e=mc2

I saw on CNN Headline news this week that scientists, along with lots of computers, determined that Einstein's formula for the theory of relativity is, in fact, correct. Such a seemingly simple equation could help explain something as complex as our universe. How often do we find that what seems like a very complicated situation, has a very easy solution? I think we can take this approach with the current economic crisis. We have seen bailout after bailout. We have bailout waiting in the wings for the Big Three. Make no mistake, the U.S. economy is in bad shape, and there is not easy, or quick way out of our difficulties. That said, it soes not ahve to be as complicated, or expensive, as what we have seen.

Here is how things work in the real world. If a business finds itself in financial trouble, or wants to expand, there are generally several options open to it. If the business is a good business, with a good customer base, well capitalized, and needs some money to achieve its goals, it will go to the bank for a loan, issue stock, or sell bonds, and use the money for the business. This business will find that banks are more than willing to lend, and investors will giv ethe company an good price for its stock or a good interest rate on its bonds. If the business is not as sound, it will find fewer banks willing to lend, those that do will charge a higher rate and add loan covenants, require more collateral, investors will not give as much for their stock, and bind holders will require a higher rate. If a business cannot be saved, banks will not lend, they will not be able to issue new stock, and no one will buy their bonds. That business will fail.

You will notice that the Federal Government is not mentioned once in the above example. There is no need. These things happen everyday. The market decides winners and losers. Certainly, there is the need for some government involvement. The Federal Reserve and the Treasury have their roles, but picking winners and losers is not in their job description. Businesses, as well as individuals have the responsibility to act in such a way as to insure that they remain economically healthy now, and in the future. If they fail, they have the responsibility to get up and try again. This goal can be accomplished in a variety of ways, but it basically boils down to acting responsibly now, and saving for the future. That's it.

You will notice that I did not say banks, auto makers, or mortgage holders. I said businesses. I'd like to narrow it down to just those three, but, and this cannot be surprising to anyone, there is now a long list of people the government wants to give money to, and an even longer list of people with their hats out. We are now in dire economic straits. But bailouts are not the answer. In earlier editions of my blog I recommended that banks and insurance companies be allowed to fail. The government should take the same role as they did during the Savings and Loan crisis of the early and mid 1990s. They should reestablish the Resolution Trust Corp to sell the assets of the banks and insurance companies that fail. Keep in mind that this crisis is all about over-priced assets. All that is happening in the housing market and the stock market is that buyers are waiting for the bottom of the market to show its face and then they will know how to act prudently.

We have enjoyed years of sustainable and dependable economic growth. Now we are going through some bad times. While not as popular, these bad times are as important as the good times. The bad economic times, the busienss losses and failures, the foreclosures are unfortunate, but necessary because they tell us where we went wrong. In this case, they remind us that when you package loans, given to people who can never hope to pay them back, into investments, even if you call them something else, like a CDO, they are still bad investments. True, credit rating agencies like Moodies and Standard and Poors gave them investment grades, but we all knew the loans would go bad. I remember watching this activity for years and I could not believe investors actually bought these. There was no way this was going to work out anyway, but bad. It's the old silk purse from a sow's ear analogy. The loans are called sub-prime for a reason. There was an inertia (probably something from Newton) that was unexplainable, but there, nevertheless. I am not soothsayer, and I was not alone. Alan Greespan warned of a Fannie Mae and Freddie Mac crisis years ago. But people sometimes believe only what they want to, and there is a price to pay for that.

All of that being said, in addition to the resurrection of the RTC, and the just say no attitude towards all bailouts, here is what we can do to help insure we do not have a crisis like this again. First, we need to establish a FDA-type agency to "test" investment vehciles before they are allowed to go to market. Just like prescription durgs are tested, we can test investments. In the case of CDOs you simply have a very limited amount of these turned into investments and sold. Wait a few years, see how they do in good times and bad, and then you have enough data to propery structure them. There is not need to regulate the amrkets any more than they are now. What is needed is to make sure the investments are transparent and understandable. Remember, the credit rating agencies freely admitted they did not understand may of the investments they rated. The new agency gives rating agencies lots of time and data to do their jobs properly. Some may argue that this will slow the the ability of brokers to get new types of investments to the market, but one look at a Wall Street Journal will show anyone that we have plenty of investments to choose from right now. We'll make due, thanks.

Second we need to rescind government promises to bailout institutions and let the free market take over. Let's keep in mind that all of the doomsday scenarios presented assume that once an insitution fails, every business will just sit back and let the economy spiral out of control. Here is what will happen. CitiGroup fails. Another bank, or a company like American Express who is trying to become a bank, will buy the assets cheap. They won't buy them now because they do not need to. All they ahave to do is wait fo rthe price to drop and they will buy. They will not let the price drop too much for fear that someone else will buy what they covet. This will happen with other failed institutions, including AIG. There is no such thing as "too big to fail." The market will just hold a going out of business sale. It will take a while for all of this to happen, but we will get through it easier and cheaper than the way we are currently going through this crisis.

Third, Sarbanes-Oxley-like legislation must be enacted for credit rating agencies and other market players to punish fraud. Punishment should include significant Federal Prison sentences and fines.

Overall, the philosphy of the federal government should be to properly test new investments, regulate the the market players, and let the chips fall where they may. If the amrket goes up and investors make millions, that's great. If the markets go down and investors lose millions, that's the way it goes. No bailouts. Let the free market decide winners and losers.

We are beginning to see the alternative. People and companies who made bad decisions are being bailed out, and those citizens who acted prudently are paying for it.