Credit Crisis Ground Zero - Fannie Mae

We are smack-dab in the middle of setting the conventional wisdom for the financial crisis. The argument on the left is that due to deregulation, unrestrained capitalism [greed etc] has failed us. That argument, which includes people not normally on the left of the political spectrum like Richard Posner, has got some splanin to do to, given the points made by Peter Wallison from Bloomberg.com:

• There has been a great deal of deregulation in our economy over the last 30 years, but none of it has been in the financial sector or has had anything to do with the current crisis. Almost all financial legislation, such as the Federal Deposit Insurance Corp. Improvement Act of 1991, adopted after the savings and loan collapse in the late 1980s, significantly tightened the regulation of banks.
• The repeal of portions of the Glass-Steagall Act in 1999 -- often cited by people who know nothing about that law -- has no relevance whatsoever to the financial crisis, with one major exception: it permitted banks to be affiliated with firms that underwrite securities, and thus allowed Bank of America Corp. to acquire Merrill Lynch & Co. and JPMorgan Chase & Co. to buy Bear Stearns Cos. Both transactions saved the government the costs of a rescue and spared the market substantial additional turmoil.

On the right, I'll summarize economist David Friedman's arguments about why it is not a failure of unregulated capitalism, using Fannie Mae as an example of how we got where we are.

• Fannie Mae was established by the federal government [1930's] for the purpose of making mortgages more readily available. In 1968 it was "privatized." In the late 1990's, under Clinton, lending standards were relaxed in order to make it easier to obtain loans.
• How Fannie Mae works: it buys mortgages from the lenders who issue them and bundles them into mortgage backed securities to be resold to investors on the secondary mortgage market.
• The problem with mortgages as investments is the risk that a borrower will default. A bundle of mortgages is less risky, but the problem still remains. To solve it and make the securities attractive to investors, Fannie Mae guaranteed them.
• If Fannie Mae were an ordinary private firm, buyers of its securities would take that risk — the possibility that the seller would go broke and be unable to make good its guarantees — into account in pricing them.
• But Fannie Mae is not an ordinary private firm. It was established by the government and it has generally been assumed [correctly] that the government will be unwilling to let it default on its obligations. That fact gave it an advantage over ordinary private firms in the same business. The result was that it could sell its securities for a higher price than they could sell theirs, which explains why it held a dominant position in the mortgage market. It also explains why I put "privatized" in quotation marks [see Palin note below - JC].
• Housing prices are now going down, mortgages are defaulting, and Fannie Mae is unable to make good on its guarantees.
  
• The proper outcome is that firms that bought risky securities on the theory that if they went up the firm would make money and if they went too far down the government would step in to limit their losses should have to pay the price of a losing gamble.
• The alternative, a massive bailout, simply encourages firms in the future to take risks that are worth taking only because, if they lose, someone else will pay for it.
• Fannie Mae was created by the Federal government for the explicit purpose of lending money to people who wanted to buy houses and could not borrow the money to do so on the private market. It has continued to pursue that purpose, first with explicit and later with implicit government support, throughout its term of existence, has repeatedly boasted of doing so, and has now gone broke as a result. That is indeed a failure, but not a failure of unregulated capitalism.

When Sarah Palin stated that Fannie Mae had gotten 'too expensive for taxpayers,' she was accused of not understanding how they were a 'private' company, her first gaffe they said. Don't hold your breath for any of that arugula-eating, Oprah-loving, low-carbon footprint talking crowd to come after David Friedman. There's a reason baloney rejects the grinder.

All articles referenced are copied in full at end of post.

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David Friedman post & comments
Thursday, September 25, 2008
The Current Financial Mess

I have been a little reluctant to post on this subject, since I have no special expertise in mortgage markets or financial matters. But at this point I think the basics of what happened are fairly clear. The following is a brief and somewhat simplified account. Readers are welcome to correct any factual errors.

Fanny Mae was established during the New Deal by the federal government for the purpose of making mortgages more readily available and so encouraging home ownership. In 1968 it was "privatized." In the late 1990's, under Clinton, lending standards were relaxed in order to make it easier to obtain loans. The basic mechanism was fairly simple. Fanny Mae bought mortgages from the lenders who issued them and bundled them into mortgage backed securities to be resold to investors on the secondary mortgage market.

The problem with mortgages as investments is the risk that the borrower will default, a risk which depends on the detailed facts of that particular mortgage—the borrower's income, the state of the local housing market, and similar matters. That makes a single mortgage a very poor investment. Not only is it risky, the risk is hard for the investor to measure. A bundle of mortgages is less risky, but the problem still remains. To solve it and make the securities attractive to investors, Fanny Mae guaranteed them. If the borrower did not pay off on the mortgage, Fanny Mae would make good the investor's loss.

An insurance company can afford to insure houses against fire because the risk of my house burning down is unrelated to the risk of your house burning down, assuming we are not neighbors. If the probability is one in a thousand the and the insurance company insures a million houses, it can expect to have to pay off on about a thousand a year.

That does not work so well for mortgages. The chance that I will default on my mortgage depends, among other things, on the state of the economy and the state of the housing market. If house prices are going up, I can borrow more money against my house to make payments. If they are going down, I can't—and, for reasons discussed in my previous post, it may be in my interest to default on the mortgage, getting rid of a $95,000 debt at the cost of an $80,000 house. That means that the same circumstances that make me likely to default make you likely to default.

Which raises an obvious problem for Fanny Mae: If enough borrowers default, the amount it will owe to holders of its securities may be more than its total assets. If Fanny Mae were an ordinary private firm, buyers of its securities would take that risk—the possibility that the seller would go broke and be unable to make good its guarantees—into account in pricing them.

But Fanny Mae is not an ordinary private firm. It was established by the government and it has generally been assumed that, although the government has no legal obligation to pay its debts, the government will be unwilling to let it go bankrupt and default on its obligations. That fact gave it an advantage over ordinary private firms in the same business. The result was that it could sell its securities for a higher price than they could sell theirs, which explains why it held a dominant position in the mortgage market. It also explains why I put "privatize" in quotation marks.

Housing prices are now going down, quite a lot of mortgages are defaulting, and Fanny Mae is unable to make good on its guarantees. The proper outcome, in my view, is that firms that bought risky securities on the theory that if they went up the firm would make money and if they went too far down the government would step in to limit their losses should have to pay the price of a losing gamble. The alternative, a massive bailout, simply encourages firms in the future to take risks that are worth taking only because, if they lose, someone else will pay for it. That applies both to firms dealing with government established entities such as Fanny Mae, and to firms that may reasonably believe that they, like Fanny Mae (and Freddie Mac and ...) are "too big to fail."

One disturbing feature of the present situation is the widespread view that this collapse is a failure of unregulated capitalism. Fanny Mae was created by the Federal government for the explicit purpose of lending money to people who wanted to buy houses and could not borrow the money to do so on the private market. It has continued to pursue that purpose, first with explicit and later with implicit government support, throughout its term of existence, has repeatedly boasted of doing so, and has now gone broke as a result. That is indeed a failure, but not a failure of unregulated capitalism.

[I have simplified the story by focusing only on Fanny Mae, but I think have described the essential features of the situation]

posted by David Friedman @ 5:31 PM 12 comments links to this post
12 Comments:

At 9:23 PM, September 25, 2008, Blogger Joe Bingham said...

Do you have an understanding of how this relates to the failure of private investment banks? I was explaining my understanding (similar to yours) to a far-lefty classmate, and he said that this may be correct, but that he didn't think mortgages actually played a big part in this crisis. He cited "bank deregulation that occurred under Reagan," but I'm not sure what he meant.

(He also said this crisis had turned him from a moderate liberal into a hey-socialism-may-not-be-so-bad guy... heh.)

At 10:04 PM, September 25, 2008, Blogger dWj said...

Joe: Mortgages played a huge role in getting this crisis going, though it has acquired a certain amount of self-reinforcement at this point. Bear and, to a lesser extent, Lehman ended up with a lot of mortgage debt exposure on their balance sheets. It's really that direct. (Goldman and Morgan Stanley are mostly at risk only to 1. losses due to credit exposures to other financial firms and 2. self-fulfilling credit runs -- people fear their credit for no good endogenous reason, but that leads customers to cease doing business with them.)

They ended up with most of that exposure because they, too, were doing some of what the GSEs were doing, though of course without the ability to finance it quite as cheaply as FM could. Here the "Community Reinvestment Act" plays a heavy role: banks were, to a large extent, required to make sub-prime loans. I've been saying for the last year or two that it's only a matter of a decade until we have political figures cheering on "credit access" for poor credit risks, but based on the latest add-ons to the bailout, it looks like we're getting that right in the middle of the disaster it wrought.

There were private participants at banks and investment houses making a variety of unforced errors as well, but the CRA and FM played a big, big role, and without them I can't imagine it would have gone nearly so far.

At 10:46 PM, September 25, 2008, Anonymous ACK said...

Hoping on Dean's comment on self-reinforcement, even though I find the explanations of contemporary Austrians very relevant to understand what is going on, I have seen very little mentioned on the marginal value concept being used to explain why institutions which were "too big to fail" were denied liquidity by their creditors, which are supposed to be the most sophisticated of investors.

Those who believe that prices and value can be achieved quantitatively seem to have a hard time explaining why market players would deny credit to Lehman or Bear when quantitatively they seemed to have assets to back their short term liquidity needs.

Events seem to show that in the end the investment banks were subject to the qualitative judgment of their counterparts delivered on their capability of long-term income, rather than on more "tangible" or "scientific" justifications.

If so, one may reach interesting conclusions, such as:

1. Decision mechanisms on risk-taking for sophisticated investors ultimately do not vary as significantly as those of ordinary consumers. Hence, there is no quantitative method to pin-point how much incentive is needed to change aversion to risk, which is necessarily a subjective perception;

2. The proposed bail-out solution is therefore aimed at the wrong target and loaded with inaccurate bullets: buying assets for their "book" (as in "ultimately discretionary") price limits losses for creditors but does not restore the "marginal" or "qualitative" valuation of financial institutions by their counterparties. This may be seen as the main cause for the current over-the-board liquidity crunch, which has become resilient to "rational" assessments of financial health, interest rate adjustments and inflationary policies (which is what the bailout proposal really is).

