« The Workhouse Test | Main | The ride is getting bumpier »
Is the Sweden plan so much better?
Paul Krugman, Brad DeLong, and Matt Yglesias are all endorsing the Swedish plan for partial bank nationalization. Maybe it's better than what we'll get (I haven't read through the latest draft), but I don't think they are addressing the weaknesses of the idea. Namely:
1. Solvent banks don't need to be nationalized. Insolvent banks should be shut down. Maybe they're mostly insolvent, but that is second-guessing market prices just as much as Paulson's view that bank assets can be bought on the cheap. The implicit view is that current equity markets are overvaluing these banks. (It is complicated, however, because current equity prices are not independent of the government plan and there can also be hovering in the neighborhood of insolvency.) An alternative proposal, of course, is to reveal which banks are solvent and which are not.
2. There is much talk about taxpayers participating in the upside. First, bank ownership is probably not an efficient way of redistributing wealth (is it what you want for Christmas?). Second, Greg Mankiw's friend scored a telling point:
...we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.
I haven't seen a good response.
3. Swedish governance is in many ways of higher quality than American governance. It involves lower transactions costs, more social unity, and it is more inclusive of many different interest groups. For one thing, the concentration of wealth in Stockholm makes it harder to use policy to redistribute wealth across regions. Instead they redistribute wealth across genders and age groups but those forms of redistribution don't distort the banking system so much. The Swedish banking system is also "small as a whole" compared to surrounding markets; you can't say that about the USA. Note also that Swedish banks, circa the early 1990s, were simpler creatures than today's American banking firms.
4. The U.S. doesn't have any tradition of successful nationalization. We've had plenty of interventions, but for whatever reasons nationalization has not been the preferred model. I don't think it is just ideology. The diffuse and highly federalistic American political system is lacking in accountability and thus it is poorly suited for such policy actions.
5. Nationalization makes it harder to raise private capital next time there is a crisis. It is a high time preference solution.
6. Presumably the government wants to show it is doing a good managerial job, but in fact the sector needs to shrink. And would a government-owned bank cut off the flow of credit to, say, Chrysler?
Posted by Tyler Cowen on September 29, 2008 at 07:47 AM in Economics | Permalink
Comments
Re #2:
MM doesn't hold because markets aren't efficient in the way economists so badly wish that they were. This is especially the case in times of massive freaking out, i.e. now.
Posted by: Andrew Edwards at Sep 29, 2008 8:09:46 AM
If the treasury is buying $700B of debt + warrants instead of $700B of straight debt this will limit the government's actual purchases in proportion in inverse correlation to the degree that the magnitude of crisis is being exaggerated in order to win a bailout. That is, including the warrant is insurance against this simply being Wall Street having talked its way into a give-away.
While that warrant may be worth $2 on average, but it represents a universe of outcomes that possibly gravitate toward the extremes on both ends, and the political motivation for including it (which I think is reasonable since everyone involved is a self-interested actor) is to have put down a lesser sum if we end up on the fortunate end of that universe.
...but I could easily be wrong
Posted by: mjk at Sep 29, 2008 8:29:41 AM
In particular the worry is that the TARP will overpay for the bonds. Citing MM is just a backdoor way of claiming the market is pricing the bonds correctly. If it were, what would be the point of the TARP?
There might have been a sensible response if Mankiw allowed comments. As it is it is too silly to devote much attention to.
Posted by: bunbury at Sep 29, 2008 8:32:46 AM
Well, Angus questioned whether MM is empirically true.
http://mungowitzend.blogspot.com/2008/09/should-equity-position-be-important.html
Posted by: Jeff H. at Sep 29, 2008 8:50:30 AM
MM doesn't have to be very exactly true. The point is simply that the warrant brings other offsetting changes in price. The notion that those changes *don't* cancel each other out exactly is arguably scarier than to believe that they do.
Posted by: Tyler Cowen at Sep 29, 2008 9:09:32 AM
"The diffuse and highly federalistic American political system is lacking in accountability and thus it is poorly suited for such policy actions."
Which explains why the TSA is such an efficient organization.
/sarcasm
Posted by: Vincent Clement at Sep 29, 2008 9:12:05 AM
The MM assertion is not very clearly expressed, and so I am not sure I understand it. But doesn't it imply that options are always an exercise in futility? Is the same true of all stock options? Is the whole thing therefore a product of ignorance or delusion? Maybe somebody can explain this (and perhaps restate the original assertion more clearly).
Posted by: Dan at Sep 29, 2008 9:28:53 AM
For what it's worth, Jonah Gelbach takes this up:
http://econ4obama.blogspot.com/2008/09/smart-friend-vs-asymmetric-information.html
Posted by: cbooker at Sep 29, 2008 10:06:35 AM
Now is not the time for a broader debate about MM, but you can narrowly state a thesis as simply "in times of panic, there is systematic mispricing of equity", which doesn't seem all that hard to believe given what happened in the equity markets in 1987.
