Where Do We Go From Here
How to Navigate the Mess Now That We Know How We Got Here
In my last piece I esteblished some clear evidence that the government was complicit in creating this “crisis” that we are in (continuing my aversion for the word crisis). This piece is aimed at finding a sensible way to correct the current problem without continuing the circumstances that got us here.
We’ll start off this journey with an Op-Ed in the New Republic titled The Wrong Emergency by Roger Lowenstein. (h/t Greg Mankiw) His article is aimed directly at the Hank Paulson authored bail out where the Treasury would buy distressed assets in order to free up liquidity in the markets.
Paulson, the former Goldman Sachs banker, whose stock when he cashed out in 2006 was worth half billion dollars, is sure to argue that the appropriations are necessary because the market is illiquid. Yet a market for mortgage paper still exists. “Sellers just don’t like the bids,” a hedge fund manager told me. A manager with a big money management company confirmed that if Citigroup, Goldman, and the rest want to unload their securities, his firm has money to spend. “We just can’t spend as much as Paulson,” he noted.
This is something that should intuitively make sense. The sellers wish to sell at a price higher than the buyers in the market will accept. Until the sellers are willing to lower their prices, we continue to have the situation we are in. The sellers, however, are betting against having to lower their prices. They hold on to them in hopes that the Treasury will swoop in a buy them all at a premium. This is one of the greatest concerns of a plan to use tax-payer financing: How do we know that Paulson and the Treasury will pay the correct price? Intuitively, they will have to overpay. Like Lowenstein says:
The only conceivable purpose of Treasury intervention is to buoy the market (using taxpayer funds) by paying higher-than-market prices. After all, if the government merely intended to match the market, what would be the point?
This is a point that Freakonomics co-author Steven D. Levitt voiced in a talk that he gave in St. Louis on September 23. He wrote a blog post asking this question:
Here’s the question: if these troubled assets are so cheap, why doesn’t anyone else besides the U.S. government want to buy them?
Indeed. If these assets really are available at fire-sale prices, why is the U.S. Treasury the only body that is licking their chops to get hands on them? It would make sense that if these were such a good “investment” (not the role of our government), then every other country should be scrambling to get a piece of the action.
Donald Luskin, in the National Review, wonders if the Paulson Plan is even necessary.
Of the $1.26 trillion in non-prime mortgages — that is, “sub-prime” and “Alt-A” mortgages — $743 billion is already either owned or guaranteed by Fannie Mae and Freddie Mac, companies that were shored up by a government rescue earlier this month. That leaves $521 billion, which means the Treasury’s $700 billion would be more than enough to buy them all. And that’s even if the Treasury paid full value. In fact, the Treasury will get a steep discount, considering that many of the mortgages in question are in delinquency or default. Does the Treasury really have to buy every single non-prime mortgage — even the healthy ones — twice over?
So where does Paulson get his $700B number from? That surely calls into question the legitimacy of the plan if he is asking for a number without a clear picture of how much it really will cost.
Opposition to the Paulson Plan is plenty (and growing): Newt Gingrich (and here, OpenMarket.org (here, here, here, here, here, and here), Sebastian Mallaby who has supported bailouts before, a dog pile of economists(over 100 and growing) have sent a letter to Congress asking for prudence and careful thought, Republican Study Committee Chairman Jeb Hensarling, Jonah Goldberg, the Senate Conservative Fund notes that the combined bailouts are going to cost $1.416 trillion(How can we afford that much?), etc., etc., etc.
So, what are the alternatives to the Paulson Plan? Senate Banking Chairman Chris Dodd, yes this Chris Dodd, has proposed that the federal government buy equity shares in companies that have the distressed mortgage securities. The theory is that it keeps the government from becoming the owner of the assets (at least directly anyway). Tom Maguire sees a few problems with this plan as well:
At first blush this approach does nothing to address Krugman’s assertion that the Treasury must inject new capital into the system. On day one, “Troubled” had $50 billion in bad assets. On day two, they had a check from the Treasury for $50 billion, which presumably was used to retire short term debt. And on Day Three “Troubled” showed $50 billion less in bad assets, $50 billion less in short term debt, and 1.25 billion new shares outstanding. The upshot – current holders were diluted in exchange for an opportunity to sell their bad assets at a negotiated price with Treasury. When did new capital come into the system? Not ever.
Dodd is calling, in effect, for random equity issuance with no underlying cash in order to dilute some owners if the Treasury chooses to sell assets at a loss, regardless of why or when that loss may have occurred. This does not bring new government equity into the system but may create enough uncertainty to deter private investors from joining in. That is stabilizing? How in the world will any of these firms attract new capital investors (if that is what is needed) with that random cloud over their heads? How will a prospective new investor in a firm evaluate the joint probability that (a) the assets sold by the firm a few years ago have depreciated and (b) the Treasury will actually sell them rather than ride it out?
So, in essence, the Dodd plan probably doesn’t do anything to help. It may even make matters worse.
What does that leave us with? Well, there are a smattering of other proposals that haven’t been formally introduced or duscussed much in the general public.
Arnold Kling argues that we need to lower capital requirements although he does admit that this still exposes the tax payers to risk.
The Republican Study Committee takes a three prong approach that looks to both alleviate the current problem and take steps to stop a repeat.
Raghuram Rajan and Luigi Zingales wants the government to tell banks that they can’t pay dividends. This frees up capital. [Banks won't do this on their own because it is a signal of weakness.]
The National Taxpayers Union has 11 points that they would like legislators to consider when creating an answer.
Megan McArdle cautions against simple sounding solutions like ending capital requriements and the mark-to-market accounting rules.
Economist Brian Westbury wants to allow firms to segregate assetts. “The government’s main role would be in providing insurance for the sequestered assets instead of buying them outright.”
Senator McCain offers five improvements to the Paulson Plan.
Senator Obama offers four.
After all of that, what do we do?
You got me. The one thing that we don’t do is rush to pass a bill without understanding what it will do and any potential pit-falls. This decision is too important to screw up by rushing into something nilly-willy.
Somebody pass that last message to Chairman of the House Banking Committee Barney Frank:
I think we have to recognize the reality that we don’t have a choice now of debating whether this is a good or a bad thing.