Paulson plan vs. Dodd plan: my email to Eric Posner

I thought the original Paulson plan was terrible with regard to rule of law, and in that sense I thought the equity stake idea of Dodd was better.  A modified Paulson plan might be as good, it is hard to say.

[Eric now blogs that the Dodd plan gives the Treasury more power than current versions of the Paulson plan.  His post is very important.]

In reality I expect that either the Paulson or the Dodd plan would have to move quickly to incorporate some aspects of the other.  We’ll likely get some version of both loan-buying and equity shares, in any case.

The key factor is what kind of institutions are set up for making the next round of decisions.  That’s not getting much attention but of course there is no reason to think this is the final step or the final change in conditions.

Think of a barrel of apples, some good, some less good.  To oversimplify, the Paulson plan has the government buy some of the bad apples.  The Dodd plan has the government buy a 20 percent share in the barrel.  In both cases government buys something.

My intuitive rule of thumb is to want the government to be doing its buying in the better organized, more liquid market.  They are less likely to screw that up.  That tends to favor the Dodd plan in my view.

I like one other feature of the Dodd plan.  Our government loves cash revenue.  Furthermore the U.S. economy is set up so the "public choice" advantage of the government owning banks for the long haul is not so obvious.  We don’t have "insider-based" capital markets, for instance, so owning a bank wouldn’t give a politician so much chance to dole out loan favors.  I believe our government would be in a hurry to reprivatize those banks in return for the cash.  The Paulson plan, as I understand it, does not have an equally clear end game.

I may put this email of mine, or an edited version of it, on MR, check there for reader comments…

Tyler

Night thoughts: How or whether do equity holdings give the government "upside" in eventual bank recovery?  Holding equity yields nothing if the banks never recover.  If the banks will recover, you would think a loan from the Fed would suffice.  But we’ve already tried that.  So what exactly are the assumptions here?  Somehow it is the Fed/Treasury actions which *cause* the banks to recover.  How does that happen?  They overpay for the loans at mysterious prices?  That just puts the Dodd plan back into all the problems of the Paulson plan.  If the government ends up overpaying for loans in the Dodd plan, and then someday gets 20 percent of that overpayment back through its equity share, is not a huge positive advertisement.  (Isn’t simply "knowing when to stop the subsidies" the best way to protect the taxpayers?)  And in the meantime, what kind of credit guarantees is the government offering these banks and their creditors?

Don’t forget Mark Thoma’s good analysis: "So, by having the government take a share of any upside, the result may
be less willingness of the private sector to participate in
recapitalization."

It is easy to say that the Paulson plan is worse.  (Oddly I think the Paulson plan makes most sense in Paul Krugman’s multiple equilibria model for asset values.)  But you shouldn’t think that the Dodd plan is very good.  Most of the Dodd plan boosterism I’ve seen doesn’t look very closely at how it actually going to work.  There’s lots of talk about justice and the taxpayers getting upside and then a reference to the RFC from the New Deal.

Finally, in my view the Paulson plan makes (partial) sense if a) the major banks are in much worse shape than anyone is letting on, and b) you believe in multiple equilibria confidence models for these underlying asset markets.  I’m not saying those assumptions are true, but it would be nice to start by confronting the exact assumptions under which each plan might prove better than the other.

Comments

I hate the Paulson plan because it's all carrot and no stick. I can't state how strongly I oppose using taxpayer money to shelter private sector investors from the consequences of their profit-seeking choices.

I hate the Dodd plan because it hands over even more control of the economy to the government. I can't state how strongly I oppose giving the government greater power as a participant in markets.

Here's my proposal (call it the "Speak softly and carry a big stick" plan):

The Treasury acts as a market maker for impaired assets, but any overpayment that goes to companies must be clawed back in the form of future tax obligations.

How it would work:

Let's assume you've got an MBS or CDO security with $1 face value, held by a number of different institutions. The market isn't trading, and the bid is 20 cents with an ask of 40 cents.

If the Treasury is going to get the market trading, it's got to narrow the spread, and if it's going to put taxpayer money on the line, it's got to take steps to protect their investment.

It can run a dutch auction, where it says it will buy $x of secuirities, and the insititutions compete for who will ask the lowest price (say 35 cents). So far, this is all carrot.

Here's where the stick comes in. As a condition of selling, the insititution must post a non-retractable bid, along with their asking price. The bid helps add liquidity to the market. To provide incentive for the company to place a higher bid (and narrow the spread), as a condition of buying the security the Treasury gets a priority claim (in the form of a deferred tax obligation) on the company for the difference between the bid and ask, times the face value purchased.

So if a company sold $1 million in face value to the treasury at a price of 35 cents ($350,000), and raised their market bid to 25 cents ($250,000), they would incur a $100,000 tax obligation to be paid out of future profits before any dividends can be paid to shareholders.

This would allow the markets to get moving again, banks can move impaired assets off their balance sheets, re-capitalize, and restore their credit-worthiness (since the tax claim is paid after interest costs), plus shareholders have to fully pay back taxpayers before they can realize any benefits of the bailout.

One week and counting: the world is still spinning just fine.

I like Alex's bridge analogy. Let's stop propping up collapsed bridges and instead support the ones that haven't failed.

I recommend Congress recall that it, in fact, is the law-making body of the land, and it could come up with an economic 'rescue plan' not only whether or not the Secretary of the Treasury liked it -- it has the authority to create entities like the Treasury in and of itself.

Maybe Congress ought to recall that they are, in fact, the ones with the power, here, and not an ad-hoc committee called together by the Secretary of the Treasury.

A year ago King Juan Carlos told Hugo Chavez "Porqué no te callas". Sorry Tyler but that's what I thought when reading your post.
You write "Think of a barrel of apples, some good, some less good. To oversimplify, the Paulson plan has the government buy some of the bad apples. The Dodd plan has the government buy a 20 percent share in the barrel. In both cases government buys something."
To have any serious discussion of the Paulson plan you have to know the terms and conditions of the purchase of assets. So far I have not seen any details and it is clear that you don't know them either (I have not been able to find any detail about the Dodd plan so I cannot say anything about it).

Anything that allows companies in need of bailouts to survive is not good. It contributes to moral hazard and encourages EVEN less reliance on individual responsibilty in the future.

Why is Goldman Sachs and JP morgan critical to the survival of our country? If some companies are so important could we have a list published of the sacred companies in this country? So that all the country can know who they should asprie to work for? or is this jus ta secret that only the right kind of people are priveleged to know about?

Paulson = douchebag
Wall Street = douchebags

They basically flushed the economy down the toilet and now they want us to crawl through the sewers to help them out.

Can someone tell why Dodd is involved in fixing this when he is part of the problem? He received a special mortgage rate from Countrywide, and he took money from Fannie Mae. I see a major conflict of interest.

So my understanding was that the equity stake business was partially to induce foreign governments to bail out their banks rather than letting the treasury do so. The idea being that these governments would be skittish about the US government having a substantial equity stake in certain big banks and thus be induced to bail these banks out themselves instead of having us do it.

No real idea if this is true but this is what I heard on some news program.

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