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Another modest proposal
This one is even more modest than the last.
Let's say you have ten banks and two of them are insolvent. But you don't yet know which two. So the credit market is messed up for all ten because at some sufficiently high level of risk credit just shuts down. The goal then is to reveal which two of the ten banks are insolvent.
I've been thinking of all those old puzzles where a bunch of guys enter the room and only so many of them have smudges on their foreheads and you have to find the algorithm to reveal that information.
What can be done? Temporarily allow insider trading, with short selling of course? (Bryan Caplan's idea) Make executives either resign or post personal bonds, where default of the bond follows if the bank ends up insolvent? Change laws and make banks exhibit their books to the public and let traders sort it out?
I don't know. But maybe sorting out the bad banks is one alternative to finding and isolating the toxic assets. Because once all the remaining banks are good and known to be good, the problem of toxic assets no longer seems so paralyzing.
I'm still not sure that the Treasury buying bank assets is to best way to make this sorting, and that's leaving aside the price tag. In fact maybe Treasury buying postpones this revelation of information.
Of course if eight of the ten banks are bad, maybe we don't even have the luxury of asking these questions.
Posted by Tyler Cowen on September 26, 2008 at 06:43 AM in Economics | Permalink
Comments
I tend to share the fear echoed in that last sentiment. Why? Because as yet we have not seen a serious proposal for a bank holiday, where we close down these institutions for a short period of time and send in examiners ... when the holiday ends, only the solvent and better capitalized institutions emerge - and hopefully the paralysis will stop.
So what can possibly prevent this from being a decent idea? First is that the holiday would become a permanent vacation for most firms. Second, maybe the Wall St. firms simply won't allow it, despite their precarious situation. Who knows?
Posted by: wintercow20 at Sep 26, 2008 7:09:20 AM
Nice proposal.
But I also agree that the last sentence is close to the truth.
Posted by: londenio at Sep 26, 2008 7:12:16 AM
neither Bear, Lehman,Fannie, Freddie nor Wamu were given the time to find out if their assets were sound or their capital was adequate. If an enormous amount of support is not provided right now there will be a run on all 10 banks. We can then sort out the hypotheticals while we shiver around the fires at night.
Posted by: misplaced trust co. at Sep 26, 2008 7:36:51 AM
To solve the problem you pose (btw, this has been the problem from the very beginning), all banks should have the opportunity to sell assets to a government agency with the obligation of repurchasing the assets and with conditions similar to those of restructuring processes in bankruptcy until they have repurchased all the assets (if they fail to do it after a few years, then they will be liquidated). This could have been done by attaching appropriate terms and conditions to the purchase of assets in the Paulson plan. This was done in Chile-1983 crisis and it worked. It's very unfortunate that most economists writing about the ongoing crisis do not know the history of financial crises and don't pay attention to experts (the ones that bring milk to the table, not the ones that write about milking cows).
Posted by: E. Barandiaran at Sep 26, 2008 7:59:58 AM
There was a short story (I forget the name, anyone have a reference?) where the intrepid detective locks himself in a room with all the suspects, in classic fashion, and proceeds to use logic and cunning to question everyone to determine who is the murderer. Except, as it turns out, he deduces that all of the suspects took part in the murder. When he announces this, they murder him too. The end.
Posted by: Mr. Market at Sep 26, 2008 8:01:00 AM
i like the post personal bonds idea. that's something i've been wondering about
Posted by: at Sep 26, 2008 8:19:51 AM
Maybe the real problem is that all ten banks are sort of both bad and good.
Posted by: spencer at Sep 26, 2008 9:26:06 AM
The heck with finance and their math models. Let's look for an answer in the models of quantum physics: Schrodinger's bank.
Put a bank in a box (obviously, a safety deposit box). The bank fails (all equity is lost, executives are beheaded) with p=.5 or is saved (Treasury buys junk) with p=.5
Actually, this uncertainty might be the problem now; credit is frozen because nobody knows who to trust.
But the Paulson plan seems to assume we should now try and save everybody. Why? Maybe we just need clarity on who is saved and who is damned [Lehman employees: insert "why me?" rant here]
Example using the classic cat
http://www.phobe.com/s_cat/s_cat.html
Unlike the cat, banks and the FDIC get to choose whether to go into the box.
(Ordinarily, the bank gets to choose, but if certain criteria aren't met, the FDIC can force the issue.)
