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Will it work?

September 28th, 2008 · 1 Comment

The bailout plan seems on track, that’s step one. But another, more fundamental question is, will it work? Opinions differ. Not everybody is enthusiastic, or even optimistic…

Paul Krugman is not convinced.

The good, the bad, and the ugly

  • Brad DeLong says that Swedish-style temporary nationalization is the right answer to a financial crisis; he’s right. I haven’t been clear enough about this, it seems, but it’s where my basic diagnosis leads: the problem is insufficient capital, you want to inject capital, but you don’t want it to be a windfall to existing stockholders — hence, take over and recapitalize the failing firms. By the way, that’s what we did with AIG 10 years days ago.
  • So that’s the good solution. The Paulson plan, which is some combination of sheer giveaway and mystic faith that a slap in the market’s face will make everything OK, is a bad solution (and probably no solution at all.)
  • But nationalization doesn’t seem like a politically realistic answer now. This leaves the rough question of whether to hold out for a good solution, which won’t be possible until Jan. 21st, or accept the ugly compromise that the WH and the Congressional Dems, once again, say they’ve reached. It’s a tough call, but as I’ve written, I’ll probably hold my nose and say OK — as long as it has broad Republican support.

One of the more important questions is whether the fundamental problem is a lack of liquidity or a lack of capital.

Proponents of the first, a lack of liquidity, basically argue that the markets for all those derivative products based on mortgages are jammed and unrealistically pessimistic. A slap in the face of these markets would get them out of their funk, and this would enable ‘price discovery’, which would lead to higher prices and functioning markets again.

Banks and other financial institutions with a lot of this stuff on their books (which they have to value at market prices, hence their ‘perceived’ lack of capital) would be able to sell it when the government operates as a big buyer, and hence they would be able to recapitalize.

On the other hand, there are those, like Krugman, who think that the problem is more fundamental than that, it’s a lack of capital.

Once again, Paul Krugman:

  • Nouriel Roubini has a characteristically scathing takedown of the Paulson plan, and here’s the thing: language aside, his economic analysis is similar to mine. The fundamental problem in the financial system is too little capital; bizarrely, the Treasury chose not to address that problem directly, by (say) purchasing preferred shares in financial institutions. Instead, the plan is premised on the belief that toxic mortgage-related waste is underpriced, and that the Treasury can recapitalize banks on the cheap by fixing the markets’ error.
  • The Dodd-Frank changes make the plan less awful, mainly by creating an equity stake. Essentially, this makes it possible for the plan to do the right thing through the back door: use toxic-waste purchases to acquire equity, and hence inject capital after all. Also, the oversight means that Treasury can be prevented from making the plan a pure gift to financial evildoers. But it’s still not a good plan.
  • On the other hand, there’s no prospect of enacting an actually good plan any time soon. Bush is still sitting in the White House; and anyway, selling voters on large-scale stock purchases would be tough, especially given the cynical attacks sure to come from the right. And the financial crisis is all too real.
  • So is it better to have no plan than a deeply flawed plan? If it was the original Paulson plan, no plan is better. Dodd-Frank-Paulson may just cross the line — let’s see what details we have if and when agreement is reached.
  • If the plan looks not-awful enough, I’ll be pro. But I won’t be cheering — I’ll be holding my nose.

Nouriel Roubini, the now famous economist who predicted all this mess years ago, isn’t too impressed witht the plan either:

  • Specifically, the Treasury plan does not formally provide senior preferred shares for the government in exchange for the government purchase of the toxic/illiquid assets of the financial institutions; so this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the firms; with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.
  • Moreover, the plan does not address the need to recapitalize badly undercapitalized financial institutions: this could have been achieved via public injections of preferred shares into these firms; needed matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; suspension of dividends payments; conversion of some of the unsecured debt into equity (a debt for equity swap).

If banks lack capital, buying these mortgage backed assets won’t solve the problem unless the government offers way higher prices, because they are valued at market prices on the books of financial institutions.

However, there are those that argue the Treasury doesn’t need to overpay for the mortgage backed securities, as they are priced way under their real value. From an anonymous friend of economist Greg Mankiw:

  • But the assertion that the plan will not boost capital is wrong. If Treasury gets the asset prices exactly right next week when the reverse auction starts, those prices will be higher than the prices that would have obtained before the program was announced. That difference means that by paying the correct price next week we will be injecting capital relative to the situation ex-ante. Treasury does not need to overpay. And the taxpayer can still see gains — say if the announcement and enactment removes some uncertainty about the economy and asset performance, but not all. Then prices could rise further over time. But the main point is that it is not necessary to overpay to add capital. I think Krugman is a leading purveyor of the “they must be intending to overpay” assertion.

