Sept.23

“Some said we should just stick capital in the banks, take preferred
stock in the banks. That’s what you do when you have failure,” Mr.
Paulson told the Senate Banking Committee on Sept. 23. “This is about
success.”

Here is the link.

Comments

If it is success, he wouldn't be begging in the first place.

My prior that he's utterly incompetent is now at 105.3%.

In a sense he's right. The argument of Paul Krugman and other economist goes like this. Say a bank's balance sheet is the following:

Assets:
Alright mortgages/cash/car loans: 450
Toxic subprime mortgage exotica: X
Liabilities: 500

The Paulson plan assumes the true hold-to-maturity price of X is much greater than 50, but banks' balance sheets have started to appear insolvent to creditors due to mark-to-market. A good reverse auction gets the assets priced, the market moving and the government eventually comes out even. Then, everybody has a merry Christmas.

However, what if the Paulson plan's reverse auctions work, but correctly set the toxic stuff at X<50? Banks still cannot pay creditors nor take out more credit for themselves. To survive they'll need straight-up cash, not treasury bills nor cash for any of their existing assets. Cash will increase equity, which the government should be given ownership of. It's a very drastic step for banks that are indeed in failure.

Is it cheaper to prop up banks that are failing than close them, sell the deposits, and liquidate the assets? Perhaps in the short-run, but what happens in the long-term? Just putting in cash to cover the toxic securities may not be enough. What if there is a run? When do you stop supporting the institution? How much money do you risk?

At the time, I reckoned that this was the stupidest thing said by anyone in authority in the three days up to and including the 23rd. And there was plenty of competition.

I give Mr Paulson every credit and honor for changing his mind.

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