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Luigi Zingales on the Paulson bailout -- Kazow!
He doesn't like it. And he has another idea:
As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?
The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.
And now come the real zingers:
It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.
Addendum: Here is further comment.
Posted by Tyler Cowen on September 19, 2008 at 09:39 PM in Economics | Permalink
Comments
I have a few questions about the bailout:
1. What's the pound of flesh?
With AIG, the government got 80%. Lehman went bankrupt. Bear Stearns shareholders got hosed. Do shareholders and management get a free pass?
Personally, I wouldn't suggest a pound of flesh. I'd suggest $10 billion a finger. Any CEO who wants to foist $10 billion face value of junk paper on the government should be willing to part with a finger. Maybe there are other suggestions, but this one's handy.
2. What's the price?
The talking heads on TV are saying nobody wants to buy this stuff because nobody knows what it's worth [either now or on a discounted cash flow basis after mortgage repayment]. But the financial firms have had years to study this stuff, and have detail on each mortgage.
The suspicion is that they know what it's worth (22 cents on the dollar, according to a recent Merrill Lynch sale), and it's not much. But they aren't saying what it's worth. How's the government to know?
3. Will it work?
The talking heads really don't know.
4. Exactly how is this really like the RTC?
The Resolution Trust Company took assets the government ALREADY OWNED, because the ALREADY INSURED savings and loans had ALREADY FAILED. They then disposed of them and lost $billions.
We don't own the bad mortgages YET. We DIDN'T insure them. The main thing this has in common is that we'll likely lose $billions. (given the banks are the only ones that have the repayment information and it's the government that's selling)
I've also posted this here:
http://mikekr.blogspot.com/2008/09/bailout-bullshit.html
so if you want to comment on this, rather than commenting on Tyler's post, it's probably done there.
I'm just really mad, like my pocket's being picked.
Posted by: ZBicyclist at Sep 19, 2008 10:25:08 PM
"Benefits the few"? Obviously, we don't know how this will play out in practice, but it's hard for me to see how recapitalizing the entire US banking system, freeing up liquidity and presumably increasing lending, cutting the number of foreclosures, and stabilizing the value of mortgage-based securities is only going to "benefit the few." We can argue over whether the plan will accomplish these goals, or whether even if it does accomplish whether the costs to taxpayers will be too high. But painting this as some kind of handout to Wall Street, without an eye to the massive spillover effects the credit crunch is having on the rest of the US economy, seems to me hopelessly crude as an analysis.
Posted by: K. Williams at Sep 19, 2008 10:35:47 PM
How exactly would a mandatory debt-for-equity swap change the fact that people are pulling cash out of money markets, which in turn is destroying the market for commercial paper? Or, put more simply, how would a mandatory swap prevent a run on a bank?
Posted by: Richard S. at Sep 19, 2008 11:09:17 PM
Elsewhere in the article Zingales writes: "Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms?"
To date, I’ve lived in a system where profits were socialized and losses privatized via the Federal income tax. And I’ve seen that money spent on earmarks to prop up failed politicians.
Posted by: dsm at Sep 20, 2008 12:22:58 AM
Nassim Taleb's view of the current crisis: http://www.edge.org/3rd_culture/taleb08/taleb08_index.html
Posted by: Black Swan Baby at Sep 20, 2008 12:24:12 AM
It would be nice if Congress (especially the Dems) presented themselves in opposition to this massive bailout.
But, of course, even the most egalitarian east coast democratic congressmen are big supporters of the finance community and the bailout (Shumer, Dodd, Clinton, Biden, etc.)
Posted by: thehova at Sep 20, 2008 1:44:48 AM
Luigi writes: "If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay."
As I understand it a problem here has been created by so called "fair
value" accounting regulations that force companies to mark assests
to the market. In a thin market this can create a negative self
reinforcing cycle as firms mark thinly traded assets down and then
have to raise new capital in thin markets.
Posted by: indiana jim at Sep 20, 2008 1:52:25 AM
It is interesting that Goldman's star boy Paulson didn't conceive of a "solution" until much of Goldman's competition had been wiped out. Could be a coincidence or God's will, either way, we're all financing it!
Posted by: Jake at Sep 20, 2008 6:20:05 AM
Jim: if a firm marks down a security and can't find any buyers at that price, isn't it likely that they haven't marked it down enough? While there was liquidity for these things, banks were happy to mark to market, but now that no one wants to touch them they're forced to mark "to model."
As Zingales says, there's no way that the government is going to get a good deal buying CDOs and RMBS and CMBS from banks. The information asymmetry problem is enormous. Absent some forced punitive measure (equity warrants, forced debt to equity swap, etc) this is going to be a bloodbath for the taxpayer. Unfortunately, I think it's a done deal - Barney Frank will be able to sell it as 'helping homebuyers.'