Non-interventionists (including Paulson on his past life) have rightfully being concerned with moral hazard, but they should be even more concerned (particularly Paulson in his present incarnation) with the fact that the source of moral hazard produces the same ill effects and guarantees none of the results.

Should we say welcome to stagflation? This is a good time for policy-makers to look again at South America's lost decade and see how mirror-like the country is about to get.

At 11:00 PM, September 25, 2008, Anonymous Anonymous said...

Here's a footnote to the mortgage mess which is infuriating. Lehman Brothers recently went bankrupt, due to its bad mortgage bets, and as it happens some money market mutual funds held Lehman debt.

Now, money market funds are not guaranteed against loss any more than other funds. But there is a tradition in the money market business of fund managers absorbing losses, even though they are not obligated to do so. It's done out of pure self-interest to maintain a good reputation. This is what happened in the case of the Lehman bankruptcy, with one exception. One money market fund decided not to absorb the loss, and as a result the fund investors took a 3% loss.

There is nothing extraordinary or shocking about any of this, and yet the fact that one money market fund lost money (something that is expected to happen occasionally) is being widely cited as a sign of financial Armageddon and a reason for a massive Wall Street bailout. "Even money market funds that invest in [risky] corporate bonds aren't risk-free! Oh my God!"

At 1:45 AM, September 26, 2008, Anonymous MachineGhost said...

On top of what David said, the end-game to the sub-prime crisis and the resulting fallout goes like this:

Bush passes Regulation FD and the Sarbese-Oxley acts that put the responsibility of checks and balances on incompetent government bureaucrats instead of the private sector. As a consequence, whistleblowing becomes de facto illegal. This is a result of overregulation, not deregulation.

Bush cuts income taxes, institutes a $250K/$500K real estate capital gain exemption, and the Federal Reserve cuts the Fed Funds and Discount Rates. With the marginal cost of capital and returns on equity so low, in accordance with Gresham's Law, the cheap capital all flows into real estate because that's where the money and yields are.

Spurred by lax lending policies from mortgage lenders and outright incompetence, if not fraud, at the Big Three rating agencies that securitize mortgages into mortgage-backed securities, they are sold as AAA investment grade bonds to foreigners who finance our capital account deficit. Some savvy domestic companies borrow short and buy only Fannie and Freddie and leverage the difference multiple times as it is allegedly "risk free" (since found out to be implicit).

Now that the chickens have come home to roost on yet another market distortion caused by government interference, Wall Street -- is trying to engineer a bail-out plan that screws the taxpayer by placing them even behind the bondholders in the pecking order. Because the troubled insitutions DO have enough other non-mortgage backed assets to cover their liabilities, the proper recourse is dissolution or bankruptcy by selling off the valuable assets which will wipe out the stockholders but give to the bondholders whatever is left, if anything. It's important to note that in dissolution or bankruptcy, the counterparties, the clients, the customers, the depositers, etc. everyone BUT the bondholders and the shareholders are protected and not at risk. As a consequence, in the subsequent failures taxpayers will receive nothing just like the shareholders, i.e. socializing the losses but privatizing the proftis to the bondholders, the directors and the executives, aka socialist corporatism. Instead, the bailout plan wants to preserve the companies intact and sell off just the bad assets to the government in a reverse auction scheme which will then price the illiquid mortgage-backed securities systemwide and cause a chain reaction of even more defaults as other institutions can finally "mark to the market" their mortgage-backed securities and their stockholders finally get wiped out for real. Aside from the fact a reverse auction is another opportunity to take the government to the cleaners in setting the pricing.

Truly, this is upper class elitism at its finest. Only investment bankers could have cooked up such a scheme to screw everyone but themselves and their families, friends and cronies, and that just happens to be the two men advising Bush.

At 10:09 PM, September 26, 2008, Blogger William A. Ryan said...

You could also add the troubles with AIG and credit-default swaps. And money market funds breaking the buck.

At 2:37 PM, September 27, 2008, Blogger Chris Hibbert said...

The piece of history that most commentors are apparently unfamiliar with is what caused the wave of defaults. Most analysis (like Krugman start with "the bursting of the housing bubble [which] led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities."

But the bubble didn't burst for unknowable reasons. What actually happened was that several years ago, the mortgage companies, under increasing pressure to provide more mortgage-backed securities to feed the investment banks apparently insatiable appetite, loosened their requirements for mortgage borrowers. Loan agents were rewarded for pushing weaker applications through the system by lying about people’s resources and ability to pay. The CRA was also pushing them to make more loans, but that had been in place since the late 70s.

Eventually, the borrowers reached the end of their introductory "teaser" rate (their loans “recast” to a higher rate). Since they’d stretched to qualify for the loan in the first place, they couldn’t afford the new rate. That’s what started the cascade of borrowers in default. And the reason it hasn’t stopped yet is that the marginal lending went on for several years. There are quite a few more borrowers in the pipeline who won’t be able to make their payments when their initial low rates expire, so there’s no imminent end to the defaults and foreclosure.

The defaults and foreclosure led to the bursting of the bubble, not the other way around. Housing prices fell because of the downward pressure from banks dumping foreclosed houses.

At 3:09 PM, September 27, 2008, Anonymous Anonymous said...

"The defaults and foreclosure led to the bursting of the bubble, not the other way around. Housing prices fell because of the downward pressure from banks dumping foreclosed houses."

This is like saying that margin calls cause stock market declines.

The basic issue is that a lot of people were betting heavily on increasing housing prices. These bets have gone bad and now the un-winding process exacerbates the decline.

At 3:59 PM, September 28, 2008, Blogger Chris Hibbert said...

> This is like saying that margin
> calls cause stock market declines.

Margin calls come after initial price declines and cause some investors to have to react immediately to the declines when they had hoped to be able to wait for an increase. When prices don't rise, short sellers win.

The borrowers I'm talking about could barely afford their mortgages (and they weren't paying down principal) and were slated to fall way behind when their teaser rate ended. That's usually long before house prices have gone up enough to justify a refinance, so they weren't going to get out of the problem by that route. Many of them didn't understand the loans they were in, and didn't see that they were going to have to pay a higher mortgage two years after they took the loan. If prices had gone up 25% in the intervening two years, they could have sold and moved and kept the increase, but they couldn't capture the gain by refinancing; it was too soon after the purchase for that.

> The basic issue is that a lot of
> people were betting heavily on
> increasing housing prices. These
> bets have gone bad and now the
> un-winding process exacerbates
> the decline.

This part is true, but it omits the mechanism that caused prices to stop rising. That's what's missing from most accounts.

Whatever started the escalator, all the forces were still in effect: rates were low, employment hadn't fallen, the economy was doing alright, etc. The thing that started happening before we noticed the bubble bursting was that people in arrears, in default, and in foreclosure rose.

That happened because people had gotten loans 3 years previously that they couldn't afford. The value of mortgage-backed securities fell because payouts didn't match projections, so fewer investors were buying them, so banks had less money to lend, and that's when housing prices stopped rising, and eventually started falling.

At 1:36 AM, September 30, 2008, Anonymous Anonymous said...

Great post. But it is skips a passage that is not obvious for me.

It is the link between these facts:

(A) Fanny Mae was able to sell its securities at a higher price than it would have been able to on the free market.

(B) some people who would not have been able to borrowed money in the free market were able to borrow money.

How does B follow from A ? I can almost see it, but not quite.

Thanks for any explanation.

Maurizio

At 1:52 AM, September 30, 2008, Blogger David Friedman said...

Anonymous asks for the link:

For a given interest rate/risk combination, Fanny Mae could get more money reselling. So they could buy a somewhat less attractive the mortgage than would otherwise be profitable. So somewhat less desirable borrowers could get mortgages.

To put it differently, the higher price for selling the securities means they want to sell more, which requires buying more mortgages, which requires someone lending more money to homeowners.

At 2:14 AM, September 30, 2008, Anonymous Anonymous said...

I found the second explanation totally clear. How could I not see it?

You rock.


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Individual Taxes Under McCain or Obama -- P1

While the chart [below] of their plans appear mostly similar, they differ in the following ways:

• Sen. McCain wants to permanently extend the current federal income-tax rates. Sen. Obama would increase the top ordinary income-tax rate, now 35%, to 39.6% and the current 33% rate to 36%.
• Sen. McCain wants to retain the top rate of 15% on long-term capital gains and qualified dividends. Sen. Obama would increase that rate to 20% for households with income of more than $250,000 or individuals over $200,000.
• Sen. Obama favors higher Social Security [SS] taxes on high-income workers, but not for many years -- and he hasn't disclosed details. Currently, employee SS taxes of 6.2% [there is no cap on the Medicare portion of FICA, 1.45%] are capped at [annually indexed] $102,000 for 2008. Sen Obama would eliminate that cap for those earning above $250,000.

These tax policies are campaign promises which candidates rarely feel compelled to adhere to. So part of the voter decision is also based on the likelihood of a candidate following through on their promises. Republicans are generally seen as favoring lower taxes, so an edge to Sen. McCain there.

Obama's change in payroll taxes is significant from both a revenue and physiological perspective. Whatever taxpayers may think about the future viability of the Social Security system, the taxes are based on expected benefits to be derived as a retiree. Once the cap on SS taxes is raised for revenue purposes, it unambiguously becomes an income redistribution plan, with all the resentment that could entail.

Click on image to enlarge or print.


The chart above is taken from a WSJ article.

For a very detailed analysis, see the following links from:
Deloitte
CCH
Tax Policy Center

All articles referenced are copied in full at end of post.

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WSJ 9/24/08
How Your Taxes Will Fare Under Obama, McCain
Both Promise Overall Cuts,
But Vary Widely on Specifics;
Time to Load Up on Munis?

By TOM HERMAN

Election Day is less than six weeks away, and the economy is once again a front-burner issue. Not surprisingly, the political rhetoric about taxes is heating up.

