We have published several articles that lay the blame of the present financial mess essentially at the table of a lack of proper regulation of financial market (see here for our fundamental take). Turns out that the raison d’etre of the Paulson bailout plan lies in a market failure.

First, a take on the essentials on the present mess and how we got there from the Brookings Institution:

Know What Went Wrong Before Beginning to Fix Anything

There has been a “domino-like” character to the financial crisis that is now readily apparent to all:

• the bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;
• the peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;
• losses thereafter on the complex “Collateralized Debt Obligations” (CDOs) that were backed by these mortgages;
• increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued “credit default swaps” contracts (CDS) that insured the CDOs;
• losses suffered by financial institutions that held CDOs and/or that issued CDS’s;
• cutbacks in credit extended by highly leveraged lenders that suffered these losses.

Our essential theme was that many of these markets were loosely regulated (infested by a dogmatic belief that markets would, somehow, take care of themselves). In fact, some of these markets now work so badly that the prime mechanism through which the Paulson plan is supposed to work, according to Krugman, is helping the markets with ‘price discovery‘.

This is more than a little ironic. Markets are supposed to be much better at that than governments. But the products traded on some of these markets are so complex, and therefore the possibilities for opportunistically profit from information advantages so rife, that the government has to throw $700B at them in order to normalize. Cool.

Here is Krugman on the problem:

• It took four days before P&B [Paulson and Bernanke] offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.
• As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.
• So, three points:
• 1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.
• 2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?
• 3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.
• Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

Gregory Mankiw wrote something similar:

• Here is the key passage from President Bush’s speech last night:
• [“as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.”]
• In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people’s money are better at judging the value of complex financial instruments than are private investors gambling with their own.

Government intervention to create better price formation, it’s almost out of the former communist economies, where central authorities used to set many prices. After the socialization of numerous financial institutions, can it get any crazier than this, the prime capitalist economy in the world relying on socialism to sort out its market problems?

So dogmatic market fundamentalism got us under-regulated markets that got us into this mess, but it takes undiluted socialism to get us out of the mess. How’s that for an ironic turn of events.