On purely mechanical grounds, others can better explain why the notion that Treasury will be able to use market mechanisms (e.g. reverse auctions) to price the junk transparently is laughable, given the extremely heterogenous nature of the instruments they'll be buying. Again, as a mechanical matter, I'm less concerned about objections that Treasury would hire outside firms to dispose of the assets that are purchased -- the use of Asset Management Companies to handle the cleanup of busted banking systems is a familiar solution in financial crises. The objection to AMCs isn't their structure but that they don't move us any further in promoting workouts of mortgages so that the downward spiral in asset values can be ended.
But rather than objecting on political or technical grounds, I want to focus on what I see as the fundamental problem with the proposal. We don't know what this proposal is trying to accomplish. And under almost any scenario, it is highly unlikely to work. If this proposal had been made by an Asian government during the financial crisis of 1998, it would have been hooted down by international financial experts, led by the US Treasury, as wishful thinking and crony-protection on a gigantic scale.
This proposal isn't simply a matter of removing some toxic sludge that's gumming up otherwise healthy financial plumbing. As a two-year roll-over facility of $700 billion, it's a much bigger deal than the government getting new authority to provide liquidity to the system. With hundreds of billions involved, it's more than simply being authorized to take risky assets of uncertain value in return for providing liquidity to otherwise healthy financial institutions (FIs) who don't have access to the interbank markets due to the uncertainty that has frozen the global markets.
In very simple terms, there are two alternative possible objectives to this gargantuan proposal, but we haven't been told which one is the real purpose.
- Treasury intends to pay a low price for toxic waste to desperate financial institutions (FIs), get the junk off the FIs' books, and allow the "system" to recognize the losses but stop further bleeding (any futher bleeding will take place in Treasury's hands at taxpayer expense), so the affected FIs can take further steps to delever their balance sheets and recapitalize.
- Treasury intends to pay a high price for toxic waste, which will serve to effectively recapitalize FIs who are allowed to sell their junk to the government.
Scenario 1. If the government's purpose is to pay a low price merely to "stop the bleeding," there are two challenges. First, since FIs will not be eager to book losses that will leave their balance sheets exposed, only those FIs who find themselves in extremis are likely to take advantage of the facility. Second, stopping the bleeding is only the intial step. If an FI's core businesses is solid after the junk is removed, they'll still be left with repairing their balance sheets. They'll have to deleverage (selling off assets and engaging in less, not more, new lending) and recapitalize (finding new equity or highly subordinated debt from private investors). Most will be looking for a buyer. And if a buyer can't be found, it's liquidation time, most likely in the hands of a government agency like the FDIC. So a "low price" scenario will necessitate further government action, both to complete the clean-up process and to counter the credit crunch that will accompany deleveraging by surviving FIs. if Treasury is trying to smooth things over until the private sector or the FDIC or a future RTC can recapitalize/liquidate these firms, why not just do it straight away in a clean (and probably cheaper to the taxpayer in the long-run) fashion by setting up an RTC now.
Scenario 2. If the government's purpose is backdoor recapitalization, we have a different set of problems. This would be a pure bail-out, with no apparent cost to the participating FIs. The core dilemma, then, is how to allocate this taxpayer largess. Toxic waste is littered across the entire global financial system, not simply in US-based banks and investment banks but in foreign FIs (which are inextricably linked with American FIs -- a major reason why both Fannie/Freddie and AIG had to be taken over) and in non-banking institutions, from hedge funds to pension, insurance and mutual funds.
Objections to preferential deals will rise not only from those footing the bill -- US taxpayers -- but from other holders of US MBS, especially competing FIs. Treasury could allocate the goodies on the basis of need -- giving preference to FIs who needed recapitalization -- but that would reward the managers and shareholders who are most responsible for the current state of affairs. If I'm Citibank or BofA (or Deutschebank) and have managed to survive this long, how enthusiastic am I going to be if WaMu gets a bunch of junk taken off its hands at a price that allows it to stay in business? The "healthy" FIs benefit only to the extent that the system avoids a catastrophic meltdown or they escape rising liabilities or declining assets as parties to toxic Credit Default Swaps. These aren't minor benefits, but when the time comes for FIs to queue for freebies, how likely will it be that the healthier FIs won't scream bloody murder if they're forced to go to the back of the queue? Or as an individual investor, why should WaMu get a good deal on the junk it holds, when my own investment-grade bond fund, where I have my retirement funds, gets no benefit? (As an early indicator that eligibility for the toxic waste buy-up program may be highly prized, Calculated Risk notes that the Treasury Fact Sheet implies that foreign institutions may be eligible if they have substantial US operations. Not only fair but, since the crisis is truly global, probably necessary if the program is to have a chance at working.)
The only scenario that makes any sense is a highly unlikely "Goldilocks" scenario -- Treasury is able to set a price that's just right. This is the condition that Williem Buiter at the FT says is critical.
Prices should be higher than what the banks that own these assets now can obtain in the market, but as far below their fundamental value as is consistent with the survival of these banks. This is both to protect the tax payer and to create the right incentives for future risk taking by the banks. Punitive pricing is therefore essential. If the banks and their shareholders don’t complain loudly about expropriation through under-pricing, then prices are too high.Buiter thinks a reverse auction would be able to find this just mean -- I and many others have my doubts given the characteristics of the instruments to be auctioned. But accepting for the sake of argument that a market mechanism could be devised to auction the toxic waste, it's a futher heroic assumtion that it will set a Goldilocks price. The prospects of the auction must hurt a little so sound FIs won't be encouraged to participate (they'd rather take the risk of further declines in asset values). But it can't hurt a lot, so wobbly FIs will be eager to participate. With a "Goldilocks price," only the toxic waste that's gumming up the system is removed. Under this unlikely scenario, once the dust settles and the "true" condition of everybody's balance sheets is clear, counterparties can once again deal with each other with confidence, and the regulators can determine which FIs are still in trouble and force their sale or shut them down.