Sen. John McCain, the Republican presidential nominee, is campaigning on a strong antitax platform. That includes extending President Bush's income-tax cuts, raising the exemption for dependents and cutting the corporate income-tax rate.
Cast Your Vote

Between McCain and Obama's administrations, which would be more responsible with your tax dollars? Vote in the Question of the Day.

Sen. Barack Obama, the Democratic nominee, is calling for higher taxes on high-income Americans -- families making more than $250,000 a year and singles making more than $200,000. But he is also proposing tax cuts for lower- and middle-income households.

Sen. McCain stepped up his attack this week when he said that the Obama plan's "billions of dollars in higher taxes would kill jobs." An Obama aide responded that "Sen. McCain's tax policy is an exercise in unprecedented fiscal recklessness" that would "explode the deficit."

The government's historic rescue of the financial markets will be so costly that it could itself severely deepen federal budget deficits, thus increasing the chances of higher taxes in coming years no matter what happens in the November elections, some investment advisers say.

Whatever the case, below is an updated summary of both candidates' major proposals affecting individuals, advice from financial advisers and examples of how each plan might affect individual taxpayers at various income levels. The examples were calculated by tax specialists at Deloitte Tax LLP in Washington, which has also issued a new report comparing the candidates' tax plans.
[chart]

"Taxpayers should not expect either of these candidates to get everything they are proposing," says Clint Stretch, managing principal of tax policy at Deloitte. Congress "will have its own ideas, and the economic as well as the budget realities of 2009 will shape the new administration's actions." Even so, many taxpayers and investors may find the still-evolving proposals to be useful for planning purposes.

Dueling plans. Both Sen. McCain and Sen. Obama have proposed lower overall taxes, but their plans differ sharply from each other.

Sen. McCain wants to permanently extend the current federal income-tax rates. He also wants to retain the top rate of 15% on long-term capital gains and qualified dividends. He has called for gradually increasing the dependent exemption amount. And he has proposed raising the basic federal estate-tax exclusion to $5 million while cutting the top rate, now 45%, to only 15%. The exclusion, now $2 million, is scheduled to rise to $3.5 million next year. (However, transfers from one spouse to another are typically tax-free.) Sen. Obama would make that $3.5 million exclusion permanent, along with the 45% top rate.

"It's unlikely that Congress will let the full repeal of the estate tax take place as scheduled in 2010," says Mark Luscombe, principal federal tax analyst at CCH, a unit of Wolters Kluwer. Instead, many tax advisers expect a compromise that includes raising the estate-tax exclusion to somewhere in the $3.5 million to $5 million range and cutting the top rate.

Sen. Obama has proposed lower taxes for most taxpayers, but higher taxes for those with the highest incomes. Staffers say his plan wouldn't raise taxes -- including income, capital-gains, dividend and payroll taxes -- on couples with adjusted gross income of less than $250,000 a year or individuals making under $200,000. Sen. Obama has called for raising the top ordinary income-tax rate, now 35%, to 39.6%. He also has proposed raising the current 33% rate to 36%. But he would leave the other income-tax rates unchanged.

For more details of the Obama and McCain tax plans:

* Deloitte: http://www.deloitte.com/us/familiarcallforchange
* Another Deloitte report: www.deloitte.com/tax
* Tax Policy Center: www.taxpolicycenter.org
* Grant Thornton: www.grantthornton.com
* CCH: www.cch.com

Sen. Obama wants to raise the top long-term capital-gains rate on stocks, bonds and other securities (as well as the rate on qualified dividends), now 15%, to 20% for households with income of more than $250,000 or individuals over $200,000. He hasn't said what he would do about the top capital-gains rate, now 28%, on sales of art and collectibles.

He also favors higher Social Security taxes on high-income workers, but not for many years -- and he hasn't disclosed details. He also has called for expanded targeted tax breaks for many groups, including retirees, according to the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution.

The senator says his plan will cut taxes for 95% of workers and their families. That includes new and expanded breaks for many workers, retirees, homeowners, savers and students. On his Web site, he says his plan represents a "net tax cut" since the relief for middle-class families exceeds the revenue raised by his tax increases for upper-income taxpayers.

One big question about the Obama proposals is when they would take effect. Jason Furman, the candidate's economic-policy director, says only that none of the changes would be retroactive to 2008. On the alternative minimum tax, Sen. Obama would "continue the current AMT patch and index it to inflation," says Mr. Furman.

Advisers to the two senators say their candidates generally favor legislation to curb the rapid growth of the alternative minimum tax. Congress appears likely to pass a temporary stopgap measure that would prevent a surge in the number of people hit by the AMT for this year. If Congress doesn't act, about 26 million people will owe more for this year because of the AMT, up from only about four million last year. Sen. McCain "would like to ultimately eliminate it, but it obviously has to be done in a phased fashion," says Douglas Holtz-Eakin, the senator's senior policy adviser.
[Tax Plans Under McCain or Obama] Getty Images

Barack Obama, left, and John McCain.

Total repeal of the AMT is considered highly unlikely, at least anytime soon. Proposals to eliminate the AMT "are politically popular but prohibitively expensive," the new Deloitte report says.

For more details of both plans, see summaries published by several sources, including Deloitte (www.deloitte.com/us/familiarcallforchange), CCH (www.cch.com), the Tax Policy Center (www.taxpolicycenter.org) and Grant Thornton (www.grantthornton.com/pres-tax).

What investors can do now. Some investment strategists, worried by the prospect of big federal budget deficits, expect higher taxes in coming years no matter who wins the White House, especially because the government's historic rescue operation is likely to mean much larger budget deficits. That, in turn, could greatly increase the attractiveness of tax-exempt municipal bonds.

"I think munis look very attractive," says Ed Yardeni, president of Yardeni Research, an investment strategy consultancy based in Great Neck, N.Y. "With the credit crisis, the yields on these securities on a tax-adjusted basis are extremely compelling." He urges investors to focus on high-quality bonds, since many state and local governments have been going through budget woes of their own.

Some high-income investors may be wondering whether to sell stocks that have gone up sharply in value over the years to take advantage of the current 15% capital-gains tax rate. Investment advisers say they're urging investors not to make investment moves solely because of tax reasons. But someone planning to dump a highly appreciated stock soon for investment reasons might consider doing it this year.

Selling this year could be a smart move for an investor with a highly concentrated position in one stock or who owns a private business and was thinking of selling part or all of it soon anyway, says Gregory Singer, director of research for Bernstein's Wealth Management Group in New York, a unit of AllianceBernstein LP.

But in most cases, investors would be well-advised to sit tight and resist the temptation to rush out and make investment moves today based on bets on how the election will turn out or what will happen with taxes next year. Even if it were possible to know the election results, nobody knows when any capital-gains tax changes might become effective or what the new rate will be.

For most people with well-diversified portfolios, the benefit of selling now "is not substantial enough," says Mr. Singer -- unless you're convinced that the capital-gains rate will surge to 25% or higher next year.

Email: taxreport@wsj.com
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Norman Braman's Public Leak on Marlins

Wow, is Norman Braman a sore loser or what? The article in Miami Today, which quotes Mr. Braman, does not specify where the supposed 2003 Florida Marlins pro-forma financial projection was obtained, but only Freddie Mac regulators would be surprised if Braman were not the person behind the leak.

The article suggests that the Florida Marlins are in such bad financial condition that it would be a mistake for local governments to enter into any agreements with them. But the only concrete impression which can be taken from the limited data and sloppy presentation is that someone [Braman] is desperate to convince us of that position. However, not desperate enough to provide all the facts or the pro-forma financial itself. Given the importance of this issue to the community, to present the article as unbiased news was irresponsible. It should have been labeled as a Braman op-ed.

Here's why:

1. Pro-forma financials are hypothetical. The pro-forma may have constituted a worse case scenario -- limited national revenues and high non-player expenses -- designed to convince an investor of the need for capital. So to quote pro-forma losses without addressing the assumptions on which they are based, is at best potentially misleading and at worst, a con job.
   
2. Lack of reliability. What a company may share with a potential investor varies from what it would turn into a bank or file with the IRS. There is no penalty or disincentive associated with inaccuracy, it's the equivalent of no-income verification loan.
   
3. Huge difference between a net loss vs. an operating loss. The article notes a 'net loss' of $66 million in 2003. It is a mistake for outsiders to focus on anything other than operating results, since a 'net loss' is subject to manipulation involving depreciation and other non-cash expenses. That's why Forbes deals with operating results in its annual analysis of MLB's finances. Operating results is the best indicator of how your main business is doing. But let's let David Samson explain - this from a 2004 ESPN article:

Jeffrey Loria has had more experience with write-offs than any recent professional sports owner. Owners typically can deduct player contracts for the first four or five years of franchise ownership. Loria purchased a majority share in the Montreal Expos in 1999, but the clock started over again three years later when he sold the Expos and purchased the Florida Marlins.

"If we had a loss of $60 million on paper, but $20 million in cash, that's a big difference," said David Samson, president of the Marlins, which reportedly lost $20 million last season despite winning the World Series. "But the only number Jeffrey cares about is that actual cash loss. The benefit of depreciation is far outweighed by the reality of cash losses when you are losing money operationally."

