Scott Garrett versus Conventional Wisdom on Financial Bailouts

I first met Scott Garrett when I began my service as Senior Policy Advisor on the Assembly Republican Staff in June, 1992 while he was serving in his second term as an Assemblyman. Over the past 17 years, both in his capacity as an Assemblyman and as a member of the U.S. House of Representatives, I have had the good fortune to work with Scott on numerous issues, and my respect for his intellect, character, ethics, integrity, and courage has grown.

What I have found most admirable about Congressman Garrett, however, is his total willingness to go up against conventional wisdom on a multitude of issues. Never has this been more evident, however, than on his opposition to the bailouts of financial institutions and General Motors. Despite conventional wisdom to the contrary, Scott Garrett has already been vindicated on these issues, both on policy and political grounds.

The meltdown of key banks and other major financial institutions, most notably AIG, had its roots during the Clinton administration, when the then Secretary of Housing and Urban Development Andrew Cuomo and Senator Chris Dodd (D-Connecticut) and Representative Barney Frank (D-Massachusetts) put enormous pressure on banks to extend subprime mortgages to home purchasers who had little prospect of being able to repay same. Later, Freddie Mac and Fannie Mae, as Government Sponsored Enterprises, began to insure these most risky and imprudent mortgages. Once these subprime mortgages were bundled in the form of mortgage securities, you had the creation of truly toxic assets.

Finally, insurance companies such as AIG began to issue Credit Default Swaps, which were basically insurance policies purchased by owners of bundled mortgage securities and corporate bonds to compensate them in the event of a default. These instruments were a legitimate form of insurance, but matters became totally out of hand when individuals who did not even own the securities or bonds in question began to purchase Credit Default Swaps on them, in effect betting on their default. Such purchases were most accurately defined as “side bets”.

Thus, in the case of Credit Default Swaps, what had begun as an economically sensible insurance market had evolved into a literal casino of Wall Street. Even worse, these derivatives were not traded on any exchange and therefore had no transparency, except to the two counter-parties. While I am a free market advocate believing in the avoidance of excessive regulation, I feel most strongly that regulatory disclosure is absolutely essential in order that parties have full access to information regarding these instruments and their underlying securities prior to any purchase.

Much to her credit, the then chair of the Commodity Futures Trading Commission, Brooksley Born tried to enact disclosure regulations on Credit Default Swaps in 1998. She was thwarted in this effort by the Clinton Administration “Gang of Three” – former Federal Reserve Chair Alan Greenspan and Treasury Secretaries Robert Rubin and Larry Summers – the latter currently serving as President Barack Obama’s Economic Czar.

Thus did the Clinton administration bequeath to George W. Bush a financial system with a growing cancer of trillions of dollars of toxic assets, to wit: 1) Credit Default Swap “side bets”; and 2) Fannie Mae and Freddie Mac- insured subprime mortgage securities. In all fairness, President Bush did submit to Congress legislation to stop the out-of-control insuring by Fannie Mae and Freddie Mac of subprime mortgages to people who could not afford them. He was thwarted however, by a Democratic filibuster in the Senate in 2005 by individuals who believe that everybody is entitled to home ownership, regardless of whether or not they can afford it. A leading participant in the filibuster was none other than a new Senator from Illinois, Barack Obama.

Bush’s tax cuts did give the economy five years of economic growth that outpaced the other nations of the world. Unfortunately, by early 2008, the growing cancer of toxic assets in the banking system was resulting in the credit crunch and a lengthening shadow over Wall Street investment banking houses, i.e., Bear Stearns and Lehman. Once Lehman filed bankruptcy on September 15, 2008, panic gripped Wall Street and the banking system.

The proper response by the Bush administration would have been to allow insolvent banks to file for bankruptcy while providing to the Federal Deposit Insurance Corporation (FDIC) enough money to ensure that depositors did not lose a penny. It is the function of the federal government to protect depositors, and not shareholders and bondholders of banks who become insolvent due to foolish decisions on the part of their management. It is the existence of deposit insurance that prevents the monetary supply contraction that resulted from bank failures in the 1930s.

