Myths about the proposed Paulson rescue plan
The devil is in the details, so lets focus the discussion better
The following myths and misconceptions seem about the core aspects of the Paulson plan are being widely disseminated. I think it makes sense to dispel those myths in one place.
Myth #1: A credit crunch only impacts “Wall Street”. I don’t think most people believe this myth. However, I put it out there in the interest of fairness and objectivity. I am a self-employed attorney. My clients are predominantly small businesses. A credit cruch impacts everyone. Job creation will be negatively impacted. Here in the midwest, many of the automotive companies are cash strapped and dependent upon the availability of credit. A full-board credit crunch will do considerable damage to Michigan’s unemployment numbers, which are already close to Western European levels. Not sure if the entire nation would be put into a depression, but I do think Michigan’s unemployment numbers good get close to 20% if there is a large crash.
To my fellow opponents of the Paulson plan, I say don’t use the “Wall Street isn’t Main Street” lines in an attempt to divide up parts of the country that actually depend on each other. I understand that politicians use such lines as crutches, but were are mere bloggers, so lets be honest about that aspect.
Myth #2: Opponents of the Paulson plan favor doing nothing. This is a weak straw man argument. While there may be some proponents of simply doing nothing, I am not aware of a single official in Washington DC or any voice in the public debate supporting the position of doing nothing.
Myth #3: Its either the Paulson plan or nothing. For a partial list of alternative ideas, check out the following links. Maybe we can’t get these through Congress, but they seem a lot less extreme than the Paulson plan, so who knows. Besides, some things can be done by executive order and regulatory rule making. Suspending the Mark-To-Market Accounting rule for a couple of weeks would be a great start.
Myth #4: This problem is caused solely or even primarily by bad loans. 91% of mortgages are in full compliance. 9% are in some state of deliquency. Lets assume for the sake of argument that 9% of mortgages are in 100% default and that the home values of those mortgatges is actually $0. Neither assumption is valid, but assume that negative outcome for the purpose of this analysis. GM’s losses in the last full quarter of 2008 far exceeded 9%. It has been losing money for years, and yet is still able to operate. In contrast, the Wall Street banks have been raking it in until recently. There is clearly more at play here than merely bad loans.
The equation is some bad loans + mark-to-market rule + debt to equity rule = Current Crisis. Bad loans are just the initial spark for this crisis. The other two rules are the causes of the severe spreading of that fire.
9% losses are not enough to bring a Wall Street firm to its knees. However, under Mark-To-Market accounting rules, 9% mortgage delinquency has resulted in an aggregate decrease in value of mortgage-based securities that far exceeds the 9% deliqyuency rate. The bubble popped–and many good mortgage paper is just as distressed as the bad paper.
Under the Mark-To-Market rule, an asset can only be valued as high as an immediately available sales price. Combined with a fixed debt to equity ratio, the MTM rule forces firesales of distressed assets, further reducing the temporary market value of those assets.
In other words, the MTM rule plus the DtoE rule means spiraling distress sales of relatively illiquid assets. The purpose of the Paulson plan is actually to address this by purchasing paper at “above market rates” (e.g. above teh MTM value).
Myth #5: Any deviation from the Mark-To-Market Rule is fraudulent accounting. MTM was optional in this context until as recently as October 2007. I believe it was originally introducted for these types of securities in 1997. I don’t see how the temporary use of 1996 accounting rules for illiquid assets is more fraudulent than Paulson deciding the “true value” of the paper.
As a compromise, I propose we adopt the Paulson Valustion Rule–let Paulson substitute his “fair value” for each distressed asset (he would have to do this anyway under the Paulson plan, so I say evaluate away Mr. Paulson) and let companies use that valuation in their balance sheets, which will expand the debt they can take on, etc. and generally unravel the problem.
Anyway, I hope this helps. This “debate” is very frustrating as we are all talking past each other. Of course, it would be nice to have actual policy makers address some of the Paulson alternatives . . .