So it’s all about whether the prices for these assets on the markets today are real, or whether they are grossly underpriced. Markets should be efficient of arriving at the right prices, but under-regulated markets, especially when dealing with very complex financial products, might not be so good at that, as we argued earlier. Here is another take on that:

Chicago economist Robert Schimer:

  • Next, let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues, not necessarily the opinion of other signatories of the letter. As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.
  • When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof’s classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information this makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers’ belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.
  • The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.
  • With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.
  • This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. (Of course, it cannot increase too much, or no one would sell to the government. They would wait to sell at the higher market price. I have not worked out the equilibrium of an auction with an option to resell later. It seems complicated.) But this is fundamentally no different than giving taxpayers’ money to owners, managers, and debt-holders of firms that made the worst decisions.

It’s akin to what we argued before, the fundamental problem is under-regulation of financial markets leading to exploitation of information asymmetries (Akerlof’s ‘lemon problem’). Shimer offers some interesting description on how that works here.

Anyway, another question is whether the bailout plan will save the US economy. Not much optimism here either, if past experience offers anything to go by:

Bailout Too Late to Matter Much

  • Saturday, September 27, 2008 3:00 PM. SAN FRANCISCO — Not even $700 billion will be enough to spare the United States from more economic anguish if the government’s proposed banking bailout pans out like similar desperation moves during the past two decades.
  • It usually takes years to recover from a financial crisis severe enough for politicians to ride to the rescue with truckloads of taxpayer money.
  • Take, for example, the U.S. government’s August 1989 bailout of the savings-and-loan industry. The stock market fell by 12 percent within the first 14 months of the rescue plan while the economy slipped into an eight-month recession that began in July 1990. Housing prices that had just begun to erode continued to fall for another three years.
  • There’s little reason to believe it will be dramatically different this time around, particularly since this bailout involves harder-to-value assets and comes with the U.S. economy already on the edge of a recession, if one hasn’t begun already.
  • This is going to take years to work out and it will be incredibly complicated,” predicted banking consultant Bert Ely, who has extensively studied the U.S. government’s 1989 bailout.
  • Although lawmakers are still sparring over the precise details, the proposed bailout would authorize the government to borrow up to $700 billion to buy the toxic assets poisoning banks. Most of these holdings are tied to mortgages made to borrowers who either can’t afford to make their monthly payments or have simply chosen to default because they owe far more than their homes are worth. No one seems quite certain how much these assets are worth, but the government is betting that _ with time _ it can get a handle on it and eventually profit.
  • Even as the government tries to clean up the mess left by reckless home lenders, borrowers and investors, more problems are likely to stack up.
  • The trouble could include longer unemployment lines as struggling companies faced with declining sales and limited access to credit trim their payrolls. That could lead to even more bank failures as cash-strapped borrowers don’t repay loans. And most experts think there’s still a good chance the downturn in the housing and stock markets will deepen to further spook already frightened consumers.
  • The government is hoping its intervention will unclog the lending pipeline, but that isn’t a certainty either, said Sung Won Sohn, an economics professor at California State University, Channel Islands.
  • “If I am a medium-sized bank on Main Street, simply because the government is bringing a bailout package to Wall Street doesn’t mean I am suddenly going to change my mind and start lending money again,” Sohn said.
  • That suggests the economic statistics won’t even capture some of the collateral damage _ all the lost lending opportunities that occur as banks try to bolster their rickety balance sheets. Many banks have curtailed their lending because they are already swimming in losses and don’t want to risk drowning by taking chances on more borrowers.
  • “The real tragedy is we will never know how many businesses would have been started or how many businesses might have expanded if all this hadn’t happened,” said Jonathan Macey, deputy dean of Yale Law School, who wrote a book about a government bailout in Sweden during the early 1990s.
  • In a best case scenario, Macey said the United States will bounce back within two years, like Sweden did after the government spent billions of dollars to salvage the country’s troubled banks and prop up a slumping housing market.