Posted by: ZBicyclist at Sep 26, 2008 10:13:23 AM
I like the idea of Quantum Banking Theory-- it explains observer effects (if you look inside the box, the bank fails), non-locality (everybody fails simultaneously, even though there's no interaction), the failure of expertise (if you think you understand it, you don't), and the Financial Quantum Bell Theorem (when the bell rings and the music stops, everybody who doesn't find a chair goes bankrupt).
Posted by: MattF at Sep 26, 2008 10:27:57 AM
How about this version? If eight out of ten banks are bad, we're screwed no matter what. If it's two out of ten, the whole bailout is a scheme to give tax money to bankers, and we should just let those two go down the drain.
Personally, I don't trust the president all that much (and I voted for him twice).
Posted by: Alan Gunn at Sep 26, 2008 10:37:26 AM
This seems to be already happening with the short-selling exemptions. Some banks have asked to be removed
from the "no short selling list". If the SEC continues to allow banks to do this, then information will
emerge: if you don't ask to be removed from the list, that means your loans suck. Investors will figure it out.
Posted by: Person at Sep 26, 2008 11:00:05 AM
Temporarily allow insider trading, with short selling of course?
What, you think this isn't already going on? You've got to be kidding.
Posted by: Jeff Hallman at Sep 26, 2008 11:17:03 AM
Sorry... misposted this comment below...
If I read it right, the gov't *made* $1.9 bn on the WaMu sale. If in fact WaMu was solvent, if not on a current basis, and they were in the worst shape (ok, maybe Wachovia), why doesn't that answer the question of whether it more like 2 or 8?
Posted by: jfalk at Sep 26, 2008 11:59:35 AM
Why not collect $0 in income taxes for the 2008 FY? Refund all taxes paid by individuals and let them use that money to pay down mortgages/debt.
In filing 2009 income taxes, the filer has to show that all 2008 taxable income was used toward mortgage payment/debt repayment otherwise that full amount is owed.
Posted by: meter at Sep 26, 2008 12:08:12 PM
This assumes some insiders know what's going on. In some cases, this might be an unsafe assumption.
I think one key result of this financial crisis is that much of the key leadership within many of these companies... they didn't really know what was going on.
Posted by: mgunn at Sep 26, 2008 12:32:00 PM
Let's say you have ten banks and two of them are insolvent. But you don't yet know which two. So the credit market is messed up for all ten because at some sufficiently high level of risk credit just shuts down. The goal then is to reveal which two of the ten banks are insolvent.
I know how you don't get them to volunteer the information: Tell them that if they can keep it a secret for 13 months, then they get taxpayers to take the assets off their books. First-year grad students could model this one.
Posted by: Bob Murphy at Sep 26, 2008 3:49:58 PM
Your solution becomes less tenable if 8 of the 10 banks have these assets on their books.
Posted by: daddysteve at Sep 26, 2008 6:21:17 PM
Why "Joe Six Pack" should support the bail out proposal (AND PAY FOR IT).
How exactly did the inflated value of mortgage backed securities get inflated and who benefitted from these high prices? In short, the American home-owning public was able to find easy access to liquidity that allowed them to bid up the price of home across the country. And, I mean everyone who took out a home equity line of credit or sold a home and made a big capital gain in the process.
For example, in 2005 the neighbors across the street from me sold their home at an inflated value, moved inland, bought another home outright, and pocketed the rest of their equity. These are folks that had only moved into my neighborhood 5 years earlier. They are Joe, but in the last, unprecedented run up in housing prices caused by loose capital markets there were lots of Joes like them. They weren't speculators, but they received capital gains in the matter of years that hitherto before took most homeowners a lifetime to accumulate.
Certainly, the Wall Street financiers were complicit in buying the packaged mortgages and pay more for them than they were worth, but the gains to the go-go naughts were broad based and shared by middle America, not just Wall Street. So, everyone who benefitted from cheap money or is related to someone who did, which is most of us, shouldn't feel like they deserve to be exempted from paying the big bill that's coming.
One more point worth making about who will benefit most from the bailout: If the banking industry freezes and liquidity dries up for commercial and consumer lending, what will happen to the value of Joe Six Pack's home then? And, what about Joe's job if there is no money to build the factory that Joe works at? Then, Joe will be jobless and homeless and really need his six pack!
If you think my analysis is a bit unfair to Joe, I have to say I know that the guys on Wall Street should have recognized bad paper when it was issued - but if they had priced the mortgaged backed securities correctly, Joe's equity would have never materialized. So, I'm not saying that Wall Street isn't to blame for keeping the party going, but Joe had a good time too. And, now its time to pay up, and if Joe doesn't everyone will suffer - and I think Joe is especially vulnerable to the vagaries of the market.
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