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A defence of the Paulson plan
It's always worth hearing from both sides, in this case Nadav Manham:
This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of these financial institutions. More importantly, with the toxic waste off the books, it improves the likelihood that an outside investor--Treasury itself, a sovereign wealth fund, even our man in Omaha--now feels able to value the enterprise. Hold your nose and admit it: the relatively few franchises that manage the capital raising and M&A activities of Corporate America are worth a lot.
3) Said outside investors collectively have enough capital to recapitalize the major Wall Street insitutions via injections of new equity. Here comes the tricky part: In exchange for their largesse, both the outside investors and Treasury (e.g. via warrants struck at the same price as the outside investor) must be allowed to invest on very favorable terms. In a perfect world existing equity holders and stock options would be essentially wiped out, a la AIG. In an even more perfect world, existing debt holders (i.e. unsecured lenders to Morgan Stanley, Merrill, etc.) would also take a big haircut, just as they usually do when corporations declare bankruptcy.
4) Both liquidity and solvency are restored, credit starts to flow again, and the downward spiral of asset sales is prevented, allowing whatever pain will occur to occur over time, and to be spread widely.
...as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG. Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.
There is more at the link. A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end. I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue. The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue. Maybe. But still I do not like the Paulson plan. It reminds me of everything I dread about unchecked power and the administration's score on this question is very, very bad.
Posted by Tyler Cowen on September 21, 2008 at 10:49 PM in Economics | Permalink
Comments
Tyler: the Fed tonight announced:
The Federal Reserve Board on Sunday approved, pending a statutory five-day antitrust waiting period, the applications of Goldman Sachs and Morgan Stanley to become bank holding companies.
Does anyone really know what the Paulson plan is? Are there only two sides?
Posted by: RW Rogers at Sep 21, 2008 11:05:00 PM
OK, we're all for studying all sides of this issue. Still, this sounds quite saccharine.
But if the cards fall like this analyst argues, remember the trade-off: more inflation and more moral hazard. And the people that he argues will benefit will not always be the ones who pay for it (in the form of higher future taxes and inflation taxes). And you're right. This is more than a liquidity issue. If that was the case, we'd easily solve it by inflating the currency and be done with it.
Also, this writer assumes that, finally, this is the last fix. Haven't we heard that somehwhere before?
Posted by: barry at Sep 21, 2008 11:12:57 PM
Tyler, I would amend your formulation slightly: The implicit belief is not so much that resolving the liquidity issue is needed to make progress on the solvency issue. What's needed to make progress is not liquidity per se but reduced valuation uncertainty.
Posted by: Nadav Manham at Sep 21, 2008 11:26:24 PM
the system has no liquidity because there is no trust. ruining the dollar temporarily would be one thing if the holders of bad tranches, of higly leveraged risk, etc. opened their books and sold--i.e. if it created trust. but of by "the downward spiral" of asset selling you mean selling the assets and unwinding, well duh, that IS NECESSARY.
the lunacy of the abov comment is this: "allowing whatever pain will occur to occur over time, and to be spread widely."
that is PRECISELY what has already happebed--it's been over a year now, and the solvency is worse, the liquidity is worse, and the pain got spread around more. the longer this lasted, the farther we aer from a healthy turnaround.
re : un checked power: it's not just this administration. you think either of our options for the next one will be better? don't count on it.
Posted by: annoymouse at Sep 21, 2008 11:29:09 PM
I think a lot of people are looking at the liquidity issue and thinking it's going to be easy to solve by getting the junk off the balance sheet, putting it into an RTC, and Wall Street will smile again. But what if that doesn't work? Lowering interest rates didn't work. And I understand that the Paulson plan is a much bigger deal than cutting rates 50 basis points, but what if the Treasury buys up the junk, and then the firms are in the same bad position they're in now in a couple months? It could happen, right?
Also, will the hypothetical RTC mark to market? I assume yes. Because if home values continue to decline then there's another way taxpayers can take a much bigger hit than 700 b.
Posted by: pants at Sep 21, 2008 11:33:16 PM
What are the criteria necessary for the FDIC to take over an insured bank? Put the $700 billion into the FDIC and this "new RTC", and make the new RTC like the old RTC: it can manage and sell off illiquid waste that comes onto the FDIC's balance sheet as it takes over insolvent banks. Then construe insolvent in a sober manner: insofar as possible (this is, admittedly, the "then a miracle occurs" step) ascertain which banks have assets, at legitimate valuations, that exceed their liabilities, and relieve the financial system of those institutions that don't, selling them out of receivership if possible and running them down responsibly if not. Purchasers out of receivership can put in new capital without being handicapped by old mistakes, shareholders and creditors get the solid yardstick across the fingers that we need to give them, the banking system (though not necessarily the current banks with their current capital structures) get recapitalized and can start making loans, and all we have is an economy that needs to go about the continuing process of rotating out of housing and into various products that have been underproduced in the most recent business cycle -- but with a healthy financial system as a backdrop.
