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.

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?

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.

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.

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.

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...

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.

"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 :)

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?

'..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'.

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.

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