Bailouts Forever

Senator Mitch McConnell has criticized the new financial regulation reform bill, arguing that it commits the government to permanently bailing out Wall Street. In truth, even if the bill does not pass, future government bailouts are now inevitable.

Senate Minority Leader Mitch McConnell has accused the Obama administration, Sen. Chris Dodd, and, by implication, most other Democrats of plotting for permanent bailouts of the financial system.  He’s right. But Democrats can rightly point out that McConnell, every other member of Congress, and, indeed, just about every American citizen, want the same thing.

A bailout, of course, is what happens when the government keeps an explicit or implicit promise to stop an institution from failing or a financial instrument from loosing its value.  And these guarantees are very common: many widely owned products—savings accounts, certificates of deposit, pensions, retail brokerage accounts, and admitted market homeowners insurance—all have attached guarantees.  In many cases, people even use different names for guaranteed and non-guaranteed products: a CD without a government guarantee is called a bond, property insurance without a guarantee is called an excess and surplus lines policy. One expects that these guarantees will eventually be needed: there wouldn’t be a point in offering them if they weren’t. So, as long as the government guarantees any financial instrument, in short, it will engage in bailouts. The only true “no more bailouts” policy would involve abolishing the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation, more than 50 state insurance guarantee funds, the Pension Benefit Guarantee Corporation, the National Credit Union Share Insurance Fund and at least a half dozen other entities.

Even if this were a good idea, it probably wouldn’t get a single vote in Congress.  Among other things, abolishing all public-sector guarantees would upend the business model of nearly every financial services firm in the country, lead some families to financial ruin, and end the sale of certain products. In short, while proposing an end to all guarantees may make good fodder for dorm-room bull sessions, it will never go anywhere.

Any practical look at policy towards bailouts should focus on how to limit them.

This means the government should get out of some guarantee businesses altogether, avoid entering new ones, and enforce regulations to minimize the need for those guarantees that can’t go away.

If the private market handles a type of product without problems, then the government has no business guaranteeing it. For example, the mortgage backed securities sold by Fannie Mae and Freddie Mac should never have had an implicit government guarantee even though providing it probably lowered mortgage rates. The private market is fully capable of selling mortgage-backed securities and, if the government really wants to promote homeownership, backing massive financial instruments was a poor way to do it.

A desire to minimize bailouts also means that proposals floating around to create a “resolution authority” for big financial firms, get the federal government into the reinsurance business to reduce the cost of beach home property insurance (yes, really), and provide additional security for investors who fall victim to fraud deserve enormous skepticism. They may address real problems but they also increase the chances of future bailouts.

Instead, the Congress should focus on tightening the core duties of regulators that can prevent bailouts. So long as the FDIC exists, no bank should have a reason to complain about audits to make sure it has enough reserves. Insurers shouldn’t complain when states scrutinize their books to make sure they actually can pay claims. In some cases, these regulations may be “bad for business” or “anti-innovation.” This is fine. A firm that’s eligible for a bailout shouldn’t have quite the same opportunities as one that isn’t.

Whatever happens, future bailouts are inevitable; Congress should work to minimize the need for them.