Now, my cure for cancer:
Posted by: dWj at Sep 21, 2008 11:46:13 PM
Tyler, do the world a favor and go on Bloggingheads with Paul Krugman and talk about the current financial crisis. I'm sure I'm not the only one who would like to see it.
Posted by: Jayson Virissimo at Sep 22, 2008 2:23:16 AM
No bottom to this for the forseeable future. Best I'd hope for out of Paulson's plan would be active credit again and slowing the downward spiral. Too much is unexplained - and lack of oversite is a recipe for all kinds of fraud.
Posted by: Marsha Keeffer at Sep 22, 2008 3:13:40 AM
This may be a bit dramatic, but all of this is starting to get me in an epic frame of mind, reminding me of Odysseus's repeated escapes from danger that lead him right into another situation he couldn't have expected and has to scheme his way out of...
Posted by: B Frank at Sep 22, 2008 3:29:02 AM
They were wrong about keeping interests rates low too long, then they were wrong to keep them as high as they did as long as they did. They were wrong about the impending recession. They were wrong about the stimulus checks (the jury is still out, but the abrupt drop in spending post-checks might push us into recession). They were wrong about the commodity bubble and the speculators. They were wrong about bailouts saving us and (I think) they are wrong about a few of these firms going down sinking all of us.
But, they are right about this one?
I am getting the feeling that Paulson wants to be President, except I've not heard word one from his mouth, just photo ops. I was pretty okay with this thing until the politicians (just now) got involved. In my opinion, these firms have negative social value, because for their businesses to work they have to practice voodoo economics.
And what is the goal? If it's to rescue the firms intact, then what good does making them feel the pain do. I don't think we can serve two masters on this one. You either give the addict a hit and deal with the moral hazard, or you let him go cold turkey. Trying to do both at a time is likely to leave him dead and us feeling dirty.
The banks were the last guys standing without a chair. Market failure? No way. The market has just taken the regulated sector to the cleaners. The only winners in this are the CEOs and the last guy to sell a house at the peak. They will be wrong when, with all the moral superiority they can muster, which for politicians is a lot, insist on inflicting pain on these folks.
Posted by: Andrew at Sep 22, 2008 4:29:50 AM
Of course, this does NOTHING to address the main issue: houses (and other assets)
are falling in value, and until this is arrested, the banking system won't begin
to heal.
Why are investors especially skittish about putting capital in to any bank? Partly
the former, but also - a la FNM, FRE, AIG - if the gov't were to inject capital in
said institution, you'd immediately find your investment hugely diluted.
This is a confidence issue as much as a capital issue. Lehman had no real liquidity
problems; it failed (well, due to hubris, really), but no one had enough conficence
in its balance sheet - the true value of its assets - to determine what the true
value was.
Posted by: glenn at Sep 22, 2008 4:42:48 AM
One huge unspoken question: where does the $700 billion come from? It comes from China, that's where. What if they decide enough is enough, and want to reduce their exposure to the US?
What if they want to spend their money propping up their own stock market instead? In the past few days, major-company Hong Kong shares that fall intraday somehow magically all seem to finish the day by moving back up towards the previous day's closing price. Also, China has certainly had more than its share of extremely loose lending and a bit of a property bubble, so they may wish to keep their powder dry to bail out their own banks and financial system, a few years down the line.
Posted by: at Sep 22, 2008 9:23:35 AM
"No bottom to this for the forseeable future. Best I'd hope for out of Paulson's plan would be active credit again and slowing the downward spiral. Too much is unexplained - and lack of oversite is a recipe for all kinds of fraud."
Posted by: Marsha Keeffer
And with this administration, it's not just that they'll steal a big slice as they get the job done; it's that they'll steal most of it, and (deliberately?) not get the job done. Note the Iraq war; the right is claiming victory, but I didn't see any of them back in 2002, '03, '04, '05, or '06 *or* '07 defining what we've got now as victory. In Afghanistan, we're losing, but slowly, and with relatively media coverage.
And as for Bin Laden, if I knew then what I know now, I'd have made all sorts of bets years ago that Bush would not only not kill him, but dismiss him ('I'm not that concerned about him'). I'd have gotten 100:1 odds, and would collect with glee. I could use a new house :)
Posted by: Barry at Sep 22, 2008 9:24:07 AM
Manham: "Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. "
Yes, it is conceivable that the Bush administration would do something right. It's not really *possible*, but I suppose that it is *conceivable*.
