Fed's 'Consumer Bailout' Encourages More Bad Behavior

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Fed's 'Consumer Bailout' Encourages More Bad Behavior
by Laura Rowley

Posted on Wednesday, November 26, 2008, 12:00AM

If there's a small silver lining in the nation's financial crisis, it's that households were finally getting a grip on their bloated balance sheets, reducing credit card use, and increasing savings. Consumer spending fell 1 percent in October, the biggest drop in 7 years.

But Treasury Secretary Henry Paulson doesn't want Americans to stop spending, because that will slow the economy. So he's using taxpayer dollars to make it easier for consumers to dig themselves more deeply into debt.

More of What Ails Us

The Treasury announced Tuesday that it will buy $600 billion in mortgages and mortgage securities backed by Fannie Mae and Freddie Mac, and provide $200 billion in non-recourse loans to investors holding investment-grade (BBB or better) securities backed by newly or recently originated consumer loans. That includes credit cards, auto loans, and student loans, as well as small-business loans guaranteed by the Small Business Administration. The $200 billion will come from the Treasury's Troubled Asset Relief Program (TARP).

"Millions of Americans cannot find affordable financing for their basic credit needs. And credit card rates are climbing, making it more expensive for families to finance everyday purchases," Paulson said Tuesday. "This lack of affordable consumer credit undermines consumer spending; as a result, it weakens our economy."

It's an ironic solution to a crisis perpetuated in part by consumers signing on for more debt than they could ever hope to pay off. But it's not a surprising development amid the scattershot rescue strategy that has the government prepared to pledge $7.76 trillion on behalf of American taxpayers — $24,000 for each man, woman, and child, and enough to pay off half the nation's mortgages — according to a Bloomberg analysis.

Taxpayer Stuck with the Tab

Paulson called the $200 billion in the Term Asset-Backed Securities Loan Facility (TALF) "a starting point." In other words, at a time when record numbers of consumers have spent themselves into insolvency, and millions of others face increasing job insecurity, the government is hoping to balloon their borrowing — propping up spending in the short-term but potentially setting the stage for another debacle in the future.

"You have to ask a simple question: Why is this necessary?" says Adam Lerrick, an economist with Carnegie Mellon University and a visiting scholar at the American Enterprise Institute. "Why don't the markets do this themselves? The obvious answer is they don't believe in the Triple-A rating [on the asset-backed securities]. Why should the Treasury have more confidence about the rating agencies than the market? What it's doing is shifting the credit risk of the bonds from investors to the taxpayers."

A Backdoor Bank Bailout

Lawrence J. White, economics professor at New York University's Stern School of Business, says the new strategy is a result of TARP's failure to provide liquidity after the Treasury shifted from purchasing toxic assets to buying equity stakes in financial institutions. "We didn't get a lot of liquidity out of the initial uses of the TARP program because it basically went into the banks' net worth," he says. "They weren't that much more inclined to lend. In some sense, this is a backdoor TARP."

Lerrick argues that the financial system doesn't have a liquidity problem — it has a transparency problem. "There's plenty of liquidity — lenders have more cash than borrowers need," he says. "But we have an information crisis. Let's assume there are 100 major financial institutions in world, and 20 are in bad shape. If you don't know which 20 of those 100 are bad, you don't lend to anyone. The solution is to provide the markets with information so they can identify and go back to lending to the 80 sound borrowers, and quarantine the 20 bad borrowers. That's why massive injections of liquidity have done nothing to unfreeze the credit markets."

Consume No More

But even if a gusher of credit is forthcoming, the era of consumer-driven economic growth is over, argues Robert Manning, professor at the Rochester Institute of Technology and author of "Credit Card Nation: The Consequences of America's Addiction to Credit." "It's astounding how much consumer debt has increased since 2001, and government official] realize how little flexibility they have today versus other recessions," Manning says.

"For most Americans in denial, this is going to be a real wakeup call; you're going to hear more often about sacrifice and learning to live within a budget, whether it's at the household or government level," Manning adds.

White agrees that pumping up consumer lending "is not a sustainable approach. There's got to be a transition to where the consumer is saving more and spending less, and the spending is coming from either the industrial/business sector or government sector — using those consumer savings to build capital, whether it's a private-sector plant and equipment or social sector infrastructure. The change from a consumer-driven to more of an investment-driven economy has to be the long-run pattern for our economy."

The Unending Bailout

In the meantime, the current approach to the financial crisis lacks both predictability and credibility, two things the markets crave. The Citigroup windfall earlier this week demonstrated that the goal is not only to protect the system, but to prop up favored institutions. And the longer Treasury waits to formulate a coherent strategy, the longer the line of supplicants grows at its door.

"It started out with commercial banks, then insurance companies, then money market funds, then automakers," says Lerrick. "Why not state and local governments? Why not homeowners? Where do you draw the line?"

Until a line is drawn, we won't have any idea how much risk the government is willing to take, and what the bailout will cost. And according to research firm Demos, another $250 billion in adjustable-rate mortgages are poised to reset to higher monthly payments by the year's end.