Wednesday, November 12, 2008

Why Bail-Outs Don't work

The Quintessential definition of insanity is to repeat the same mistake and expect different results.

In a free market, companies will not take on undue risk, because it will eventually come back to hurt them financially. The main reason why the real-estate market took on so many risky loans, was because Fannie Mae and Freddie Mac were empowered to buy these risky loans, freeing the banks from their risk. The only reason why Fannie Mae and Freddie Mac bought risky loans, was because the federal government guaranteed the solvency of Fannie Mae and Freddie Mac. When the government guarantees that a company will not be allowed to fail, no matter how risky its behavior, this promotes more risky behavior without restrictions or limits. As a result, Fannie May and Freddie Mac, bought up 50% of all home mortgages, mostly the riskiest ones. This was no longer a free market, because the risk has been taken out of doing business. If the financial risk is taken out of any business transaction, money is bound to be lost, because there is nothing to stop any deal from going through. The reason why most banks carefully check out a clients credit worthiness before making a loan, is that they will lose money if the loan is not repaid, not because of regulations. If enough loans are not repaid, they will go out of business. Fannie Mae and Freddie Mac had no such constraints. Commissions were made, every time a mortgage was bought or sold and the company was making lots of money while the real estate market was on the rise and they were protected from failure, should the market fall.

Liberal politicians and community organizers, pressured banks into making risky loans to minorities, poor people. Banks were inclined to acquiesce, because Fannie Mae and Freddie Mac were there to relieve them of their risk. When Fannie Mae and Freddie Mac eventually became insolvent, banks were stuck with the risky loans that they had on hand. Also, Fannie Mae and Freddie Mac, had been repackaging many of these risky loans into a financial instrument called "Mortgage Backed Securities" and they sold them on the securities market. This is how these risky loans circulated throughout the financial industry and eventually put many financial institutions at risk.

The lesson to be learned here is not that the markets require more regulation. The lesson is that the government will distort any market by guaranteeing any business from failure. That guarantee, guarantees risky behavior on the part of that institution. It will inevitably lead to insolvency.

The current trend toward government bail-outs, government acquisitions and loan guarantees is exactly the same behavior that caused these financial institutions to fail in the first place. I can see no other outcome than the eventual failure of more businesses and financial institutions resulting from this increased government interference in free markets.

1 comment:

D said...


This is one of the best explanations of the Bail-Outs I have seen.