Posted by: Barry at Sep 22, 2008 9:26:08 AM
It seems to me that the bailout amounts to tying the ability of the federal government to raise money (really, its solvency) to our ability to un-melt-down the capital markets. What happens if we fail? Won't this become an anchor around our necks?
It seems like we're betting that this will stop the credit markets' collapse, and thus stop a massive recession from happening. If we succeed, then this will have been a bargain. An unfair bargain stuffed with moral hazard and redistribution of wealth from the poor to the rich, but still a bargain.
If we fail, what happens? If the capital markets stay seized up despite this bailout (and the next one, and the one after that), and we get a massive recession, how will this affect our ability to respond to it? It seems to me that our ability to deficit finance more spending to try to get the economy out of the recession, or just to keep people eating regularly and sleeping indoors, will be seriously compromised. We pretty much will have to inflate the hell out of the dollar, which will have the effect of making a lot of our prices go up (what fraction of the stuff on Wal Mart's shelves is not imported), and will make it even more expensive to borrow money from overseas.
It won't be politically or socially workable (or economically sensible) to cut social security, medicare, or related programs at this time. So what will get cut, and how will that affect the world?
Posted by: albatross at Sep 22, 2008 9:52:59 AM
Or you could say that this plan removes the adverse selection problem in the current financial crisis.
Posted by: Robert Olson at Sep 22, 2008 10:51:13 AM
'..nor does it prevent Treasury from doing another AIG. Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. '
But this is exactly the opposite of what happened. AIG needed around $75 billion to continue operations and the government had a 79.9 percent upper limit on it's stake, otherwise the government took on their debt... So in reality the government did not go into the AIG deal thinking 'what is AIG worth?', but instead went in knowing 'you need ~75 billion and we can only take 79.9 percent, done deal'.
Posted by: brian at Sep 22, 2008 12:33:34 PM
Someone please explain to me, in small words, why the current problems with leading financial institutions would cause a Great Depression 2.0? Or even half of one? I was under the impression that the only reason the Great Depression was "great" was that the federal government ran around screwing things up for a decade by doing stupid things like restricting people from planting crops when much of the nation was struggling to keep food on the table, engaging in wild experimentation with the economy when investors were already nervous about starting risky ventures, etc. So why is Mr. Manham claiming that this time it will be some banking and insurance company problems will cripple the economy for decades? Isn't that a little like a doctor saying "the last guy named 'Bob' I treated had a brain tumor." Does it take that long for an unemployed real estate estimator or bank teller to find a new job? I hear there's a lot of work down on the Gulf Coast for anyone with a strong back or willing to learn some more tangibly useful skills. Will it take that long for people with capital to discover another way to meet up with people developing new innovations? You'd think that interweb thing Al Gore invented might shorten that process a bit this time around. Is our economy secretly driven by the purchase of luxury items by banking executives? Will bitter New York financiers form gangs of anarchists that travel the country burning down one out of every four factories, farms, homes, and hospitals they encounter? I don't get it. By what mechanism does AIG's or Morgan Stanly's problems eliminate over 10% of the productive work done in this country for over a decade?
Posted by: jrandomamerican at Sep 22, 2008 1:54:08 PM
Someone please explain to me, in small words, why the current problems with leading financial institutions would cause a Great Depression 2.0?
I'll give it a try:
Cheap money allowed home renters and speculators (large and small) to buy (and in some cases flip) real estate they couldn't really afford. The bad loans and the not so bad loans were mixed together (like lousy wine with good and very good wine), into large agglomerations of loan packages (like very, very large casks of wine) that were sold and traded far and wide. Oh, and the quality of the wine in these large casks of wine was somehow better than the sum of its parts, but that's only because no one really wanted to know the mix of the wine in the casks because the folks responsible for rating the quality of the wine in the large casks didn't do a good job. Sort of like Robert Parker rating a large cask of this mixed stuff as a 95, rather than "undrinkable". But because times were good and we were all partying, we didn't notice. (I should mention at this point that we would all have been better served if, like Christ at Cana, we had been served better wine towards the end of the party....)
As the prices of real estate started to flatten rather than continue to rise, and as borrowing became a tad more expensive, the market ran out of willing and able buyers. I.e., there were no more suckers willing to accept Robert Parker's obviously too-high rating of 95.
As the real estate market began to fall to earth, and many holders (and other potential buyers) of the large casks of wine realized that the mortgages inside the bundle weren't really all that great, and the prices of the bundled mortgages began to fall, and as some of the holders of these bundled mortgages began to sell, it began to be apparent to a LOT of folks that the underlying mortgage debt was not that great (i.e., the casks of wine were starting to turn into vinegar - and it smelled like vinegar, not 95 rated wine).
And that required the holders to liquidate to raise money to meet their capital requirements.
