Market down on bailout — Don’t compound damage with overregulation of ‘Main Street’

Today — five days after a courageous independent vote against Treasury Secretary Hank Paulson’s $700 billion bailout for Wall Street — the U.S. House of Representatives disappointingly approved the same basic measure. Many of the bill’s other “sweeteners”, such as earmarks and a regressive increase in deposit insurance for upper income bank customers –will also cost taxpayer hundreds of billions of dollars.

All this week I and my colleagues have pointed out ways this bailout could, in addition to being costly, be counterproductive for the economy. Wall Street may have been feeling this “buyers’ remorse” today as the Dow Jones Industrial Average pared back ealier gains to end the day down by 150 points. As Yahoo Finance noted, “financial stocks, which had traded sharply higher on the promise the bill would be passed, fell after the House vote on profit-taking and as the market focused on the tough road that still lies ahead for the U.S. economy.”

As I had noted previously, despite the scare tactics from Paulson to Pelosi of economic Armageddon if no bailout was passed, the volatility of the past few weeks was in siginifcant part due to fear about what goverment was going to do as well as fear of market conditions.

We can only hope the economy will get better. However, much of that will depend on what policy steps are taken, or not taken, next. The ink is hardly dry on this bill, and politicians are already talking about a new round of regulation.

Our regulatory structure need some modernization, as CEI has argued. But the most dangerous thing to do would be to double-punish “Main Street,” already carrying a costly burden of paying for Wall Street sins, with overregulation that will stifle American entrepreneurs who had nothing to do with the mortgage and credit crisis.

In this debate, we heare a lot about “Wall Street” and “Main Street” and their supposed connections. In fact, I found myself agreeing with the suggestion of bloggers that the bailout package should contain a mortorium on using those terms together. But there is one more analogy in which the serve a use.

The firms that this bailout will prop up will be overwhelmingly on Wall Street: established firms with failed business models who should have met the fate of “creative destruction,” as coined by economist Joseph Schumepter, that smaller firms are faced with every day. The bailout will create a “moral hazard” by socializing risk giving a second life to these firms who should be subject to the market discipline of failure or bankruptcy.

But the proposed new regulations, ironically and unfortunately, will likely reach far beyond the big stodgy firms participating in the bailout and hit entrepreneurs throughout the country outside the “Wall Street” financial system who are vital to reinventing how investment banking and brokerage works.

As Hans Bader and other CEI experts have noted, this crisis was not caused by deregulation. Though some fiancial regulations were lifted (per widespread bipartisan agreement in the Clinton adminitration), such as bans on banks merging across state lines and the separation of commercial and investment banking, banking was still a heavily regulated. As Bader and CEI’s Michelle Minton have pointed out, the Community Reinvestment Act practically mandated that banks use looser underwriting standards for a portion of their loans to serve various constituencies. And the government-sponsored enterprises Fannie Mae and Freddie Mac helped spread the contagion around by purchasing and securitizing many of these mortgages.

One regulation that everyone from former Speaker Newt Gingrich to liberal Rep. Peter DeFazio, D-Ore., says needs to be eased is the mark-to-market accounting rule that forces healthy banks to take paper losses and constrain their capital for lending if a highly leveraged bank sells off its loan portfolio at a fire sale price. The SEC’s widely promited “clarification” of the rule earlier this week really didn’t change anything, as experts are now saying and I will show in an upcoming blog post. And this means, as I have stated earlier, that government purchases of illiquid securities under this new bailout could actually further constrain credit if banks not participating in the bailout have to take more paper “losses” based on the government setting of the market price.

This example illustrates all the more reason that lawmakers must do due diligence on proposed regulation to make sure Main Street is not double-punished with overregulation as a result of Wall Street sins

Tagged as: deregulation, Henry Paulson, mark-to-market, nancy pelosi