Posted by: Andrew Edwards at Sep 29, 2008 10:17:23 AM
Like others, I'm having trouble understanding the M&M argument.
I see that in a perfect market if I'm willing to sell the MBS for $10, then if I'm required to throw in a warrant worth $2 I will want $12.
But isn't the warrant intended to deal with imperfections in the market, as well as some other problems? Isn't the whole bailout idea predicated on the idea that the markets are not functioning?
There seems to be huge uncertainty as to the value of the MBS. The warrants let the govt buy the MBS at some guessed-at price, and let the seller gurantee that this is a fair price without risking any direct cash payments. The seller gets sorely needed cash in exchange for the assets, and the govt gets compensated if it overpays. In other words the warrant feature is intended to reduce the risks of the transaction to the govt.
Alternatively, we might think the seller knwos a lot more about the MBS' value than the govt. If that's the case, then the warrants discourage taking advantage of that, especially if they are for 125% of the difference, as in Dodd's original proposal. I'm not sure if that's still in the bill.
Posted by: Bernard Yomtov at Sep 29, 2008 10:19:48 AM
This seems like the equivalent of a bank requiring a 20% downpayment. The other side needs to have some skin in the game.
Posted by: meter at Sep 29, 2008 10:47:42 AM
"For one thing, the concentration of wealth in Stockholm makes it harder to use policy to redistribute wealth across regions"
Why would it make it harder? Wouldn't it in fact make it easier since the rest of Sweden can just gang up on Stockholm?
Posted by: virgule at Sep 29, 2008 10:58:27 AM
Here is my better plan to end the crisis:
Financial firms lost capital because of the plunging prices of mortgage-backed-securities (MBS) which securitized subprime mortgages. The result was financial failures, a credit crunch, and money market upheaval. With housing prices falling to a degree never anticipated, and the future unclear, no one is certain about the long-term value of subprime MBS.
The bank rescue negotiated by US Treasury Secretary Paulson and Congressional Democrats treats the symptoms of the financial crisis, not the causes. It will commit up to $700 billion under the dubious theory that subprime MBS are irrationally underpriced. The Treasury would buy underpriced MBS, thereby establishing a liquid market and better prices. That would boost bank capital and end the credit crunch. Supposedly, by holding the MBS to maturity, the Treasury would recover most of its initial outlays, or even make a profit. Alas, with two more years of house price deflation likely , mortgage delinquencies and foreclosures are sure to rise further. If Paulson’s optimism is unfounded and subprime MBS prices remain depressed, the taxpayers could get stuck with a large bill.
Here is a plan that treats the cause of the crisis. The Treasury would get more “bang for the buck” by funding the repayment of all subprime mortgages. Participating households would surrender an equity stake in their houses in exchange for the mortgage payoff; it would be a debt-for-equity swap.
An illustration should help. “Mr. Smith” bought a house in 2006 for $130,000 with a subprime adjustable-rate mortgage of $125,000 and a small down-payment of $5,000. In 2008, the mortgage payment reset to a level that strains his budget. Meanwhile, his house’s value declined to $100,000; he cannot afford to stay, he is not able to refinance, and he cannot afford to sell his house and pay off the mortgage. Rationally, he goes delinquent and waits for the bank to foreclose. If his mortgage was securitized, his delinquency would damage the s ubprime MBS, which, in turn, would damage the balance sheets of the bank that owned it.
The US Treasury would sell bonds to pay off Mr. Smith’s mortgage. Mr. Smith would have no mortgage and could stay in his house as long as he continued to stay current on property taxes, utilities, and insurance. Taxpayers may not be happy about assuming $125,000 of fresh debt, but Mr. Smith would give the Treasury an equity stake in the house of, say, $90,000. When Mr. Smith (or his heirs) sold the house, the Treasury would get the first $90,000 of the sale price and Mr. Smith would retain the rest. If the eventual sale price of the house fell below $90,000, the Treasury would get the entire value but Mr. Smith would not have to pay anything more. By allowing Mr. Smith to keep a small stake in h is house with unlimited upside but no downside risk, the government would give Mr. Smith incentives to maintain and protect his house and act as a good citizen improving his neighborhood. And local governments would get their taxes paid.
With an equity stake, the taxpayers eventually would recover much of what they spent. The loss to the taxpayers (ignoring discounting) would be the difference between the mortgage payoff and Treasury’s equity stake. The Treasury needs an equity stake to prevent every homeowner from defaulting to get a mortgage payoff. Only those who are, or are soon to be, “underwater” would apply for the Treasury program. The program is designed to assist only those who desperately need assistance. By relieving burdensome mortgage payments on low-income households, this plan would give a moderate boost to their consumer spending, a benefit the economy could use.
