The Meltdown Lowdown (No. 14)

This week in economic news: McCain's offshore drilling plan is designed to support his campaign, not lower gas prices, and bailing out Fannie and Freddie could cost $100 billion.

Perhaps McCain Wants to Try Drilling in Your Toilet to Bring Down Gas Prices?

Senator McCain has decided to make drilling for oil in protected offshore areas one of his key points of difference with Senator Obama. He argues that drilling in these areas is necessary to increase the supply of oil, which will then push gas prices down from their current $4 a gallon level.

There is one big problem with this story. There is very little oil in the protected offshore areas. According to the Energy Information Agency, if we allowed drilling in the offshore areas now protected it would only increase world production by about 0.2 percent (we have a world oil market, so prices depend on global supply and world demand). This increase in production would be too small to have a noticeable impact on oil prices. So when McCain is saying that he wants to open up environmentally sensitive areas to oil drilling, it has nothing to do with bringing down the price of oil.

Why then the urge to drill? It is possible that this position will help him gain support from some oil companies that hope to profit from drilling in these areas. There may not be very much oil there, but it can still make for some nice profits.

There is an alternative explanation. Focus groups may show that the voters will support someone who places low gas prices above protecting the environment. Therefore, McCain wants to be seen as the candidate who is prepared to take environmental risks to bring down the price of gas, while Obama is an elitist environmental who doesn't care that Joe Sixpack has to pay $120 to fill-up his pickup truck. In fact, McCain has already run TV ads to this effect.

Even though McCain's drilling agenda actually has nothing to do with the price of gas, he likely bet that the media would never be so rude as to point this fact out to the public. Thus far, McCain is winning that bet.

What Is Wrong With Shorts, Naked or Otherwise?

The latest enemy of the economy and all right-thinking people is the “naked short.” The Securities and Exchange Commission (SEC) banned naked shorts on 19 financial sector stocks last week, ostensibly to prevent speculation from driving down their prices.

A quick Wall Street refresher course: A short sale is when an investor arranges with a brokerage firm to sell shares in a company that she does not actually own. She then commits to buy back the shares at a future point in time. If the stock falls in price, then she buys back the shares at a lower price, and pockets a profit.

A naked short takes place when the investor carries out the short without contracting with anyone currently holding the stock. Such a contract, in a standard, or non-naked short, would obligate the stockholder to sell the stock to the short seller whenever the shorter is prepared to buy.

In reality, a naked short is not hugely different from a covered short. It is simply a convenience. It is easier to carry through shorts without making the covering arrangement with a current stockholder. In this sense, it is comparable to buying stock on the margin, where the investor borrows money from the brokerage to pay for part of the value of the stock purchase.

Back in the recent stock bubble days many people advocated raising the margin requirement set by the Fed as a way of curtailing irrational exuberance. Greenspan wasn't interested; he thought it best to leave the market to work itself out.

This raises the question of why regulators have suddenly lost confidence in market outcomes. If we were prepared to live with irrational exuberance, why shouldn't we be prepared to live with irrational pessimism?

And who says that the pessimism is irrational? Has the SEC done an analysis showing that the 19 protected stocks are undervalued? If so, the SEC could probably do more to raise their share prices by making this analysis public than by restricting short sales.

Of course, if the stocks are not undervalued, then the SEC would have temporarily acted to boost the stock price, providing investors an opportunity to sell and recoup some of their losses. There is no obvious public benefit in this situation, but the folks who hold large amounts of stock in the protected 19 would likely be thankful.

The Price Tag for Bailing Out Fannie and Freddie

The Congressional Budget Office, which missed both the housing bubble and the stock bubble says the bailout of Fannie Mae and Freddie Mac will cost approximately $25 billion and that there is probably a better than 50 percent chance that the mortgage giants won't actually need to be bailed out.

My guess is that the price tag will be close to $100 billion. A lot of bad mortgage debt will show up in the next two years -- in many cases these mortgages are not even in trouble now, but they almost certainly will be in the future as homeowners owe far more than the value of their home. When it comes to meltdown from the bubble, we are still in the early innings.

And, What Does the Public Get for a $25 Billion Bailout?

That's what many of us would like to know. As I wrote last week, at the top of my list would be a strict cap on executive compensation of $2 million. That $2 million must include everything: salaries, bonuses, stock options, life insurance, personal use of corporate jets, etc. The authority figures at the Fed, in the Bush administration, and in Congress all seem intent on just handing over the money, no questions asked. Given the astounding failure of Fannie and Freddie, it is appropriate that many questions be asked.

Basically, Fannie and Freddie are facing bankruptcy because of the incredible incompetence of their management in failing to recognize the housing bubble (following the housing market is all they do). If they recognized the housing bubble, they would have refused to buy loans that were used to buy houses at bubble-inflated prices. This would have prevented the meltdown that they are now experiencing. It also would have likely prevented the bubble from rising to such dangerous levels, because it would have choked off a major source of capital.

Instead of being fired for their very costly incompetence, the Fannie and Freddie managers want the government to bailout their companies and keep paying their paychecks. It's nice work if you can get it.

You need to be logged in to comment.
(If there's one thing we know about comment trolls, it's that they're lazy)

Connect
, after login or registration your account will be connected.
Advertisement