Even under the Goldilocks scenario, the financial system would remain in a precarious state. That's because the proposal doesn't deal with the underlying deterioration in asset values -- the mortgage crisis itself -- nor does it address the ever-increasing liabilities (bond insurance, Credit Default Swaps) that are linked, directly or indirectly, to declining asset values and eroding FI balance sheets. Because it doesn't take a sufficiently systemic approach -- the erosion of asset values and the disruption to the credit markets -- it also isn't set up to deal with contagion into other classes of financial assets such as asset-backed commercial paper (credit card receivables, etc). So even the best case Goldilocks scenario doesn't address the ongoing credit crunch because it doesn't recapitalize the financial system, it only keeps it from collapsing.
The Treasury proposal is a gigantic exercise in temporizing. It's still treating the problem as a liquidity crisis, and as Dean Baker points out, Paulson's track record at temporizing hasn't been stellar -- he's consistently underestimated the scope and intensity of the crisis at each stage. And fundamentally, the proposal doesn't address the heart of the problem -- the continuing downward spiral in the value of US mortgage assets and the permanent damage that has been wrought on global financial institutions.
For $700 billion we should make headway on the core problems. It's evident that we can't rely on voluntary participation by mortgage holders in cleaning up the housing market mess, but the experience of the FDIC with IndyMac suggests that progress can be made when "voluntarism" is removed. Any workable proposal must, at its heart, provide a system that will force underwater mortgages into workouts where feasible rather than continue to flood local housing markets with vacant foreclosures. "Equilibrium" in the housing markets can be found at several levels -- we shouldn't have to wait until we have a total bloodbath in housing to begin gaining traction at a bottom of the mortgage market. Addressing the housing crisis isn't a "Christmas tree" add-on as a sop to Democratic politicians. It should be a core part of any proposal.
Any proposal should also openly undertake the process of recapitalizing or liquidating dodgy FIs at a cost to the managers and shareholders of those FIs. Backdoor recapitalization via generous prices for toxic waste isn't going to solve the crisis of confidence. First, it's non-transparent. It would reward the worst offenders. It would also privilege some FIs over others on arbitrary (regulatory discretion) grounds or by applying eligibility rules that leave out important classes of affected FIs. When combined with other recent regulatory forebearance (e.g. allowing the recognition of "goodwill", exemptions to net capital requirements that have permitted excessive leverage), non-transparent recapitalization will leave much of the financial system fragile and susceptible to further unpleasant surprises.
We need a FDIC/RTC-type hybrid now that would temporarily take over problem FIs, engage in triage, supervise the purchase or recapitalization of those that can survive, and liquidate the others in an orderly fashion.
The proposal should also outline a plan for bringing the Credit Default Swap market under control and for establishing a regulated market in credit derivatives going forward.
If that costs $700 billion -- or even eventually carries a higher price tag -- so be it. But at least we would know where we were trying to get to and how we intend to get there. Which we certainly can't say about Treasury's proposal.
But whatever we decide to spend our $700 billion on, it's important to recognize that we have choices. The real economy may not yet have taken a giant hit from our financial sector difficulties, but it's just a matter of time. We're not going to avoid a significant recession, but attention to the real economy should help us avoid a depression. While addressing the current financial crisis, we need to take real sector effects into account in any program going forward. Here are some thoughts on what our choices might be from Steve Randy Waldman at Interfluidity:
I think we'll only get one shot to set things right by throwing a ton of money at the problem, so we'd better think carefully before we throw it at symptoms rather than causes. Trying to figure this out in a week before Congress goes off to reelect itself strikes me as ambitious. Broadly, my view is that if we are going to legislate, Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. Going forward, investors should understand that firms that are too big to fail are too big to be debt-financed, and government enforcement of debt claims against such firms will be limited. If economies of scale are real, equityholders should be glad to reap them. Otherwise markets function better anyway when populated by small actors who compete rather than by behemoths who dominate. The government should not subsidize the many negative externalities of scale. Members of the Pigou Club might suggest that bigness should be taxed and diversity subsidized.
As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I'd rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let's spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.
There's no such thing as a choice-free bailout. The government's largesse will go to some and not to others, and we have to decide. Don't believe self-styled technocrats who claim that science or the market tells them who deserves the tax- (or inflation-) payers' dollar. In a bail-out, there are winners and losers, and we get to pick. I think we should focus on a simple goal: Restructuring the economy so that the vast majority of Americans can afford a middle-class lifestyle with very little leverage on household or government balance sheets. That may be a radical suggestion in 2008, but our grandparents would have considered it only common sense.
Recommended reading:
Doublas Emendorf, Brookings: Concerns About the Treasury Rescue Plan -- good technical analysis; includes pros/cons of optional approach of Treasury buying equity in troubled firms
Paul Krugman: Doubts about the rescue
No Deal
Authorization for use of financial force
Henry Blodgett, ClusterStock: The critical question about Paulson's rescue plan
Naked Capitalism: Why you should hate the Treasury bailout proposal
Calculated Risk: Some thoughts on the bailout
Interfluidity: Truth and Reconciliation -- on why transparency in pricing and participation is essential to a bailout proposal
David Merkel: Oppose the Treasury's Bailout Plan -- and bring back a true RTC
Robert Reich: The Coming Bailout of All Bailouts Bill -- A Better Alternative
Mary Kane, The Washington Independent: AIG raises bar for action on mortgages: Activists push for mortgage crisis intervention
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