Participants would not be allowed to take out another mortgage or home equity loan, lest we end up in the subprime mess all over again. Any participant who wanted to shed these restrictions need only repay the Treasury’s stake. The rescue should not be available to the affluent. Households could get assistance only if they own just one house. Real estate speculators or investors would not be eligible.
By paying off subprime mortgages, those who own subprime MBS would get their full principal back, rather than the fraction likely without the rescue. That would go a long way toward recapitalizing the financial system, thereby freeing up the money market and ending the credit crunch, without the government needing to inject capital directly into banks or micro-managing banks.
This plan would simultaneously provide affordable housing to over one million low-income households, wipe out most current and prospective mortgage delinquencies and foreclosures (and avoid the substantial legal and social costs of foreclosures), protect neighborhoods from being devastated by vacant foreclosed properties, recapitalize the financial system without having the government socialize it, boost market liquidity, relieve the money market panic, end the credit crunch, start a necessary deleveraging of the economy, and provide a modest stimulus to consumer spending. This rescue plan is neither more “unfair” nor more expensive than any other workable rescue plan, and it has a good chance of preventing a severe recession and massive wave of financial fail ures. A 12% unemployment rate is unfair and expensive also.
Posted by: B.H. at Sep 29, 2008 11:24:50 AM
Wasn't Krugman suggesting investing in the banks a la Buffett/Goldman and letting the markets determine the value of the bank's assets? With sufficient capital, the banks wouldn't be forced to sell assets at fire sale prices and the markets could sort out the mess in peace and quiet (sort of).
Posted by: Tim Keese at Sep 29, 2008 11:51:10 AM
BH, interesting plan. Lord knows I'm in over my head here, but here goes anyway:
Are you betting that many home "owners" will default, or few will default? If it were many, it sounds like an expensive intervention.
If you are right that only a small percentage of subprime mortgages would need to be paid off, does that not imply that subprime MBS's are undervalued?
The Paulson plan's bet is that most subprime MBS's will pay off if held to maturity, therefore intervention is cheap.
Your bet looks exactly the same: most subprime mortgages don't need assistance, but some do, therefore intervention is cheap.
Again, I'm not even close to an expert, so I may be missing something.
Posted by: mk at Sep 29, 2008 11:59:57 AM
Re #2: The warrants are basically a bet that, like many government auctions in the past (remember the 1st few spectrum auctions?), the securities auctions will be poorly designed and cause taxpaxers to dramatically overpay.
If the auctions were designed correctly, M-M would suggest there is no difference.
(If you think the government will be designed correctly and price the securities efficiently, I'd be happy to bet against you $10K.)
Posted by: Dan at Sep 29, 2008 12:18:28 PM
Modigliani-Miller assumes no transaction cost and no economic cost of bankruptcy. As such, it's completely useless to understand the current situation. The private market for near-insolvent banks has collapsed because they're essentially lemons with spillovers. Potential buyers aren't willing to pick up distressed banks at more than fire sale prices because 1. they can't properly evaluate the solvency status of the banks and find no way to incorporate future disclosures into a contract, and 2. in the current situation, the value of a solvent bank is negatively affected by the distress signals of its peer banks. The point of nationalization is to alleviate those two problems, not to achieve some form of redistribution or to make money off it.
Posted by: ogmb at Sep 29, 2008 12:21:08 PM
Forgetting about everything else ( like empirical validity or the simple fact that if the MM-theorem holds it is hard to see why the financial sector was so highly leveraged anyway) the MM just does not apply to the situation. It indeed says that it does not matter for the value of a firm how you slice its cash flow (assuming that this slicing itself does not affetct the cash flow for example by changing tax liabilities). It does in no way say that if a very large player that is big enough to influence market prices (in our case the government) decides for some reason to hold large amounts of one kind of asset instead of large amounts of another kind of asset that does not make a difference. And if the Government decides to hold a juge amount of equity in firms instead of debt I suppose that would effect market prices of one kind of asset versus the other. The idea behind MM is that if a firm for example increases its leverage the holders of its shares just can decrease their own leverage and offset the effect on their returns in this way. But there is no way the private sector as a collective can readjust its portfolio so that its cash flows remain the same so that it does not matter if the government takes the one or other cash flow in its own hands. The Cash flows that the private sector as an aggregate holds must be different, so MM arbitrage arguments cannot apply.
(The only way to ressurect MM is to assume that the cash flow of the Government is returned to the private sector. But even is one was willing to make such a daring assumption what kind of assets the government holds would probably affects its distribution of these cash flows to the private sector).
