of that when he’s investing the taxpayers’ money.

So when our trillionaire gets into the picture, what does it do?  Well, if its chief operating officer is Hank Paulson, it takes the money and ignores the strings attached, and hands out billions without even disclosing where the money went.  If its board of directors is a Congressional committee, it postures, pleads for special favors for the districts of the committee members, and largely fails to understand what it is doing or rein in its rogue manager.

Republicans have long insisted that government should operate like a business, but when they get the chance to do so, they ignore all their business training and throw money into one bad deal after another.  Evidently clearer heads are required.

The first thing to do is to get an accurate picture of what is going on and where the economy is headed if no intervention occurs.  Clearly the financial industry is in trouble, but there are two kinds of trouble:  that which impacts individual companies, and that which impacts society.  It is the latter on which our attention should be focused.  Unregulated greed led to imprudent behavior fueled by the apparent ability to externalize risk to a level approaching 100%.  This was so astonishingly brilliant, it’s no wonder their executives were compensated so handsomely.  They deserved everything that was coming to them, but the nation did not deserve the consequence:  a broken commercial credit system and a system of private homeownership that has left millions destitute and simultaneously laid low thousands of private and public pension plans.

The auto industry’s problems are of a different order entirely; those companies operate on very long timelines and their troubles originated in decisions they made years ago.  Car makers have lost sales for several reasons:  production of gas guzzlers, a distribution network that forces prices up to generate profits for dealers, and of course a drastically reduced ability of consumers either to buy cars or to get car loans.  Although the effects of a depressed auto market will be serious, they are not different in kind from the experience of many other industries that either sell big-ticket items to consumers or supply the basic materials with which those goods used to be made.  If Detroit firms went through Chapter 11, they could cut back on dealerships or even sell direct to consumers at the factory (as they once did, many years ago).

In each of these cases, our trillionaire needs to make hard decisions about what kind of concessions it needs to extract from those it assists.  This is not unfair; people who receive unemployment compensation are required to look for work, and those who receive food stamps are required to spend them on food, not lottery tickets.  Nor is it analogous to government regulation which is imposed on an unwilling industry; these companies are begging for our money.

What’s the best way to unstick the credit system?  We could open our own bank and lend money directly to businesses and individuals, in competition with the private banks.  They’re skittish about lending money right now; our trillionaire sees social value in taking those risks when they are needed most.  If we decide instead to funnel our money through existing banks, it’s entirely legitimate to tell them they have to run the way our state enterprise would run: low executive pay, a requirement to shove money into the credit pipeline, and restructuring of consumer loans to put individuals back on their feet.  And no mergers, dividends, stock buybacks or expensive “conferences” for the duration.

And what do we want from the auto makers?  Most of the above, plus retooling the plants to produce smaller and greener vehicles, or even (heaven forbid) trains.  Big investors follow the “golden rule” — he who has the gold, rules.  That’s how our trillionaire should think.

As a small contributor to the trillion, I have a say too.  My top priority would be to bail out state and local governments before they begin to cut essential services like education, police and fire protection.  The wave of foreclosures is causing a loss of revenue from income, sales and property taxes, which are the backbone of most state governments (other than Alaska, apparently).  And the fall in stock prices is putting retirement pensions in peril.   Before it gets worse, we ought to inject revenue there — say, $300 per inhabitant.  That would cost only $90 billion.  Surely after we’ve helped out the poor investment banks and auto makers, that much should be left over.

Now,  how to get more money into the consumer sector so someone will buy those cars, refrigerators and homes?  One way is to write down their mortgages so they can afford them, and perhaps have the trillionaire take an equity stake in the home in compensation for its generosity.  Another is to create jobs as was done in the New Deal — building roads, bridges, train lines, schools, national parks and water supply systems and forward-funding the future costs of maintenance.

A third priority would be to reward savings and reduce the demand for loans.  Unfortunately, there’s no direct way to do this, although proposals for a consumption tax have their appeal.  The best way, short of that, is to force a tightening of credit standards and terms.  Here are three ways to do that:  Bring back state usury laws (which are now outlawed by federal preemption) to shrink the credit card tumor.  Have Fannie and Freddie change the basic home mortgage term from 30 years to 20.  Change the tax law that excludes gain on the sale of a home, to exclude from taxation only the gain that is attributable to the cash investment of the homeowner.