  • Before the medicine took effect, Sweden suffered through a 20-month recession that saw nearly 60,000 companies go bankrupt, housing prices fall by 19 percent and the country’s bellwether stock market index plunge 45 percent from its peak. Once the hangover ended, the good times resumed; Sweden’s economic growth has averaged 3.2 percent since 1994.
  • Sweden spent 65 billion kronor (about $10 billion at the time), but made most of the money back because it bought a stake in some of the troubled banks. The government still owns nearly 20 percent in one bank _ a stake that is now up for sale. U.S. lawmakers also have been debating whether it makes sense to acquire stock in some of the banks that the government intends to help out.
  • In a more sobering situation, the payoff from the U.S. bailout might take much longer. That’s what happened in Japan after its government finally intervened in a real estate and banking crisis that began in the early 1990s.
  • By the time the government acted in 1997, the economic hole was so deep that it took another seven or eight years to climb out. The net public outlay to clean up mess was 18 trillion yen ($168 billion), according to the Financial Services Agency.
  • The abysmal times in Japan during the 1990s are now known as the “lost decade.” Even though the economy is better now, the Japan’s stock market still hasn’t returned to its peak before the bubble burst. And Japan still has about $9 billion worth of property held as collateral that needs to be sold.
  • It seems unlikely that the United States will have to wait as long for a recovery because the government is wading into the financial muck much more quickly than Japan did.
  • In contrast, the United States is promising to bail out its banks 18 months after mortgage lender New Century Financial Corp. filed for bankruptcy _ a move that set off alarms about the rot ruining home loan portfolios.
  • “Some resolution measures are more effective than others in restoring the banking system to health and containing the fallout on the real economy,” the International Monetary Fund concluded in a study of 124 financial crises since 1970. “Above all, speed appears to be of the essence.”
  • Even if the U.S. government is moving in time to make a difference, success is likely to hinge on the ability to figure out the right price to pay for an exotic mix of mortgage-backed investments and other serpentine securities that aren’t easily appraised. And then the government must hope the housing market eventually rebounds to lift the value of the acquired assets.
  • If those pieces fall into place, the United States could profit or at least minimize its losses. On the flip side, the losses could be huge if the government misjudges the value of the problem assets or the housing market remains in a funk.
  • “The best we can hope for is that this (bailout) buys us time,” said Edward Yardeni, who runs his own economic research firm.
  • The United States moved a little quicker to address the mortgage crisis than it did in the savings-and-loan debacle of the 1980s. Although warning signs of an industry breakdown started to flash in the mid-1980s, the government waited until August 1989 to create the Resolution Trust Corp. to dispose of the repossessed homes, offices, cars, planes and even artwork held by failed S&Ls.
  • During the next six years, the RTC sold nearly $400 billion in assets on the books of more than 700 failed thrifts. Taxpayers ended up sustaining a loss of $125 billion to $150 billion on the fire sale _ about 2 percent of the country’s gross domestic product by the time the bailout was completed in 1995. Entering the S&L bailout, the government had projected a taxpayer loss of $40 billion to $50 billion.
  • If the ratio of losses to assets inherited in the latest $700 billion bailout is similar to what occurred in the S&L crisis, the taxpayers will be saddled with a bill of more than $250 billion, which also translates into about 2 percent of the nation’s current GDP.
  • Data from the IMF’s study suggest the losses could run even higher. The monetary fund calculated governments typically recover about 18 cents on every dollar spent in bailouts _ a rate that would translate into a loss of more than $500 billion. The United States seems unlikely to sustain a loss that large since it presumably will be buying the banking assets at a sharp discount _ leaving plenty of room for an upside.
  • Although the S&L bailout was the biggest in U.S. history before this one, the challenges facing the government are radically different.
  • In 1989-95, the government and an army of contractors disposed of assets that were dumped into their laps as S&Ls collapsed. And it wasn’t too difficult to figure what those assets were worth because their value could be easily measured against similar property. That’s not the case this time. Part of the reason so many banks are imperiled is that no one is sure what their investments are worth.
  • Most economists agree absorbing the bailout’s costs are preferable to running the risk of the entire U.S. financial system unraveling _ a calamity that would probably trigger a global depression. But knowing things could be even worse probably won’t make it easier to stomach the turmoil still to come.
  • Unwinding asset and credit bubbles is a long and arduous task even with aggressive government involvement,” Merrill Lynch economist David Rosenberg wrote in a report titled “Capitalism takes a sabbatical.”

Tags: The Markets

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