4. Sloppy presentation of amounts. Pro-forma team debt of $141 million was stated in the article. However, it was not specified when the debt would have accumulated to that amount. Other parts of the article indicate what equity would have been in 2005 and profits in 2007. Any financial presentation needs consistency to be useful.
5. Source of debt unaddressed. The Marlins were purchased in 2002 for $158.5 million, $120 million of which was the value ascribed to the Montreal franchise which Loria exchanged for the Marlins. The remainder, $38.5 million, constituted a loan from MLB, $15 million of which was conditional on securing a stadium within 5 years. Forbes estimates the Marlins operational profits from 2002 through 2007 as totaling $44 million. Whatever debt may or may not be currently on the Marlins books, none of it can reasonably be ascribed to either the team's purchase value or operating results since 2002.
6. Current performance ignored. As John McCain might say, the Florida Marlins financial fundamentals -- highest revenue sharing recipient and lowest payroll in MLB -- since 2006, are all good. There is no reason to believe that 2008 operating results would not be in the $40 million dollar operating profit range, consistent with the team's operating profits in 2006 [$36 million] and 2007 [$43 million]. When I look at those numbers, I don't see debt. I see a team funding its portion of the new stadium through revenue sharing monies intended for other purposes.
7. Forbes estimates are verifiably accurate and consistently ignored. The way that Forbes estimates are ignored or discounted always amazes me. Let's take 2003. The Forbes estimate of the Florida Marlins losses was $12 vs Samson's self-admitted $20 million operating loss. Pretty close no? But take it a step further, who thinks that Samson would have felt compelled to be exact, or even conservative, in estimating the team's losses to an ESPN reporter? Let's take 2008. Forbes nailed the team's valuation. It would be extremely difficult to get revenues and expenses wrong and be accurate on a valuation. Maybe more credit should go to team president, David Samson, given his interest in movies, for achieving Keyser Söze or Jedi-like deceptions regarding their finances.
8. One undisputed fact. The pro-forma indicated that the Marlins planned to pay below average salaries. Some things just don't change, even on pro-forma financials.

All articles referenced are copied in full at end of post.

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Miami Today week ending 9/25
Florida Marlins' 2003 fiscal projections portray dire need for stadium, huge debt
By Risa Polansky

A 2003 Florida Marlins projection shows a team $141.1 million in debt, with equity declining until it gets a new stadium.

Equity, at the time $28 million, was projected to fall to $7.2 million by 2005.

Marlins officials declined to comment on their 5-year old financials or update details.

The team is in line to put $120 million plus $2.3 million a year rent toward a $515 million ballpark.

Miami-Dade County and the City of Miami are to fund the rest, though a preliminary document shoulders the team with cost overruns up to at least $20 million.

Deal opponent Norman Braman has for months protested that the team could not afford to pay for the deal.

He tried through a lawsuit this summer to have the team's financials made public, but Circuit Court Judge Jeri Beth Cohen wouldn't allow it.

The Marlins asked Mr. Braman to invest in the team in 2003, he said, but he declined.
"They have no tangible net worth, only debt. That was the decision I made not to invest at that time."

The financial pro-forma showed the Marlins at a $66.3 million net loss in 2003.

The Marlins expected losses to shrink over the years and predicted an $8.5 million profit in 2007, the first year they thought they'd be in a new stadium.

The documents reveal also that, in a new ballpark, the Marlins planned to charge above-average ticket prices and pay players below-average salaries.

"Everything should be a concern to the public," Mr. Braman said.

Sports management experts also raised concerns over charging high prices and building a quality team.

"What a stadium does is that it gives you potential revenue," said sports economist Andrew Zimbalist. "You don't get the revenue unless you put people in the seats."
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ESPN.com: Sports Business [Print without images]

Thursday, April 15, 2004
New owners' tax break losing value
By Darren Rovell
ESPN.com

Tax day used to be a sigh of relief for new owners of professional sports teams, but for today's owners recently welcomed into the sporting world fraternity, the reception from Uncle Sam isn't as great as it was decades ago.

Boston Red Sox owner John Henry, along with a group of partners, spent $700 million to purchase the team two years ago and will spend $125 million on a team that hopes to beat the New York Yankees this year. But Henry will not benefit as much from what used to be one of the sporting world's greatest perks -- writing off large portions of player payroll. Had he bought a team 35 years ago, his tax breaks would be worth a fortune.

When a group led by Bud Selig bought the bankrupt Seattle Pilots in April of 1970 for $10.8 million and moved them to Milwaukee, the 35-year-old used car dealer and future Major League Baseball commissioner later reported only a franchise purchase price of $600,000 to the government for tax purposes, attributing $10.2 million of the cost to player payroll.

Bill Veeck
Based on his genius and ingenuity, Bill Veeck was elected into the Hall of Fame in 1991.
The accounting practice was first used by former owner and renowned promoter Bill Veeck, who discovered that a new owner could use the value of the players' contracts in a sale in order to report a lower purchase price when his group bought 54 percent of the Chicago White Sox in 1959. The deduction could then be used to show smaller profits or larger losses on paper, reducing the taxable income.

But in the three decades since Selig bought what would become the Brewers and trucking magnate Leonard Tose led a group to buy the Philadelphia Eagles for $16.4 million -- he reported a $50,000 franchise sale price to the Internal Revenue Service -- the value of writing off the costs of player contracts has been severely diminished, meaning that there's less celebration among new sports owners on April 15.

There are a number of reasons that tax breaks for new owners are less appealing, including higher franchise prices, a greater net worth of owners and government rules that have restricted amortization -- spreading the cost of a contract over time to help reduce future income taxes.

"In the old days, when men were made of steel and ships were made of wood, the teams cost a fraction of a fraction of what they do today and the tax benefits were therefore huge," said Paul McKenney, a lawyer who has advised several sports owners on tax issues. "Now the tax benefits are very minimal."

"It's definitely not a significant motivating factor in purchasing a team," said NBA commissioner David Stern, who has been at the league's helm for the past 20 seasons. "No matter what the tax treatment is, if the team isn't profitable, it can't provide a substantial benefit."

The principal behind the idea that allows a percentage of payroll to be deducted and used to report slimmer profits or inflate losses, is based on the fact that the government considers sports contracts to be an intangible asset. Much like a piece of machinery, whose cost can be written down over a period determined to be its useful life, players also have a useful life value to a sports team, under IRS rules.

Selig and his investors deducted roughly $2 million off the balance sheet from the Brewers and used it to offset the reporting of their personal income for each of the next five years. But in the year after Selig's tax benefits ran out -- write-offs equaled more than $140,000 -- the IRS began limiting the degree to which owners could discount the cost of players contracts to their advantage.

In October 1976, the government unveiled the Tax Reform Act of 1976, which established that no more than 50 percent of the purchase price could be allocated to intangible assets, such as player contracts, unless a rare exemption was granted if an owner provided a reason for exceeding that amount.

The impact was immediate.

Oil investor Robert K. Moses Jr. was reportedly interested in buying the Houston Rockets, but when the deal fell apart, he cited the inability to make the financing package work with a smaller write-off.

In 1986, the IRS added another reform for those looking to become partners in sports teams and use the depreciation value to offset the taxes on their personal business income. In order to do so under the new criteria, owners had to pass one of seven tests that would allow them to be classified as active owners.

"The whole deal shouldn't really exist because owners are not buying the players as much as they are buying the franchise, the rights to the name and the rights to play in the stadium," said Paul Weiler, the Henry J. Friendly professor of law at Harvard and author of "Leveling the Playing Field: How The Law Can Make Sports Better for Fans."

But the tax break has become less of a factor, given the modern state of the business.

"When owners are losing millions of dollars in real money, it's crazy to think that they're fine with it because they are not paying as much tax," said Jeff Smulyan, who owned the Seattle Mariners from 1988 to 1992.

Jeffrey Loria
Despite a World Series title, Jeffrey Loria's Florida Marlins still experienced significant cash losses.

Jeffrey Loria has had more experience with write-offs than any recent professional sports owner. Owners typically can deduct player contracts for the first four or five years of franchise ownership. Loria purchased a majority share in the Montreal Expos in 1999, but the clock started over again three years later when he sold the Expos and purchased the Florida Marlins.

"If we had a loss of $60 million on paper, but $20 million in cash, that's a big difference," said David Samson, president of the Marlins, which reportedly lost $20 million last season despite winning the World Series. "But the only number Jeffrey cares about is that actual cash loss. The benefit of depreciation is far outweighed by the reality of cash losses when you are losing money operationally."

The process of convincing the IRS to even grant the 50 percent deduction became harder when local auditors usually assigned to random projects were replaced by national auditors who specialized in the finances of sports teams, said Carl Fortner, a tax partner on Foley & Lardner's Sports Industry Team, which has counseled several professional team owners on tax issues, including Selig. In October, the IRS sent a 15-page memo to those that audit teams to be aware of the latest government standards as it applied to taxing franchises.

"The IRS has been much less receptive to greater deductions because franchises cost so much these days," said Bob DuPuy, president and chief operating officer of Major League Baseball.

Whereas it used to be automatic that a team owner could attribute a huge chunk of the franchise price to player salaries, team owners now have to hire auditors who determine a true market value for the player's contract instead of the actual dollars being paid to player.

It is that value, according to Fortner, that is shown to the IRS. Unlike decades ago, where owners would simply spread the costs over the first five years of ownership, player contracts in most cases now may be depreciated based on the length of individual contacts. This debunks the theory that new owners are more likely to sell after their fifth year of ownership because the write-off period is longer. Plus, owners are allowed to depreciate other intangible assets, including season ticket waiting lists and suite revenues.

Despite the stress put on cash losses and a more scrutinizing IRS, some say the write-offs still have value.

"The total money for the tax benefit should be increasing in terms of dollars because the salaries have been on the rise for so long," said Scott Rosner, lecturer at the University of Pennsylvania's Wharton School of Business and co-author of "The Business of Sports." "The value is just diminished due to the astronomical wealth of the owners coming into the sport. So the old-guard owner might have saved $2 million in taxes and that meant a lot. The new age owner could be saving $20 million and that's less of a deal."

Ted Leonsis bought the Washington Capitals five years ago and the chance to write-off player salaries from his $85 million purchase of the team is declining. But Leonsis has reportedly lost more than $100 million throughout his ownership reign, so creating larger paper losses won't dull the pain of having to still dole out the cash.

Said Leonsis: "I look forward to the day where (write-offs are) an issue for me."

Darren Rovell, who covers sports business for ESPN.com, can be reached at Darren.rovell@espn3.com.
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washingtonpost.com
Expos for Sale: Team Becomes Pawn of Selig

By Steve Fainaru
Washington Post Staff Writer
Monday, June 28, 2004; Page A01

Second of three articles

SAN JUAN, Puerto Rico -- As the 2002 baseball season approached, Commissioner of Baseball Allan H. "Bud" Selig held a financial stake in two major league teams.

In the National Football League, National Basketball Association or the National Hockey League, even one would have been prohibited. But Major League Baseball has no conflict-of-interest rules preventing the commissioner from owning teams.