Posted by: Kyle S at Sep 20, 2008 9:52:34 AM
See today's article by John Berlau in the Wall Street Journal
on the problems stemming from governmentally enforced rules that
force firms to mark assets to the market (if you are interested in
a fuller explanation of what has spread financial problems from firm
to firm).
Posted by: indinan jim at Sep 20, 2008 9:53:20 AM
Yeah, this is ridiculous.
I'm surprised I haven't heard more of an uproar from Republicans on libertarian grounds.
This whole ordeal has shown us one thing: high ranking Republicans couldn't care less about the principals of libertarianism.
Posted by: thehova at Sep 20, 2008 10:58:33 AM
Isn't it the case that one problem is that bad bets are built on bad bets? That is, Morgan Stanley has a lot of illiquid subprime assets. Lots of other parties have Morgan Stanley's paper. All of them have made bad bets--Morgan Stanley on subprime, others on Morgan Stanley. Which ones do we go after first? Would Zingales be happy to have the Feds owning a significant stake in half the banks in the country? Or should we just fix Morgan Stanley's problem by cramming down a restructuring plan on Morgan Stanley? In either case, aren't we still using taxpayer money to prop up failed firms?
Posted by: Thomas at Sep 20, 2008 11:59:53 AM
Thomas: "Would Zingales be happy to have the Feds owning a significant stake in half the banks in the country?"
I can't speak for Zingales, but I know I would -- relative to the give-away alternative we seem headed for.
1. This need not be an active stake.
2. It need not be permanent.
3. It creates the possibility that this may be taxpayer neutral, or even positive.
4. We just took over 80% of AIG earlier in the week. Now banks want a better deal.
Posted by: ZBicyclist at Sep 20, 2008 12:36:49 PM
Just to be clear: you mean that, for example, you would want those firms holding Morgan Stanley's paper to be restructured, rather than just focusing on the problems at Morgan Stanley. You want a solution that is very broad over one that is targeted.
Of course these kinds of positions need not be active or permanent. But they needn't be inactive and impermanent. (Which way would President Obama take us, the investments having already been made?) Both alternatives offer the possibility of taxpayer neutrality, but neither is likely.
Posted by: Thomas at Sep 20, 2008 1:11:36 PM
The bill that Congress received today (it fits on one piece of paper) is a blank check. http://www.bloomberg.com/apps/news?pid=20601087&sid=aS7kIVsK77hs&refer=home is Where are the incentives that create the desired behavior?
Reverse auctions for something like a promise to pay from a government work far better than auctions for bundles of loans (CDOs) that are of very different quality. A loan to one troubled borrower is not a loan to another.
Combining a reverse auction and a cram down might be possible. For example, terms might be: "to participate in the reverse auction, this is the equity cram down price you will pay" for loses not reflected in the price. For example, the government would have rights to an equity cram down, if returns were not greater than x on the assets bought at auction. The seller gets cash, but remains significantly on the hook for asset quality. This aligns incentives. Letting bankers get away with fully transferring risk destroys the incentives for the behavior you want. The risk of equity cram down would be discounted in the auction price. The banks get cash but remain on the hook as they should so the incentives are right.
In essence, the government buys the loans in a form which has the nature of a bond (which it should) and if things are actually worse than discounted into the price of the bond at auction, then warrants should allow the government to stick the loss to the seller as equity dilution. The bank has the incentive to behave in the desired manner.
As an aside, what we do not want is banks buying paper from hedge funds and others that is particularly odious and then selling it on to the Treasury. No paper bought by a bank after last week should be part of this scheme at a minimum.
Posted by: T Griffin at Sep 20, 2008 2:09:36 PM
Imagine a terrorist announced there were 50 Megaton bombs ready to detonate in all of the US's top 10 cities in 2 weeks. $2 Trillion would allow him to pull the plug on it, saving millions of lives and the US economy to boot.
If you were the Treasury Secretary (just saying, so we can be clear about who's in charge here), would you do it?
And if you did it, it would be for the benefit of all Americans, even if it had the unfortunate side effects of (a) enriching somebody who caused the crisis in the first place and (b) costing Americans a boatload of money.
President McCain would like to believe he would say, "Millions for Defense and not one red cent for those greedy Wall Street types!" and perhaps end up president of a smoldering ruin.
As they say, "just saying..." Seems we've gotten thru the Denial phase pretty well, and let's see if we can get thru Anger without getting stuck too long. Hank's already moved on to Negotiation.
Posted by: Walt French at Sep 20, 2008 3:19:38 PM
Two practical questions about the grand Paulson bail out:
1. It is so vague that it ought to leave room for terms that give the taxpayer an eventual payback for assuming the risks; but has anybody in the Treasury or the Fed begun to think out these terms?
