The Rescue Mission

by The Editors

Wall Street has gotten itself into a very serious mess, and it’s becoming clear that taxpayers are going to have to rescue some of the largest, most interconnected firms to prevent a worldwide financial meltdown. The terms built into the Fed’s bailout of distressed insurance firm American International Group (AIG) ought to be enough to discourage moral hazard, but uncertainty stemming from the government’s ad hoc approach to each firm’s failure is roiling markets and endangering other firms.

John McCain addressed this problem by calling for the creation of a mortgage and financial institutions trust, similar to the Resolution Trust Corporation that Congress created in 1989 to deal with the savings and loan crisis. Such an entity would have the power to buy troubled assets, such as mortgage-backed securities, from otherwise stable firms. These assets have real underlying value, because most people are still paying their mortgages. But rising foreclosures and falling home prices have created a great deal of uncertainty as to how much value. That uncertainty has rendered these assets practically worthless on the open market and torpedoed the balance sheets of institutions that bought too many of them during the housing boom.

Obviously, this means a taxpayer rescue for firms that made irresponsible bets on housing prices. Normally, we would advocate letting these firms bear the full consequences of such behavior, but there are no good options for friends of the taxpayer these days. The Treasury Department and the Fed have made clear that the alternative is the ad hoc nationalization of the country’s major financial institutions.

The AIG bailout could have been worse. The Fed will loan the company up to $85 billion, but chief executive Robert B. Willumstad will lose his job and shareholders will lose most of their equity. The government will acquire a 79-percent equity stake in the company, meaning there is a chance taxpayers will make money if AIG recovers. It also means they are on the hook for any losses on the deal.

This should dampen the problem of moral hazard, but it came at a high price. In order to finance its growing interventions in the market, the Fed has asked the Treasury for a $40 billion loan. This sort of dependency could threaten the central bank’s independence, which is another reason why responsibility for cleaning up Wall Street’s toxic spill should be transferred to another agency.

With his call for the creation of such an agency, McCain is finally on the right track. His harangues against boardroom greed and vague calls for more regulation were not adequate for the moment. We were dismayed to hear him attack short-sellers in his speech Thursday. Short-sellers were among the first to blow the whistle on firms that gambled recklessly on home prices.

For allegedly failing to crack down on short-sellers, McCain also called on Securities and Exchange Commission chairman Chris Cox to resign. We will always admire Cox for his achievements in Congress. But as SEC chairman, he granted exemptions that allowed the big five investment banks to play fast and loose with their capital requirements. As a result, three of those five banks no longer exist. If they and they alone had to deal with the consequences, this wouldn’t be a problem. But these institutions grew too big to fail, and now taxpayers are on the hook for $29 billion worth of Bear Stearns’s bad assets. McCain is right to demand that the chief regulator during a financial crisis be held accountable, even though he is wrong about the reasons why.

Compared to McCain, Obama’s speeches on the financial crisis have offered little substance. McCain seized the opportunity Thursday to point out that Obama’s planned tax hikes would come at the worst possible time for the fragile U.S. economy. So far, that economy has weathered the storm admirably thanks to relatively low tax rates. McCain’s tax plan is obviously more pro-growth than Obama’s, but it needs more middle-class relief to have real mainstream appeal.

A mortgage trust of the sort McCain has proposed looks increasingly like the least bad option for taxpayers. Congress should act on this idea before it adjourns for fall — before taxpayers become the unwitting owners of any more troubled financial firms.