Question: Is there a governmental responsibility to bail out sub-prime borrowers?
David Frum: In this financial crisis we're seeing, one of the big conflicts you have in the world of finance is between your long term and your short term needs. We have no responsibility to bail out short term borrowers. We have no responsibility to bail out sub-prime borrowers and we certainly have no responsibility to bail out sub-prime lenders.
The problem is we may have no choice.
That there is this old joke how, if you owe ten dollars, you have a problem; whereas if you owe ten billion dollars, the lender has a problem.
And that is sort of the situation that the Federal Reserve and Ben Bernanke face. And so they have been doing a lot of things, like the bail out of Bear Stearns that probably, if you ask them in the abstract, "Would you ever want to do this?" they all would answer, "No, no, this is terrible policy."
But when you think of the alternative to this terrible policy error is some kind of unpredictable explosion, you tend to do things that you have a feeling maybe you shouldn't do.
Question: Why bail out corporations instead of lenders?
David Frum: But the reason they bail out the lenders, we have been through this with many previous financial crises. Maybe the precedent that's most relevant here was the bailout of the hedge fund in the 1990s called Long Term Capital Management.
This was a hedge fund that had developed some very sophisticated financial instruments that allowed them, with some hundreds of millions of dollars in capital, to control tens of billions of dollars in debt. And then they couldn't meet their obligations. And then there was this panic, because if they started calling their loans, if they weren't able to pay their obligations, it would set off like one these chains of firecrackers you see on a Chinese New Year that would just ricochet around the whole planet, destroying all kinds of financial institutions--because the world is wrapped in a network of interlocking commitments and if any large number of those commitments fail, many more fail along with it.
Just think about your own situation. If the people who owe you money tell you they're not going to pay, there are a lot of people to whom you owe money that you are now not going to be able to pay, and so it goes.
And so central banks mesmerized by the terrible disasters of not only the Great Depression, but what happened in the 1980s in Japan, when Japan was stuck in a kind of one-country Great Depression all of its own, they know that the best and easiest way to deal with these kinds of problems is to prevent them from arising. And so when you have a large financial institution that can't pay its bills, they tend to step in, not because they have any affection for that institution, but because they're terrified of what might happen. And also because modern financial instruments are so complicated, that when you take over a Long Term Capital Management or Bear Stearns, you simply don't know what is buried in the vaults. What kind of explosive equipment they have down there, metaphorically, obviously.
So that's what happened with Bear Stearns, is that Bear Stearns had all these very complicated financial instruments and the Federal Reserve of New York was terrified that if Bear Stearns failed, and people took it over, and they began calling these instruments, it could set off a chain reaction of unimaginable, unknowable proportions. And so they end up, very much against their better judgment, bailing them out.
Now, they tried to impose a punishment on them by trying to bail them out at a price where people who had a hundred million dollars on Tuesday, now on Thursday have three million dollars. It's still three millions dollars; it's better than nothing; but many of the owners of Bear Stearns did take a big financial hit.
Question: What the difference between a player like Bear Stearns and an individual?
David Frum: Okay. Let me give you an analogy. You're the fire department and there's a fire in your town and you have to make a choice about where you're going to direct your fire engines.
Over on one side are a string of humble little cottages owned by hard working people who've earned their prosperity and for whom the house represents everything in the world. On the other side is a giant warehouse owned by some faceless corporation, owned by very rich people, and it's full of explosives.
And you have to stop the fire in one place of another. Now, there's a kind of moral sense, a kind of social sense, where you say, "Let me save the homes of all the little people." If the fire consumes that big warehouse there's going to be just a 10 kiloton explosion in the center of your town. And so reluctantly you say I have to deal not with the most deserving claimants but with the potential for greatest catastrophe, and so all the fire engines go to the big warehouse full of explosives because that's where the worse damage could occur.
And that is a little bit about what tends to happen in these financial bailouts; that the energy, the effort, the bailout goes not to necessarily the deserving people, although I'm not saying the sub-prime borrowers are so deserving, but not to the people with the neediest situation, not to the people with the greatest moral claim, it is to the place of greatest danger.
Recorded on: May 5 2008