Is the Sweden plan so much better?

by on September 29, 2008 at 7:47 am in Economics | Permalink

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:

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

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?

1 Andrew Edwards September 29, 2008 at 8:09 am

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.

2 bunbury September 29, 2008 at 8:32 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.

3 Tyler Cowen September 29, 2008 at 9:09 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.

4 Dan September 29, 2008 at 9:28 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).

5 Andrew Edwards September 29, 2008 at 10:17 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.

6 meter September 29, 2008 at 10:47 am

This seems like the equivalent of a bank requiring a 20% downpayment. The other side needs to have some skin in the game.

7 B.H. September 29, 2008 at 11:24 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.

8 mk September 29, 2008 at 11:59 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.

9 ogmb September 29, 2008 at 12:21 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.

10 will mcbride September 29, 2008 at 12:26 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:

11 Randy September 29, 2008 at 1:00 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.

12 J.D.B September 29, 2008 at 2:00 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:

13 Anonymous September 30, 2008 at 1:32 am

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…

14 ML October 1, 2008 at 1:16 am

When paying, say, $1 worth of option, employers get more out of employees than if they pay the $1 in cash. That’s why employers throw options in there. Not exactly the same in the case of warrant.

15 Per H. October 1, 2008 at 4:44 am

“Swedish governance is in many ways of higher quality than American governance.”

This is probably true today, but was not so in the early 1990s. Perhaps the biggest contributing factor to the Swedish banking crisis was that the Bank of Sweden raised its steering rate to 500 percent, in order to defend an overvalued crown. This was the time when the so called time consistency problem and the necessity of tying oneself to the mast was all the rage in economics. Imagine what would happen if the Fed in the current situation would raise the fed funds rate to 500 percent, in order to defend the value of the dollar? Because the Swedish government with its mad monetary policy was destroying the banking system, it had no other choice but to bail out the banks.

16 Geoffrey October 1, 2008 at 7:44 am

Tyler, if I try to give a response to Mankiw’s correspondent, will you explain how Mankiw’s correspondent was connected to reality?

The warrants would be equal to the difference between the price the Treasury pays and the value of the asset at some future date (say a year from now), if the value of the asset is below the price. That is, V_w = min(P_a – E(V_a_future), 0). If a firm sells Treasury an asset at a price EQUAL or LESS THAN to the value of the asset at the future date (i.e., there’s no decline) than the value of the warrant, V_w, is zero. Only if the firm sells an asset at a price GREATER than the value of the asset at the future date does the warrant exist, and then is equal to the difference.

If the firm has good information on the long run value of the asset, and sells at a price equal to the value, the warrant will have a zero value, and have no impact on the price.

Now, can you explain why the @#$#%% you paid attention to Mankiw’s correspondent in the first place?

17 jdcrisp34 October 30, 2008 at 12:47 pm

I believe that the nationalization of banks in the US is a horrible idea. You cannot have realistic economic growth and a reasonable free market system when you envelop it with an artifical system of control like nationalization. We are not Sweden, we are the United States of America. We Americans live in a democracy and the nationalization of banks is just putting us one step closer to being like the socialist countries out there. I think that although the $700bil. bailout plan is highly unpopular, it will produce good results as long as the corrupt businessmen don’t take advantage of it like the AIG executives did by taking a $400,000 retreat.

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