Joseph Stiglitz, "A better bailout," The Nation, September 26, 2008.

The banks will pass on their lousiest mortgages. Joseph Stiglitz

The champagne bottle corks were popping as Treasury Secretary Henry Paulson announced his trillion-dollar bailout for the banks, buying up their toxic mortgages. To a skeptic, Paulson's proposal looks like another of those shell games that Wall Street has honed to a fine art. Wall Street has always made money by slicing, dicing, and recombining risk. This "cure" is another one of these rearrangements: somehow, by stripping out the bad assets from the banks and paying fair market value for them, the value of the banks will soar.

There is, however, an alternative explanation for Wall Street's celebration: the banks realized that they were about to get a free ride at taxpayers' expense. No private firm was willing to buy these toxic mortgages at what the seller thought was a reasonable price; they finally had found a sucker who would take them off their hands--called the American taxpayer.

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There are four fundamental problems with our financial system, and the Paulson proposal addresses only one. The first is that the financial institutions have all these toxic products--which they created--and since no one trusts anyone about their value, no one is willing to lend to anyone else. The Paulson approach solves this by passing the risk to us, the taxpayer--and for no return. The second problem is that there is a big and increasing hole in bank balance sheets--banks lent money to people beyond their ability to repay--and no financial alchemy will fix that. If, as Paulson claims, banks get paid fairly for their lousy mortgages and the complex products in which they are embedded, the hole in their balance sheet will remain. What is needed is a transparent equity injection, not the non-transparent ruse that the administration is proposing.

The third problem is that our economy has been supercharged by a housing bubble which has now burst. The best experts believe that prices still have a way to fall before the return to normal, and that means there will be more foreclosures. No amount of talking up the market is going to change that. The hidden agenda here may be taking large amounts of real estate off the market--and letting it deteriorate at taxpayers' expense.

The fourth problem is a lack of trust, a credibility gap. Regrettably, the way the entire financial crisis has been handled has only made that gap larger.

There are alternatives. Warren Buffet showed the way, in providing equity to Goldman Sachs. The Scandinavian countries showed the way, almost two decades ago. By issuing preferred shares with warrants (options), one reduces the public's downside risk and insures that they participate in some of the upside potential. This approach is not only proven, it provides both incentives and wherewithal to resume lending. It furthermore avoids the hopeless task of trying to value millions of complex mortgages and even more complex products in which they are embedded, and it deals with the "lemons" problem--the government getting stuck with the worst or most overpriced assets.

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