Selig had owned the Milwaukee Brewers since 1970. When he was elected commissioner in 1998, he placed his ownership stake in a blind trust, suspended his $316,926 annual salary and announced his withdrawal from the Brewers' day-to-day operations.

Even then, the perception that Selig was still involved would lead to an ugly internal power struggle with the Brewers' president and chief executive officer, who ultimately resigned over the matter last year.

Selig's relationship with the second team was in many ways thornier. His was one of 29 teams that bought the Montreal Expos for $120 million in February 2002 after legal challenges stopped baseball from shutting down the Expos and another franchise. Selig, as commissioner, had personally appointed Montreal's president, general manager and manager shortly after contraction collapsed.

Now, with the club in limbo, he had to figure out what to do with it.

To chart the Expos' odyssey -- from contraction to Puerto Rico, where baseball is renting out the team for 22 "home" games to raise cash -- is to see clearly how Major League Baseball uses its exemption from antitrust laws to control markets and how Selig's dual roles as commissioner and owner create inevitable conflicts.

Selig adopted essentially the same strategy for the Expos that he used to persuade taxpayers in Wisconsin to bail out his financially crippled team.

Baseball would offer the Expos to vacant markets such as Washington, Northern Virginia, Las Vegas and Portland, Ore., but at the same steep price he had set to keep Major League Baseball in Milwaukee: a state-of-the-art ballpark that would cost hundreds of millions of dollars.

With the public paying for the new stadium, private investors would have more money available to pay Major League Baseball for the team. In other words, taxpayers in the bidding cities would be helping the owners, including Selig, recover their Expos investment, which was approaching $175 million.

As he had in Milwaukee, Selig argued that a publicly financed ballpark was the only way to make the Expos competitive. "Is the community's life better [with a new ballpark]? Yes," Selig said. "Can a ballclub build a stadium and survive? No."

Selig's predecessor as commissioner, Fay T. Vincent, was not convinced. "It's hard for me to argue that local governments should be put in position to finance these facilities to help owners who themselves are enormously wealthy," he said. "That's a fairly tough way to run a business. I mean, c'mon."

Selig's strategy depended heavily on baseball's antitrust exemption. Without it, the Expos or another team probably would have simply moved to the District or Northern Virginia. As recently as 1999, for example, Selig had quietly impeded the Expos' then-managing partner, Claude R. Brochu, in his efforts to move to the Washington area, which, excluding Baltimore, is the nation's sixth-largest market.

The Supreme Court ruled in 1922 that baseball was not interstate commerce as defined by the Sherman Antitrust Act, a ruling the Court later called "an aberration." The 1998 Curt Flood Act granted antitrust protection to major league players but codified baseball's immunity on issues related to the "expansion, location or relocation" of franchises.

Without the exemption, Brochu or any other team owner could have moved into the capital region without Selig's permission and despite the objections of Baltimore Orioles owner Peter G. Angelos.

With it, Washington would become a strategic pawn in what former Expos president David P. Samson described as "one of the most insane transactions in sports history."

Samson's stepfather, international art dealer Jeffrey H. Loria, stood up at an owners meeting in January 2001 and threatened to resist if baseball tried to fold the franchise, which Loria had purchased in December 1999. Major League Baseball eventually accommodated Loria by paying him 10 times his original investment, then subsidizing his purchase of the Florida Marlins.

The Marlins' owner, billionaire commodities trader John W. Henry, bought the Boston Red Sox in what Massachusetts Attorney General Thomas F. Reilly called a "bag job" by Selig and Major League Baseball despite the existence of higher bids. Henry and Selig denied the charge, but, to avoid litigation, charities benefiting from the sale received an additional $30 million.

In 2003, Major League Baseball, operating a team over an extended period for the first time, decided to park the Expos in Puerto Rico for a quarter of the team's home games. The venture brought in about $350,000 per team and promoted the "internationalization" of the sport.

The Expos would play 103 road games -- 27 percent more than their competitors. The team traveled 40,951 miles last season. The on-field temperature at 18,000-seat Hiram Bithorn Stadium in San Juan sometimes reached 150 degrees. Announced attendance at a May 20 day game between the Expos and Brewers this year was 8,941; a reporter counted 2,443 fans by hand. When Milwaukee's Scott Podsednik homered in the top of the ninth, the ball clanged loudly against the metal bleachers, then rolled away.

There wasn't a soul to chase it down.
Washington 'in a Class by Itself'

On Oct. 5, 1998, Selig flew to Montreal to meet with the premier of Quebec, Lucien Bouchard.

The trip was a last-ditch effort, arranged by Brochu, to obtain financing for the new ballpark that was critical to the Expos' survival in Montreal. Brochu, a former Seagram's executive, hoped Selig could win over the premier, who a month earlier had turned him down. Selig launched into his standard pitch. In many ways, it was the same one he had delivered repeatedly to get Miller Park built in Milwaukee. The bottom line: Montreal would have to build a new stadium to keep the Expos.

"My government's answer remains the same," the premier responded. "We will not make the funds available. That's final."

The Expos were in a death spiral, but how it happened was a matter of debate. Montreal's main problems seemed to be caused by Major League Baseball itself. A strike shortened the 1981 season, interrupting what could have been five straight seasons of at least 2 million fans. The Expos recovered, but then came the strike of 1994. The club was 34 games above .500 and leading the National League East by six games when play ended on Aug. 12. By the following year Montreal faced a severe financial crisis and began to unload players.

"Montreal, basically, after the strike in '94, abandoned baseball," said Robert A. DuPuy, baseball's president and chief operating officer. "They turned their back on baseball."

Mitch Melnick, the sports director at Team 990, the Expos' flagship English-language station, disagreed. "The fan base was destroyed as the product was destroyed," said Melnick. "I guess this is Major League Baseball's way of wishing the problems would go away: Blame the customer."

Rejected by the local government, Brochu sought out alternatives. He opened secret negotiations with Virginia telecommunications executive William L. Collins III, who since the early 1990s had been trying to bring a team to Northern Virginia.

Brochu had explored several markets, including Portland, Ore., Las Vegas and Charlotte. "Washington always was to me in a class by itself," he said. "The economics, the demographics, the wealth of the area, the population, productivity, disposable income, the number of companies and firms that would be potential supporters -- it was just so far superior to any other location, by a long shot."

A source involved in the discussions said Brochu and Collins reached "an agreement in principle" to move the club to Northern Virginia. But Brochu called the talks "very, very preliminary," mostly because Selig stood in the way.

"I felt the team should have been moved and I told the commissioner that," said Brochu, at the time a member of the Executive Council, the commissioner's cabinet of owner advisers. "I always heard, 'Well, he's thinking it over, he'll review it, he'll know in two more months or six more months.' There was really no decision."

Selig said he wanted to preserve baseball's 31-year streak of not moving teams. He also wanted to address the game's economic problems before considering relocation. "Moving, in this system, what is that going to do?" he said.

Rebuffed from moving and at war with his fellow owners, Brochu stepped down. The search for his successor revealed a lot about the withered state of the franchise.

One of the team's main sponsors, a Mercedes-Benz dealer named Sam Eltes, located one. Eltes' sister-in-law from his first marriage had a son who worked as the financial adviser to Loria, a baseball-loving international art dealer in New York.

Loria had helped bid up the price at a sweaty 1993 bankruptcy auction for the Baltimore Orioles, only to lose to Baltimore attorney Angelos. He had owned the Class AAA Oklahoma City 89ers for four seasons.

Loria was not a typical major league owner. He had made millions dealing in 20th-century sculpture, painting and works on paper. He worked out of an unmarked private office on East 72nd Street in Manhattan. He had written two books: "Collecting Original Art," a primer on collecting with a foreword by his mentor, the late actor Vincent Price, and "What's It All About, Charlie Brown?" a psychological deconstruction of the "Peanuts" comic strip.

"My books! My records! My pool table! My Van Gogh! Sob!" muses Snoopy on the cover of Loria's book as his doghouse goes up in flames.
Action, Contraction

Loria's purchase coincided with preparations for civil war inside the national pastime.

The collective bargaining agreement between owners and players was about to expire. Selig was a veteran of the previous eight negotiations, each of which resulted in a work stoppage and, mostly, defeat for the owners. Selig began to lay the groundwork for battle.

In January 2000, the owners voted to give him full authority to address baseball's economic problems.

Then, in July, Major League Baseball released what it called a landmark report. A "Blue Ribbon Panel" concluded that baseball was no longer fair for teams in small broadcast markets, which could not generate enough revenue to compete.

Exhibit A was the Montreal Expos. The report showed that the team generated less revenue over its entire season than the New York Yankees took in during a six-game homestand.

Don Fehr, executive director of the players' union, called the report "the opening round" of the labor negotiations. Selig had also ramped up baseball's lobbying on Capitol Hill. He hired Baker & Hostetler LLP, the powerhouse Washington law firm. Selig knew that Washington could make or break the negotiations. In the event of a work stoppage, Congress inevitably would use the antitrust exemption as the hook to hold hearings and tear into the commissioner.

The lobbying effort was headed by William H. Schweitzer, a Baker & Hostetler partner who had worked nine years as general counsel for the American League. Schweitzer, a Republican, was joined by a Democrat, Lucy J. Calautti, former chief of staff for Sen. Byron L. Dorgan (D-N.D.) and the wife of Sen. Kent Conrad (D-N.D.).

Schweitzer and Calautti decided to launch the first Political Action Committee of any major sport. "My whole thought was that if you're going to participate in the process, like they said they wanted to, you needed a PAC," said Schweitzer.

Since 2002, the Office of the Commissioner of Major League Baseball Political Action Committee has raised $488,295 -- nearly all of it from baseball owners, officials and their relatives. It has distributed $102,500 to members of the House and Senate Judiciary Committees, which have jurisdiction over antitrust matters.

Major League Baseball has spent $5.045 million on lobbying over the past six years, more than the NFL, NBA, NHL and the Professional Golfers' Association combined, according to federal lobbying disclosure records.

