Government Ownership in Banks Could Cause More Problems than It Solves

By Fred Lucas

(CNSNews.com) – The federal government’s purchase of $250 billion in stocks from U.S. banks as part of the $700 billion financial bailout could cause a repeat of the same poor market discipline that caused the credit crisis, according to free market economists.

“These shares put in the hands of the government has a muting effect on incentives,” said Frank Gamrat, senior researcher at the Allegheny Institute for Public Policy. “Profit-making incentives drive the economy and maximize performance. You take out that incentive when the government is going to provide capital.”

That was the problem with Fannie Mae and Freddie Mac, two government-sponsored enterprises designed to provide mortgages for low-income earners, said Jagadeesh Gokhale, senior fellow in economics at the libertarian Cato Institute.

“The key point is that this big debacle started from Freddie Mac and Fannie Mae, and that debacle happened with the backing of the government,” Gokhale told CNSNews.com.

The U.S. Treasury Department is buying $125 billion in non-voting shares in nine of the nation’s major banks and $125 billion in shares of smaller banks around the country to provide an infusion of capital and inspire the banks to make more loans.

Congress gave secretary of the Treasury the authority to do so as in vaguely worded section of the $700 billion bailout package that defined as among the "troubled assets" the secretary could buy "any other financial instrument."

Several European countries took similar steps to stabilize their economies.

Critics of Fannie Mae and Freddie Mac said the two mortgage giants drive the market for risky loans because they used their tax-exempt status and government line of credit to buy up risky loans that they then turned around and sold to Wall Street firms who assume these two "government-sponsored enterprises" had an implicit government guarantee.

This time the banks will be cautious about relying on the government for security or more oversight given the failures of Fannie Mae and Freddie Mac, said J.D. Foster, a senior economist with the conservative Heritage Foundation.

This is the case, he said, because when government steps in, the companies are shaken up, top management is often replaced, and shareholders feel the pinch.

“It is extremely risky to make investments expecting a government bailout,” Foster told CNSNews.com.

The Treasury Department says that the stock buy in banks is temporary and that it intends to sell the shares back to private entities when economic conditions improve. However, there is no timeline to do so, and nothing in the $700 billion law requires the government to sell the shares, which also concerns some economists.

“With the buying of troubled assets, there is a clear endpoint that comes when the debt is paid off,” Gokhale said. “With purchasing stocks, there is no clear end. Taxpayers might argue they want a return. At what point do you sell again?”

The lack of a timeline for selling the stocks back to the banks or other private parties is likely to prevent the public from becoming alarmed that the banks will not be secure after a certain date, Gamrat told CNSNews.com.

But he thinks political pressure could promote the classic model of buying low and selling high in the stock market. Despite the potential revenue gains from such a move, Gamrat said it would be wrongheaded.

“If the government sells [the stocks] to make a profit, I’m not sure anyone wins,” Gamrat told CNSNews.com. “The government should sell at the same price it paid. It will show the public that this was a good faith effort to provide capital. If it is used for revenue, the government will gamble in the stock market again.”

The federal government’s purchase of $250 billion in bank stocks should already be a concern, said Sheldon Richman, editor of The Freeman magazine, who noted that the auto industry, like banks, is also seeing hard times.

“The government is not always good at picking winners,” Richman told CNSNews.com. “History shows government expands during a crisis and never shrinks after the crisis. What if Detroit’s problems continue? Will the government buy stock there?”

A bigger concern is what control the government could exert over the banks, he said. Even without a vote among the banks’ shareholders, “there are still subtle ways to control – the government regulates these banks,” said Richman. “They can say if you don’t do things a certain way, we will make life unpleasant. It’s a dangerous idea.”

The purchase of bank shares might have been necessary, said Foster, who is “concerned about the influence over the banks.”

“Even with non-voting shares, there is a lot of influence,” he told CNSNews.com. “In the long run, the worry might be whether the government likes owning stock.”