2. Was it necessary to announce the scheme on Friday 19th. September?
Following Thursday when short sellers got their fingers burnt because of the takeover terms for AIG and HBOS, and Morgan Stanley at last signalled that it was willing to pay the Chinese the market price for new capital, it looked like Friday was likely to see the stock markets slowly beginning to turn round (and I suspect that many experienced traders thought that was the most likely sort of Friday). A major sorting out of bad US mortgage debt was still needed, but there was time to work out how to do it. I fear that the grand announcement has had as much efffect in adding short-term instablity to the market as it has in reassuring participants.
Posted by: David Heigham at Sep 20, 2008 3:24:40 PM
freeing up liquidity and presumably increasing lending, cutting the number of foreclosures
It won't do that, there is plenty of money for home lending available at this time. It also won't make people's payments more The problem is we've gone back to sane lending practices, no more loaning hundreds of thousands of dollars to somebody with no down payment or documented income. Since people must fully document their income we're finding out that they can't afford the payments at the current house prices. People also need to have down payments available, but for many first time home buyers you can do an FHA loan with a 3.5% down loan. The problem is that anybody who wanted a house purchased one, and there aren't that many qualified first time buyers left.
The markets are illiquid not because of fear, but because the banks can't afford to sell at market rates. If they are willing to sell to the government at those prices then the government won't be able to sell for what they purchased for. This essentially is subsidizing the banks loss.
If the goal was to help homeowners, then just use that money to directly loan money to buyers. I'm sure at government borrowing rates that they could afford a larger mortgage, which would prop up prices. At $200,000 a house, 700 billion would purchase 3.5 million houses. They would probably be more likely to receive the money back in this situation as well, versus giving it to greedy bankers.
Posted by: JordanT at Sep 20, 2008 6:09:23 PM
What is wrong with the current system that banks can give the government collateral and get cash against that collateral with the risk that if collateral falls apart the banks have a problem not the government? No above market price paid by the government and hence no subsidy? No transfer of risk from the banks to the government?
There is no requirement in any scheme that all risk move to the government-- the banks should continue to have plenty of risk for anything transferred and the government should see the upside of any risk it takes. The way to make sure that the banks behave themselves is with equity warrants that kick in if the debt deteriorates in quality.
Posted by: T Griffin at Sep 20, 2008 6:36:48 PM
I like T Griffin's "cram down" idea above, assuming we actually have to do this thing at all.
In addition to the fact that it is kinder to me, the taxpayer, the idea of "cramming it back down the banks" has a certain political appeal that may make it easier to appease taxpayers/voters. The "cram down" repayment would be over a long period of time and so it shouldn't create more than minor ripples at a time.
The reverse auction itself seems bizarre. The banks have detailed data on all the stuff they have, so they have a pretty good idea of the mortgage pool cash flow over the next 30 years. They also know the government has a $700 billion pile of money and they've cried "wolf" so hard to get that money that they have to spend at least most of it.
The banks have all the information. How is this not a scam?
Posted by: ZBicyclist at Sep 20, 2008 8:00:30 PM
I have one [simple] question. Is an "illiquid asset" an established economic term that I just never heard before or is it a new (or newspeak) phrase that has been coined to con the inelite?
Posted by: Mike Cooks at Sep 21, 2008 1:05:37 PM
Mike -
Illiquid asset is an established economic term. It just means an asset where there is no market in which you can sell it. Nobody is trying to con you.
Some of this reminds me of the auction rate securities mess. The ARS themselves became illiquid when the auctions failed, but the underlying assets were still producing cash flow and paying interest. There was a disconnect between the value of the asset on a DCF basis versus what you could get in the market.
Posted by: nycfund at Sep 21, 2008 1:40:41 PM
nycfund -
Thanks. Do you then mean to surmise that the sum total of these illiquid assets might still be managed back to a degree of liquidity by a deep-pocket entity such as the US government? Or are they in fact the smoke and mirror devices that they seem to be?
Posted by: Mike Cooks at Sep 21, 2008 5:05:59 PM
nycfund is one of the few people on these threads (including Tyler and Alex) who gets what the problem is: the disconnect between DCF value and market value. It's been going on for over a year and it's slowly breaking down the banking system.
Mike, there are two different measures to keep in mind. One is liquidity, which is the primary economic justification of a bank. The Treasury plan is intended to restore liquidity by substituting liquid assets (Treasury bonds) for currently illiquid assets (MBS securities). The second measure is cost. The $700 billion number is meaningless. The government is going to purchase assets with another asset; theoretically, this exchange doesn't cost anything. The first level measure of cost is the difference between what is spent on buying up the MBS securities and the return on the MBS securities. I have no idea what that cost (or benefit) will be; neither does anyone else.
Posted by: Norman Pfyster at Sep 21, 2008 7:55:28 PM
Also, I would like to add that the phrase "socialized costs with private benefits" is the stupidest slogan I've heard in a long time, particularly coming from the mouth of liberals who support big government. It's an accurate description of every government spending activity (other than possibly crime protection).
Posted by: Norman Pfyster at Sep 21, 2008 8:02:09 PM