Schweitzer and Calautti bound the Blue Ribbon report and distributed it to every member of Congress. How many people actually read it is unclear, for it contained a startling recommendation: "Franchise relocation should be an available tool to address the competitive issues facing the game," the report stated.

Baseball had used the antitrust exemption to control franchise movement after the Senators left Washington in 1971. Now its own economic panel was concluding that one solution to baseball's economic problems was to break up regional monopolies "occupied by one or more high-revenue club."

The reference was clearly to markets such as New York, where the Yankees and Mets controlled an area of more than 15 million people, and the Washington-Baltimore corridor, the exclusive domain of the Baltimore Orioles.

"If the recommendations outlined in this report are implemented, there should be no immediate need for contraction," the panel added.

Within months of the report's circulation on Capitol Hill, however, baseball initiated plans to shut down at least two franchises.

DuPuy said Major League Baseball chose the more drastic step of contraction because the economic conditions in baseball had worsened considerably.

Inside baseball there was speculation that contraction was a part of the owners' pre-war buildup, a negotiating ploy designed to show the players' union that baseball was prepared to cut at least 7 percent of its work force if it did not gain concessions.

But owners and union representatives said contraction was not a tactic. "Obviously, it was real," wrote Red Sox owner Henry in a lengthy e-mail interview. Henry, whose former team, the Marlins, was a candidate, added, "In any business or industry, if you have companies or divisions that are not making it, you close them."

Richard E. Jacobs, the former owner of the Cleveland Indians, warned Selig: "It's going to be a bloody process. The blood's all going to be yours. Do it anyway."

The process began in October 2000. Selig announced at a Chicago owners meeting that he had asked DuPuy and Paul Beeston, then baseball's president and chief operating officer, to study the ramifications of eliminating franchises.

As the meeting broke up, Samson, the Expos' president, bolted across the room to confront Selig.

"What do you mean: You're contracting the Expos?" Samson asked incredulously.

DuPuy quickly grabbed Samson by the arm to defuse the situation.

"David, we'll talk," he said.

In the spring of 2001, Beeston scrawled a list of candidates on a piece of yellow lined paper and handed it to an aide. The list included the Expos, Minnesota Twins, Toronto Blue Jays, Oakland Athletics, Marlins, Tampa Bay Devil Rays and Anaheim Angels.

Throughout that summer, baseball officials met in the 31st floor executive conference room at Major League Baseball's headquarters at 245 Park Avenue in Manhattan. From the beginning, according to a former baseball official who participated, there were discussions about whether baseball had the legal authority to unilaterally eliminate teams. The contraction meetings were referred to by euphemisms such as "baseball issues" or "ownership issues." Participants sometimes were told not to take notes or to hand in their notes at the end of meetings, said the official, who spoke on condition of anonymity because of an ongoing federal racketeering suit filed by the former Expos limited partners.

Calautti and Schweitzer were asked to attend to help baseball gauge the potential reaction on Capitol Hill. With the Minnesota Twins in the line of fire, Calautti brought up potential objections by North Dakota's Dorgan, her former boss and the ranking Democrat on the Senate Commerce Committee's sub-committee on competition, foreign commerce and infrastructure.

"He's not going to go for that," Calautti warned.

Calautti said she did not recall bringing up Dorgan but said she raised concerns about a number of potential pockets of resistance, including the Minnesota and Florida congressional delegations.

A scheduled meeting for Sept. 11, 2001, at Selig's Milwaukee office was postponed because of the terrorist attacks on New York and the Pentagon. Within two weeks, according to Selig, owners were again clamoring to liquidate franchises. Selig told the owners he would wait until after the World Series.

On Nov. 6, 2001, baseball's owners, meeting in Chicago, voted 28-2 to contract. Only the Expos and Twins opposed.

But lingering in the air was a fundamental question: What about Washington?

"The Washington/Northern Virginia area was obviously very aggressive in pursuing a club, and we'll be very sensitive to their issues as time goes on," Selig told reporters.

Inside Major League Baseball's offices, Washington was an issue that seemed to hover in the air without ever being addressed head on. "It was amazing what a sticky point Washington was," said the former baseball official. "Anytime it got brought up it was like Ralph Kramden and the hummana, hummanas. Almost every time the discussion would eventually come around to, 'What about Washington?' "

Most believed Loria would have jumped at the chance to move the Expos to D.C. or Northern Virginia. "I think he always had his eye on Washington," said a baseball executive who worked closely with him. But that was out of the question. Around baseball, Loria's brief ownership was already viewed with disdain. He had quickly alienated his Montreal partners, which included some of the most influential businessmen in Canada. His stepson, Samson, was widely regarded as abrasive and disrespectful.

The former MLB official said DuPuy, Selig's closest adviser, told him more than once that the chances of Loria getting Washington were nil.

According to the former official, DuPuy conveyed the message, "It'll be over Bud's dead body before he lets that [expletive] have Washington."

DuPuy denied speaking pejoratively about Loria, with whom he said he had a good relationship. But he said the "sentiment" was accurate.
Power Move

Loria, who declined requests to be interviewed for this article, and Major League Baseball were on a collision course.

As the owners moved forward on contraction, Loria was systematically assuming total control over the Expos, the team in baseball's crosshairs.

Loria's plans for the Expos were unclear. When he bought the team, the deal included a critical second step in which Loria would put up an additional $38.8 million toward a new downtown ballpark.

Before the 2000 season, though, he had failed to negotiate a new local television deal and alienated sponsors. Plans for the ballpark evaporated. At the first meeting of the new partnership, Loria's chief financial officer, Joel A. Mael, stunned the limited partners by announcing a possible capital call -- a demand for cash to support operations.

Loria was an absentee owner, commuting from New York while Samson, his then-31-year-old stepson, ran the team. A former private wealth manager at Morgan Stanley with no previous baseball experience, the 5-foot-5 Samson grated on the limited partners, one of whom pushed him into a wall during a meeting. He came to be known around the Expos' offices as "Little Napoleon."

Soon, Loria and the limited partners were at war. After Loria issued a cash call on March 17, 2000, they staged what amounted to a coup. They told Loria they would give him back his $12 million if he would step down.

"They basically put a check on the table and said, 'Bugger off,' " said a source familiar with the meeting. Loria instead initiated another series of cash calls. If the limited partners failed to come up with the money their shares in the team would be diluted. Within 17 months Loria had gone from owning 24 percent of the Expos to more than 93 percent.

Asked why the partners failed to meet the cash calls, their lawyer, Jeffrey L. Kessler, said, "All they knew was that this was a destroyed team" run "by a general partner who they thought was totally out of control. . . . It was impossible for any sane investor, and Loria knew that." The move gave Loria the power to do basically whatever he wanted with the team.

But Major League Baseball had its own designs on the Expos. It wanted to buy out Loria and shut down the franchise, redistributing tens of millions of dollars in broadcast and licensing revenue, as well as millions of dollars the Expos received each year in revenue sharing.

Loria informed the owners he wasn't going anywhere. In January 2001, he stood up at an owners meeting in Phoenix and read an impassioned statement vowing to resist to stay in the game he loved. The drumbeats continued through the summer. "They were threatening us with a New York litigator virtually every conversation we had," said DuPuy.

The message: Loria would file an antitrust suit if Major League Baseball tried to muscle him out.
Shuffling Clubs

The "pushback" from Congress that Calautti and Schweitzer had predicted was fierce. Within a month, the House Judiciary Committee held a hearing that quickly turned ugly. Selig, slight and ashen, was seated next to Jesse Ventura, the former Navy SEAL turned professional wrestler turned governor of Minnesota.

Ventura accused baseball of seeking to extort a new ballpark from his state by threatening to shut down the Twins.

"Major League Baseball is really no different than OPEC; it controls supply and it controls price with absolutely no accountability," said Ventura.

Baseball struggled to find a way to placate Loria and shut down two teams. The process began to resemble real-life Monopoly, with baseball's powerbrokers bartering teams behind closed doors, unbeknownst to their millions of fans.

Under one scenario, Athletics owner Steve Schott would relocate his entire franchise -- including the players and front-office staff -- to Anaheim. Oakland would effectively dissolve and take over the Angels' territory in Orange County.

Under another, Loria was to move the Expos to Tampa Bay, where the Devil Rays would be folded. Under still another, Marlins owner Henry would fold his team and buy the Angels from the Walt Disney Co.

Henry emerged as the fulcrum around which baseball would bring order. The commodities trader was widely respected as a brilliant, honest broker who loved baseball and wanted to stay in the game -- just not in Miami.

As with most teams in line for contraction, the need for a new ballpark was the central issue in south Florida. Henry, who bought the club in 1998, had tried unsuccessfully for three years to get public financing. On April 25, 2001, Selig wrote a letter to the Florida legislature warning that the eight-year-old Marlins would be moved or eliminated if no stadium was secured. "Bluntly, the Marlins cannot and will not survive in south Florida without a new stadium," Selig wrote.

State Sen. Kendrick Meek, a Miami democrat, told the Miami Herald, "It sounds like Johnny Soprano writing that letter, trying to threaten and put pressure on us."

That summer Henry informed Selig he planned to sell. Selig asked him to stay in baseball. After his Angels bid fell apart, Henry contacted former Orioles president Larry Lucchino, who was now involved in a bid to purchase the Boston Red Sox.

"We're dialing for dollars," Lucchino told him. Henry asked if he could join forces.

For Major League Baseball, the timing could hardly have been more fortuitous. Henry, Lucchino and a third partner, television executive Thomas C. Werner, all were close with Selig and had impeccable reputations; in a sense, the group had been pre-approved. Henry denied the deal was a "bag job," as the Massachusetts attorney general alleged.

As baseball shuffled its deck of clubs, Loria found himself holding a flush. Spring training was weeks away. Henry's purchase of the Red Sox was predicated on selling the Marlins. After weeks of negotiation, baseball paid Loria $120 million -- a 900 percent return on his original Expos investment -- plus a $38.5 million loan tied to several conditions, including Loria's ability to get a stadium in south Florida.