How could Hank Paulson say no to that?

Now that the Masters of the Universe have been proven not merely venal but completely wrong, we need an agenda for the First Hundred Days that truly “puts people first.”  Will John McCain endorse even one of these?

1.    End mortgage derivatives.  There is no reason to have this toxic form of securitization (which has only been in existence for 25 years) – except that the mortgage and investment banking industries wanted yet another way to generate huge profits.  The bankers proved incapable of valuing these mortgages but forged on in the hope of saddling unsuspecting foreign investors with the risk.  We need to decide as a nation that the freebooter ideology that supports these funny-money tricks, which produce no useful goods or services, is not worth the damage it has caused.

2.    End naked short selling.  Short selling – which was a major factor in the 1929 crash – was supposed to be regulated by the SEC, but the SEC has deliberately (and arguably corruptly) looked the other way.  There is no constitutional right to sell what you do not own, and no useful purpose to be served by allowing people to sell what they do not have in their portfolios.  Brokers should be subjected to heavy penalties for processing naked short sales.

3.    Reestablish the firewalls.  The New Deal’s separation of banking from brokerage and from insurance had a simple goal:  to focus banks on protecting their depositors and insurance firms on maintaining reserves with which to pay claims.  Removing those firewalls made those companies “globally competitive” without providing an ounce of added value to their U.S. depositors; in fact, the only way for them to earn the profits they hoped for was precisely to put their depositors and policyholders at risk, to the maximum extent the SEC will allow; now that they’re all in the same business, it is impossible to wall off temporary risk.  Paradoxically, the attempt of self-interested businesses to avoid inherent risk has multiplied that risk across the entire economy.

4.    End stock option compensation.  Here’s a radical thought on executive compensation: pay them in cash like everyone else.  As with wedding and holiday gifts, cash is always appropriate.  Not to deny that it’s a useful policy for executives to own stock in their companies.  The proper way to implement such a policy is for the company’s board to require top executives to buy a stated number of shares every year – with their own money, like everyone else.

5.    End taxpayer subsidies to hedge funds and CEOs.  There is no economic justification for taxing hedge fund compensation as though it were capital gains.  And in the tax policy context, where nearly every individual deduction is limited in some way, there is no reason to allow an unlimited deduction for executive compensation.  Someone has to step in and say that the duty management owes to shareholders – always invoked to justify unlimited profit – also requires that company funds be spent making whatever product the company makes, not providing free buffet tables for the execs.

6.    End tax favoritism for homeownership mania.  The mortgage interest deduction is an irresistible carrot for most Americans, and led many to overinvest in housing they could not afford.  If this deduction must be enshrined in tax policy, at the very least renters should get a similar deduction for rent payments.

7.    End taxation of debt forgiveness on primary homes.  Homeowners who cannot afford their current mortgages may win renegotiation of their loan terms, only to find that the debt forgiveness is taxable income.  That may prove to be the unkindest cut of all.  Congress enacted a limited, temporary suspension of this awful rule in 2007, but it has been extended to 2013 – will it be made permanent?

8.    End affirmative action for the rich.  Criticism of the estate tax has focused on its effect on owners of small businesses and family farms which have significant value but low liquidity, but the Bush administration’s wholesale cuts in the tax rate chiefly benefit those who inherit publicly traded securities.  Buying shares of existing companies does not inject capital into the economy, and the heirs of deceased owners have not put an ounce of work into the wealth they now own.  The current Bush estate tax regime must be allowed to “sunset” in 2010; in fact, considering our desperate straits, estate and income tax rates could use a return to the progressive levels in effect during the Eisenhower years.

9.    Bail out state and local governments.  In the next few years, the mortgage and real estate meltdown will nearly bankrupt local governments that rely on property taxes in poor areas where the reduced tax base no longer supports the level of taxation needed to run basic programs.  This is on  top of revenues that will be lost through failed investments.  We will soon need to consider bailing out those governments to avoid creating ghost towns across America.

10.   End “too big to fail” blackmail. The management of every public company should be required to answer this question annually:  “Is your company too big to fail?”  If the answer is yes, the company should be broken up immediately.  If the answer is no, they should be held to their answer.