Posted by: Jan Klingelhöfer at Sep 29, 2008 12:21:56 PM
DeLong pretends that doing nothing is what Hoover tried. Wrong again, Hoover tried a very similar kind of bank bailout in the fall of 1931:
http://epaper.ocregister.com/Repository/ml.asp?Ref=T3JhbmdlLzIwMDgvMDkvMjUjQXIwMzYwMw==&Mode=HTML&Locale=english-skin-ocr
Posted by: will mcbride at Sep 29, 2008 12:26:09 PM
On Mankiw's friend's (MF) remark:
The idea behind the plan as explained by Bernanke seemed to be to structure the reverse auctions in such a way that the banks unload toxic assets at above fire-sale price but below hold-to-maturity value. So ideally the auction will produce bids (B) that correspond to the banks' hold-to-maturity valuation (V) minus the value of getting the assets off their books (X).
B = V - X
For any X that is positive, the tax-payer should over-all come out ahead, pocketing the difference between V and B. However, if the auctions turn out not to be such perfect price discovery mechanisms for whatever reason, then the successful bids may be overpriced such that B is greater than V and the tax-payer likely loses.
MF's argument is that incorporating warrants, i.e. functionally Put Option-like insurance (P), merely increases the price at which banks will bid by the value of P, thusly:
B = V - X + P
But that does not take into account that the value of P is a function of B and V; B being effectively the strike price of the put option and V being the bank's long term evaluation of the market price at the time the option can be exercised:
P = f(B - V)
P's value increases for any value of B above V, nullifying the profit to the banks of bidding prices above their own hold-to-maturity valuation.
So depending on how the warrants are structured, including them should serve to avoid overpricing of the bids by the asset-holders, such that:
for any bid B, B < V. In short, it makes the market mechanism of price discovery more efficient.
All this is pretty basic, but since you "haven't seen a good response", I thought it was worth spelling out.
Of course, if by 'response' you wanted an explanation of how a plan including warrants in this way is supposed to recapitalize the banks by means of a covert government hand-out, well then I suppose this isn't a response.
It achieves the aims of transparency through price discovery, the real bail-out/nationalisation will have to be sorted out later.
In any case, the warrants clause seems to be at the discretion of Paulson, and given that he does not like them, they probably will not play a significant role.
Posted by: OB at Sep 29, 2008 12:40:43 PM
Thanks for the link, Will. Good stuff.
I do suspect that the basic assumption of the bailout proposal is flawed - that is, that the assets on the books have value or will have value someday. I just don't think that the concept of value is that simple. If the assumption is flawed, if the assets have limited value and never will because the numbers on the books represent only hyper-inflated expectations, then the bailout cannot turn a profit, and is simply a short term transfer of wealth to the politically connected.
Posted by: Randy at Sep 29, 2008 1:00:05 PM
"Marx visualised the business cycle as intimately intertwined with a credit cycle, which can acquire a relative autonomy in relation to what occurs in production properly speaking. An (over) expansion of credit can enable the capitalist system to sell temporarily more goods that the sum of real incomes created in current production plus past savings could buy. Likewise, credit (over) expansion can enable them to invest temporarily more capital than really accumulated surplus-value (plus depreciation allowances and recovered value of raw materials) would have enabled them to invest (the first part of the formula refers to net investments; the second to gross investment).
But all this is only true temporarily. In the longer run, debts must be paid; and they are not automatically paid through the results of expanded output and income made possible by credit expansion. Hence the risk of a Krach, of a credit or banking crisis, adding fuel to the mass of explosives which cause the crisis of overproduction."
Isn't this what is happening now?
Posted by: eeek at Sep 29, 2008 1:42:07 PM
"For one thing, the concentration of wealth in Stockholm makes it harder to use policy to redistribute wealth across regions"
"Why would it make it harder? Wouldn't it in fact make it easier since the rest of Sweden can just gang up on Stockholm?"
True true true. Nine out of the twelve municipalities that actually pays for the whole redistribution of wealth in Sweden are in the Stockholm-region.
This might be the only link I could find in English:
http://www.kullin.net/2006/05/swedish-tax-on-entrepreneurship.html
Posted by: J.D.B at Sep 29, 2008 2:00:32 PM
I love you libertarians. You always say, "It can't work here because we don't have the social cohesion and good governance," and then go about trying to smash any social cooperation and governance. Well played, jerks.
Posted by: chris at Sep 29, 2008 4:04:33 PM
You suggest adding warrants is pointless, as each side of the transaction adjusts so that value given will equal value received. Nice in theory per M&M
Clearly you are economists and not practitioners*. Go look up Schmuck Insurance. The gov wants to retain a position in the equity so that if/when the banks shares rocket in value, they have something to cover their ass in the public debate. Or perhaps they can ditch the warrants and just post all voters a copy of the M&M papers when they start asking difficult questions. Dwayne, Sharlene and the twins will appreciate.
*Because the practitioner has a ton to be proud of right now... ahem...
Posted by: at Sep 30, 2008 1:32:55 AM