Similarly, there should have been no bailout of AIG. The absurdity of the AIG bailout is the fact that only the derivative division of AIG issuing the Credit Default Swaps was having severe losses. All the other divisions of AIG selling traditional insurance coverage were profitable. Had AIG filed bankruptcy, the trustee could have carved out the derivative division and sold the toxic assets at true market value, allowing the company to actually reemerge from bankruptcy on a more profitable basis.

I do not deny that the bankruptcy of giant banking institutions and AIG would have resulted in a serious jolt to the stock and bond markets. The downturn would have been followed after about a year, however, by a traditional recovery, as the bonds and stocks of healthy companies rose in value and the monetary system continued to function effectively.

Instead of allowing the free market to function while protecting depositors, however, Treasury Secretary Hank Paulson made the historically catastrophic decision to establish the Troubled Asset Relief Program (TARP) to bail out failing banks and other financial institutions such as AIG. TARP has proven to be both counter-productive and ineffective. It is counter-productive in that the continued financial increase of the program into the multi-trillion dollar range will result in either growth-stunting higher taxes or deficits that are financed by a galloping inflation or huge federal borrowing, resulting in an even more severe credit crunch.

TARP is ineffective in that there are tens of trillions of dollars of potentially toxic assets in the financial system, and the expenditure of even five trillion dollars will not come close to eliminating their presence. The proof of this is the fact that AIG, which has received over $100 billion dollars in TARP funds, now wants even more money.

The ultimate TARP debacle occurred when it was used in a futile attempt to rescue General Motors. Bankruptcy represents the only chance of saving General Motors, since the bankruptcy judge would have the power to modify the union contract that is choking the company to death. Instead, bailout funds were granted to General Motors, and like AIG, the auto giant is now requesting even more funding.

In short, when he established TARP and obtained funding from Congress, Hank Paulson was following the conventional policy wisdom that the bailouts were needed to save the economy and the conventional political wisdom that the public would demand these bailouts. He was wrong on both counts. The financial markets have actually had an accelerated decline since the establishment of TARP, and the polls have consistently showed the electorate to be in total opposition to the bailouts.

I believe that historians will be much kinder to George W. Bush than his contemporaries. The decisions of Hank Paulson, however, constitute the most negative part of the Bush legacy.

By contrast to Hank Paulson, Scott Garrett knew that the conventional political and policy wisdom on the bailouts was not very wise. He consistently voted against every proposed bailout funding measure, both prior to and after the November, 2008 election, and he was reelected by a comfortable 14-point margin, in spite of an Obama 15-point landslide in New Jersey and a major Democrat effort to defeat Scott.

Every two years, the Trenton insiders of both parties talk of the ultimate electoral demise of Scott Garrett. To paraphrase Mark Twain, reports of Scott’s political death continue to be exaggerated. I recently had a conversation with a prominent New Jersey political journalist in which he stated that key Republicans want to sacrifice Scott’s 5th District seat in the next reapportionment. Nothing could be a more politically suicidal move for the New Jersey GOP than that.

This past week, John McCain criticized the Obama Treasury Department for avoiding “the hard decision to let these banks fail.” This was in sharp distinction to McCain’s September, 2008 stance after the Lehman bankruptcy, at which time he was an outspoken advocate for TARP and federal bailouts.

Had John McCain followed the path of Scott Garrett last September and opposed TARP and all bailouts, he would have drawn a sharp distinction between himself, the Bush White House, and Obama, who supported TARP and the bailouts. And today, he would be President John McCain.

Alan J. Steinberg served as Regional Administrator of Region 2 EPA during the administration of former President George W. Bush. Region 2 EPA consists of the states of New York and New Jersey, the Commonwealth of Puerto Rico, the U.S. Virgin Islands, and seven federally recognized Indian nations. Scott Garrett versus Conventional Wisdom on Financial Bailouts