On their way out of Montreal, Loria and Samson stripped the franchise. With them went computers containing scouting reports on every Expos player, dozens of signed home run balls, even life-size cutouts of the team's former superstar right fielder, Vladimir Guerrero. The Expos' limited partners, meantime, became unwitting owners of 6 percent of the Marlins. In July 2002, they filed a racketeering suit in U.S. District Court in Miami. It charged Loria, Samson, Selig, DuPuy and the Office of the Commissioner of Baseball of illegally conspiring in what the suit called an "Expos Elimination Enterprise."

The ongoing suit could complicate baseball's plans for the Expos. The limited partners have 90 days to seek an injunction if baseball tries to move the team.

Last October, Loria's Marlins miraculously found themselves in the World Series against the New York Yankees. "Can you imagine?" anguished one of the limited partners. "I'm sitting here. I'm an owner of the Florida Marlins. I'm rooting for the Yankees!"

And then, of course, the Marlins won.

This spring, nearly all the limited partners received World Series rings, even as they continued to sue Loria and Major League Baseball for racketeering in U.S. District Court.
A 'Prime' Indication

The day after the Red Sox deal was announced in Phoenix, Selig came to a news conference beaming. The previous weeks had been filled with criticism about contraction, questions about conflicts of interest and editorials calling for Selig's resignation.

But, behind closed doors at the Arizona Biltmore Resort & Spa, the owners who had elected Selig commissioner and paid his salary stood behind him. "These were the best two days I've had in a long time. Make of that what you will," he told reporters.

And then, in the middle of the news conference, Selig was asked where Washington fit in to baseball's baffling jigsaw puzzle. Would the nation's capital finally get a team?

Perhaps Selig's mood got the better of him. "I'd have to say that given the demographics of the area and all the people who want it, they are the prime candidate," he said.

Relocation, Selig said on Jan. 17, 2002, was coming "in the near future."

Staff researchers Julie Tate and Margot Williams contributed to this report.

© 2004 The Washington Post Company
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On The Cover/Top Stories
Hardball
Nathan Vardi, 04.26.04

Jeff Loria has outmaneuvered foes in two countries and on the baseball diamond. Now he's trying to pull off a clean sweep.
When Florida Marlins owner Jeffrey Loria arrived at the team's spring training ballpark, the fans treated him like a conquering hero. They clamored for his autograph and a look at his 120-gram championship ring (240 diamonds, one with a rare teal hue, and 12 rubies) and to thank him for not dismantling their World Series champs as billionaire Wayne Huizenga did a few years ago.

Baseball has never seen an owner quite like Loria. The 63-year-old art dealer has shrewdly turned a relatively small investment into a potential windfall--and made more enemies than George Steinbrenner. Even now Loria is fighting his former partners (who are suing him), grabbing for controversial tax breaks and maneuvering to get all sorts of help from Major League Baseball. But he is always steps ahead of the competition both off the field and on it. "The so-called experts still don't think we can win," says Loria, watching his team play the St. Louis Cardinals from behind home plate. "It's fine for them to dismiss us again."

Baseball and dealmaking are in Loria's blood. His attorney father twice pitched to Lou Gehrig while in high school and regularly took young Loria four subway stops from home to Yankee Stadium. Loria won a city championship in high school, playing second base. He majored in art history at Yale and later hooked up with actor Vincent Price, hired by Sears, Roebuck to hawk art to the masses. In the 1960s Loria was Sears' youngest buyer. While the venture fizzled, he turned the experience into Jeffrey H. Loria & Co., buying and selling works by the likes of Léger and Picasso for an Upper East Side Manhattan clientele.



By the late 1980s Loria had turned his attention to baseball. He bought the Oklahoma City 89ers, the AAA club of the Texas Rangers, for $3.8 million in 1989, won a championship and sold the team for $8 million in 1993. In the 1990s he tried unsuccessfully to buy major league clubs, first in Montreal, then in Baltimore, where he lost a bankruptcy auction for the Orioles to trial lawyer Peter Angelos.

His break came in 1999. The partnership that owned the moneylosing Montreal Expos was without a managing partner, and the 11 Canadian limited partners, including telecommunications giant BCE and the investment bank BMO Nesbitt Burns, were looking for outside investors. They turned to Loria, who wangled a 24% stake for $12 million and became managing partner. Stephen Bronfman, a member of one of Canada's richest families, and Canadian billionaire Jean Coutu hopped on board, too.

Loria says he nearly doubled payroll to $31 million, which led to increasing losses. He then initiated capital calls on the other owners in 2000 and 2001 to fund rising operating expenses. When they chose not to meet those calls, Loria funded them himself with about $18 million. That triggered a clause in the partnership agreement that allowed him to dilute the interests of other owners down to 6%. Loria thus gained 94% of the Expos for roughly $30 million. He would soon sell the team for four times that amount.

And enrage his limited partners. They refused to meet the capital calls, they allege in a federal suit, because Loria "misrepresented important facts in an effort to destroy Major League Baseball in Montreal." They cite his decisions to pull the Expos off local radio and TV (lousy deals, says Loria) and to stop free tickets to sponsors. They also claim he torpedoed plans for a new stadium for which they'd secured real estate, $5 million a year from the Quebec government to cover interest on a planned $67 million bond and $8 million in annual tax relief. Irrelevant, says Loria's lawyer, since there's nothing about the stadium in the contract.

The federal suit additionally claims that Loria conspired with Baseball Commissioner Allan (Bud) Selig, who is also a defendant, to take control of the team and move it to another city. After Selig decided to eliminate the Expos and the Minnesota Twins in 2001 in order to apply pressure on players in labor negotiations, the commissioner agreed to provide another team to Loria, who had threatened to sue Major League Baseball if he lost his team. No evidence of a conspiracy, says Loria's lawyer.

In any event, the Canadian partners will have a tough time winning the case. Loria appears to have operated within the boundaries of his contract with them. Indeed, he has already convinced a federal judge in Miami to stall the suit and have an arbitration panel in New York hear the case this May, per a stipulation in the partnership agreement. The contract also permitted Loria to increase player salaries and contained provisions for the Expos to be sold or relocated. Loria says the Canadian partners were simply unwilling to invest in the Expos.

Loria ended up in south Florida thanks to Selig and John Henry, a hedge fund manager. At the same time the situation in Montreal was deteriorating, the Boston Red Sox were put up for sale. Henry was interested, but he already owned the Marlins (no owner is allowed to control more than one team), so Selig arranged for Loria to swap the Expos for the Marlins. The deal called for baseball's other owners to buy the Expos for $120 million from Loria, who agreed to pay $158 million for the Marlins. The balance would come from a $38 million interest-free loan made to Loria by baseball's owners--a debt that will be reduced by $15 million or so if Loria can't get a new stadium.



Clever move, since it pushes other owners to side with Loria, whose support he would need to move the Marlins, if he can't get a new ballpark in south Florida. No wonder, then, that St. Louis Cardinals principal owner William DeWitt Jr. greeted Loria at a recent spring training game with the question, "How are things going with the stadium?"

The 2002 swap still nearly collapsed because the $700 million Henry and his partners bid for the Red Sox and 80% of its cable network was less than packages put together by cable billionaire Charles Dolan and New York lawyer Miles Prentice. The Massachusetts attorney general, concerned that "Major League Baseball was calling the shots," only dropped his intervention after Henry arranged for the charity that owned most of the team to get an extra $30 million.

Loria still remembers being pilloried after the Marlins ran out of hot dogs on opening day in 2002, six weeks after he took control of the team. But he soon started to make decisions that would lead to a World Series victory. While some low-revenue teams, like the Kansas City Royals, pocket the money they get from the league's revenue-sharing system, Loria used the $20 million or so a year he got from rich teams like the Yankees to hike the Marlins' payroll by 49% in his first two seasons to $52 million. He used the money to sign stars like catcher Ivan Rodriguez. "I didn't sit on my wallet," says Loria.

Amid much criticism he hired 72-year-old Jack McKeon as manager, even though McKeon had trouble at first remembering Loria's first name was not Jerry. Loria rightly thought McKeon, who'd been out of baseball for two years, could turn around the then-slumping Marlins as he once did with teams in Cincinnati and San Diego. Loria also took a gamble by not unloading salary by trading away expensive players before the 2003 trading deadline in July, despite the Marlins' unsure playoff chances.

Loria watched his Marlins win the World Series from his season ticket box seats at Yankee Stadium last fall. After game six he rounded the bases and, thinking of his late father, broke into tears crossing home plate. "To the extent that the Canadians thought I did not know how to run a baseball team," Loria says, "I guess the record speaks for itself." But will the victory help him in arbitration with his unhappy partners? Loria has offered them championship rings--they do own a sliver of the Marlins, after all. Twelve of 14 have accepted.

The World Series success, Loria says, also netted an extra $6 million. The victory certainly helped bump up the value of the Marlins this year by 27%, according to our calculations, to $172 million. Even accounting for the $37 million Loria says he has put into the team for working capital, he is still about $100 million ahead of where he started in baseball (not counting any exposure from the lawsuits). Presumably, he can also put the team's current losses to good use, offsetting income from his art business.

But for the series victory to really pay off, Loria and the Marlins need a new stadium. His plan is to build a $325 million ballpark somewhere in south Florida, with air conditioning and a retractable roof. This is supposed to happen by opening day in 2007. The new venue would give a boost to attendance, which, despite a 60% gain last year to 1.3 million, remains third worst in the business. The team currently plays in Pro Player Stadium, a football field owned by Huizenga that has fans sitting far away from the action on the field and suffering humidity and rain delays in the summer. A new park would also get the Marlins out of one of the most onerous leases in baseball. The team pays about $2 million a year in rent and other ballpark expenses but gets none of the revenue from luxury suites and only 37% of the parking take.

Will the state build it? Loria is committing $137 million from sources he declines to specify and has set a May 1 deadline to line up public financing for the rest. So far he has convinced Miami-Dade county to put up $73 million, leaving a $115 million gap. Florida Governor Jeb Bush is on board for a $60 million state sales tax rebate over 30 years for the Marlins, but the state senate is cool to the idea.