And lo, many of these folks who were buying and selling these casks of wine got scared, and the folks who loaned money (usually on margin) to those who used to buy and sell wine also got scared, and then those who insured the financiers AND buyers and sellers of wine got scared and there was no money being lent except at much higher (relatively speaking) rates of interest.
And this impacted ALL businesses and people who needed to and wanted to borrow money, not just those mentioned above who were engaged in buying lousy wine sold as really great wine.
And now we have a huge mess, with LOTS of vinegar around.
Oh, and tell your congressional delegation that as a taxpayer, you are not interested in buying vinegar at fine-wine prices.
Hope this helps.
Posted by: at Sep 22, 2008 3:26:13 PM
Okay, I did say to use small words and ‘wine’ is only one syllable but I’m not sure that clears things up for me. I understand two big effects that would occur based on this analogy and my own understanding.
The first is that by raising real estate prices so far above the actual value of the real estate the bubble caused misallocation of resources. People who thought their homes were worth more than they were spent their money on luxuries instead of being frugal. Developers invested money in building new homes to meet the demand they believed would be there when that money would have been better spent on investing in oilfield exploration, nanotechnology research, or farm equipment. This misallocation of resources is unfortunate but what’s done is done. The bailout billions won’t transform those Harley Davidsons and European vacations bought by happy homeowners into Smart Cars or savings accounts. Neither the Fed nor the Treasury Dept. has the power to turn back the hands of time so that materials, labor, and energy that were expended building existing subdivision can be reclaimed as oil fields or John Deere tractors. We cannot take back the choices we made in ignorance. The best we can do is to admit that we shouldn’t have spent the resources that way, learn from our mistakes, and try to invest the next dollar of wealth better. But… admitting that our houses are only worth half what we thought is not the same thing as going out and burning every other house. That wealth is still there, we just have a better idea of home much it’s worth (much to our dismay) and we realize that our investment choices haven’t grown it as well as they could have if we had been more clear-eyed about real estate prices. I can’t see how admitting that our national real estate isn’t worth what we had hoped destroys even a penny of GDP, though it might force us to admit that perhaps our past calculations of GDP were not as big as we hoped. But most importantly I can’t see how any of this will cause us to produce 25% (or even 10%) less goods and services next year… and if by some mechanism that I don’t comprehend we did produce so much less stuff I also don’t see how hundreds of billions of dollars in Treasury or Fed bailouts of their colleagues in the finance industry would offset that.
The second problem I see is the loss of trust between people regarding the financial industry in this country. I admit that ‘social capital’ is an important economic factor and that the loss of trust regarding financial deals will be a real impediment to economic growth. These established financial corps are the middlemen between people with wealth they want to invest and businesspeople who need investment to grow their business. If Bob doesn’t trust to go to the bank with his savings then Sally can’t get a small business loan. So if these financial institutions disappear as trusted middlemen then it will temporarily be more difficult for investors to find investees. I see how that would slow economic growth until some other middlemen or marketplace could be developed. But slowing economic growth 25% isn’t the same thing as eliminating 25% of the GDP and neither do I see how in this day and age it would take a decade to develop some replacement middlemen for savings and loans to meet each other. I realize finance is a service and as such is part of GDP and that a slump in it would therefore reduce GDP, but I find it hard to believe that the service of managing people’s savings or debt represents a double digit percentage of all value of all the products and services produced in the US… and frankly if it costs us that much to move our money around them maybe it’s past time we got rid of all the deadwood and overhead anyway and handle the whole thing on Craigslist and Facebook.
So yeah, I understand about the wine. I understand how disappointing it is to realize that lump of gold was really pyrite all along. I also understand how losing trust in our financial sector employees would hurt economic growth and it might take a couple of years to replace them with some other money marketplace. I even understand how the temporary disruption to people’s lives would cause a short term drop in not just GDP growth but actual GDP. I’m sorry, though... Maybe I’m just not as clever as I thought but I still don’t see how the bankruptcy of some of our financial institutions possibly cause double digit eliminations of our ability to produce goods and services for more than a decade. I think it far more likely that we’d have several new domestic banks with streamlined logos, headquarters buildings that aren’t in NYC, and less overhead fighting for new market share (branded by the nice folks that sell us new flavors of soft drink, shoes, and pills), new social networking internet sites for creditor/debtor matchmaking and trust rating, cancelation of that “flip your house” TV program, and perhaps a more Scottish (no racism intended) outlook on what the general population spends its money on. But otherwise fields would still be planted, CAD systems and sheet metal presses would whirr on with the same efficiency, barbers would still give haircuts, and street corner apple vendors would still be impossible to find… all to the surprise of many finance service sector employees who find that they are not the essential engine driving the national economy that they had imagined themselves to be.
Or am I missing something large enough to account for a quarter of our economy?
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