There is some urgency. Despite its championship the Marlins had $12 million in operating losses last season. "It's not okay when you write checks each year for $15 million--it's painful," Loria says. "I am not willing to continue to lose money forever."

But certain things are sacrosanct. Loria hasn't raised season ticket prices this year, becoming the first owner in years not to exploit fans after his team has won it all. And he's holding on to many of the team's best players--with a catch. Local hero Mike Lowell, a third baseman, agreed to a four-year $32 million contract that could be reduced to two years and $14 million if no stadium deal is reached by November. "They are using my face to help get a stadium, and I think that's legitimate," says Lowell.

Taxpayers won't chip in for the stadium? Loria might take his ball and go elsewhere.
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Rescue Plan as Viewed by Economists

Forget Congress for now, whatever emerges there is a compromise of the least objectionable ideas. I'm curious about how the intelligentsia views what is occurring. The most respected university in economics is the University of Chicago. Economists there took the leading in sending out a letter of caution - see below. The letter was signed by hundreds of economists across the country, including Dhananjay Nanda from the University of Miami.

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

I'll do a roll call of where other leading economists stand on the initial Paulson plan:

Bruce Bartlett - supports:

You can see the fear in Treasury Secretary Henry Paulson's eyes and in those of Federal Reserve Chairman Ben Bernanke. But they dare not say how critical the situation is - lest it shake confidence and make matters worse.

This is not to say that the administration's plan is the best we could do. But now is not the time to come up with something better. There is no time. The program can be revised later, when the emergency is past. For now, everyone should hold their noses and vote "yes" on the bailout.

Gary Becker - supports:

Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.

Richard Epstein - rejects:

One bad regulatory turn leads to another, and lo, the bailouts come thick and fast. At the nth hour, wise heads often rightly conclude that some desperate measure has to be taken to prevent the financial disintegration brought on by, well, prior government regulation. Those bailouts, of course, come from the hides of taxpayers who borrowed prudently. The entire system subsidizes destructive behavior, which means that we will get more destructive behavior in the future. We might as well sell flood insurance at bargain prices in Galveston, Texas, and New Orleans.

Paul Krugman - supports:

The fundamental problem in the financial system is too little capital; bizarrely, the Treasury chose not to address that problem directly, by (say) purchasing preferred shares in financial institutions. Instead, the plan is premised on the belief that toxic mortgage-related waste is underpriced, and that the Treasury can recapitalize banks on the cheap by fixing the markets’ error.

So is it better to have no plan than a deeply flawed plan? If it was the original Paulson plan, no plan is better. Dodd-Frank-Paulson may just cross the line — let’s see what details we have if and when agreement is reached [weasel alert].

Joker in Dark Knight - rejects:

Treasury proposal not serious, let's blow it up. See video.

Steven Landsburg - rejects:

What's clear is that a bunch of financial institutions have made mistakes and lost money. What's unclear is why anyone (other than the owners and managers) should care. People make mistakes and lose money all the time. Restaurants fail, grocery stores fail, gas stations fail. People pick the wrong stocks, they buy the wrong cars, and they marry the wrong spouses without turning to the Treasury for bailouts.

So what's special about banks? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt.

Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other.

Greg Mankiw - supports:

Ben Bernanke is at least as smart as any of the economists who signed the [see above] letter or are complaining on blogs and editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics.

Richard Posner - supports:

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.

Nouriel Roubini - rejects:

The Treasury plan (even in its current version agreed with Congress) is very poorly conceived and does not contain many of the key elements of a sound and efficient and fair rescue plan.

Specifically, the Treasury plan does not formally provide senior preferred shares for the government in exchange for the government purchase of the toxic/illiquid assets of the financial institutions; so this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the firms; with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.

Robert Samuelson - supports:

But the biggest unknown lies elsewhere. What happens if Congress doesn't approve the plan, or something like it? Zandi, a supporter, argues that the economy will get much weaker, that many more banks and financial institutions will fail, and that the rise of joblessness will be greater, as will the fall in tax revenue and the increase in unemployment insurance and other government payments. Is this scare talk or a realistic threat? The true cost of Paulson's plan hangs on the answer, and if the danger is real and imminent, then the cost of doing nothing would be far greater.

All posts referenced are copied in full at end of post.

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The Crisis of Global Capitalism? -- Gary Becker

On Sunday of this past week Merrill Lynch agreed to sell itself to Bank America, on Monday Lehman Brothers, a venerable major Wall Street investment bank, went into the largest bankruptcy in American history, while Tuesday saw the federal government partial takeover of AIG insurance company, one of the largest business insurers in the world. Instead of calming financial markets, these moves helped precipitate a complete collapse on Wednesday and Thursday of the market for short-term capital. It became virtually impossible to borrow money, and carrying costs shot through the roof. The Libor, or London interbank, lending rate sharply increased, as banks worldwide were reluctant to lend money. The rate on American treasury bills, and on short-term interest rates in Japan, even became negative for a while, as investors desperately looked for a safe haven in short term government bills.

The Treasury" extended deposit insurance to money market funds-without the $100,000 limit on deposit insurance. The Fed also began to take lower grade commercial paper as collateral for loans to investment and commercial banks, and the Treasury encouraged Fannie Mae and Freddie Mac to continue to purchase mortgage backed securities.

Is this the final "Crisis of Global Capitalism"- to borrow the title of a book by George Soros written shortly after the Asian financial crisis of 1997-98? The crisis that kills capitalism has been said to happen during every major recession and financial crisis ever since Karl Marx prophesized the collapse of capitalism in the middle of the 19th century. Although I admit to having greatly underestimated the severity of this financial crisis, I am confident that sizable world economic growth will resume under a mainly capitalist world economy. Consider, for example, that in the decade after Soros' and others predictions of the collapse of global capitalism following the Asian crisis in the 1990s, both world GDP and world trade experienced unprecedented growth. The South Korean economy, for example, was pummeled during that crisis, but has had significant economic growth ever since. I expect robust world economic growth to resume once we are over the current severe financial difficulties.

Was the extent of the Treasury's and Fed's involvement in financial markets during the past several weeks justified? Certainly there was a widespread belief during this week among both government officials and participants in financial markets that short-term capital markets completely broke down. Not only Lehman, but also Goldman Sachs, Stanley Morgan, and other banks were also in serious trouble. Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.

Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments. Although the media has amde much of this possibility through headlines like "$750 billion bailout", that magnitude of loss is highly unlikely as long as the economy does not fall into a sustained major depression. I consider such a depression highly unlikely. Indeed, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many saving and loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, there may be a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvements were wise, but the likely losses to taxpayers are being greatly exaggerated.

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

Various other mistakes were made in government actions in financial markets during the past several weeks. Banning short sales during this week is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger". Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.

Potential political risks of these actions are also looming. The two Freddies should before long be either closed down, or made completely private with no governmental insurance protection of their lending activities. Their heavy involvement in the mortgage backed securities markets were one cause of the excessive financing of home mortgages. I fear, however, that Congress will eventually recreate these companies in more or less their old form, with a mission to continue to artificially expand the market for mortgages.

New regulations of financial transactions are a certainty, but whether overall they will help rather than hinder the functioning of capital markets is far from clear. For example, Professor Shimizu of Hitotsubashi University has recently shown that the Bank of International Settlement (BIS) regulation on the required minimum ratio of bank capital to their assets was completely misleading in predicting which Japanese banks got into trouble during that country's financial crisis of the 1990s. Other misguided regulations, such as permanent restrictions on short sales, or discouragement of securitization of assets, will both reduce the efficiency of financial markets in the United States, and they will shift even larger amounts of financial transactions to London, Shanghai, Tokyo, Dubai, and other financial centers.

Finally, the magnitude of this crisis must be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25 percent unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. American GDP so far during this crisis has essentially not yet fallen, and unemployment has reached only about 61/2 percent. Both figures are likely to get considerably worse, but they will nowhere approach those of the 1930s.

These are exciting and troubling economic times for an economist-the general public can use less of both! Financial markets have been seriously wounded, and derivatives and other modern financial instruments have come under a dark cloud of suspicion. That suspicion is somewhat deserved since even major players in financial markets did not really understand what they were doing. Still, these instruments have usually been enormously valuable in lubricating asset markets, in furthering economic growth, and in creating economic value. Reforms may well be necessary, but we should be careful not to throttle the legitimate functions of these powerful instruments of modern finance.
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The Financial Crisis: the Role of Government -- Richard Posner

I agree with Becker that capitalism will survive the current financial crisis, even if it leads to a major depression (which it may not). It will survive because there is no alternative that hasn't been thoroughly discredited. The Soviet, Maoist, "corporatist" (fascist Italy), Cuban, Venezuelan, etc. alternatives are unappealing, to say the least. But capitalism may survive only in damaged, in compromised, form--think of the spur that the Great Depression gave to collectivism. The New Deal, spawned in the depression, ushered in a long era of heavy government regulation; and likewise today there is both advocacy and the actuality of renewed regulation. I would like to examine the possibility that government is responsible for the current crisis; for if it is, this would be a powerful intellectual argument against re-regulation, though not an argument likely to have any political traction.

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.

It should be noted that because of the enormous rewards available to successful financiers, the financial industry attracted enormously able people. It was not a deficiency in IQ that produced the crisis.

Becker makes incisive criticisms of the government's responses to the crisis. He points out that those responses create moral hazard, specifically a bias toward financing enterprise by bonds rather than by stock because the government's bailouts are limited to the bondholders and other creditors; create additional moral hazard because the responses include extending government insurance of deposits to money market funds; impede hedge funds by forbidding short selling, which enables the funds to hedge their risks; reduce information about stock values (another consequence of forbidding short selling); increase regulation of financial markets, which will carry with it the usual heavy costs of heavy-handed regulation; blur the role of the Federal Reserve Board by increasing its powers and duties; and increase the federal deficit.

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.

It is true that the top financial officials of our government have usually come from the financial industry or academia. The difference is how recently Bernanke and especially Paulson were appointed, how heavily they are relying on financial experts from the private sector rather than on civil servants, and how small a role the politicians in Congress and the White House have played in shaping the response to the crisis.

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.
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