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Bailout, nationalization, policy, law.

Why do many economists prefer nationalization (or some more modest version where government takes control of financial institutions) to the bailout approach? Under the bailout approach, Treasury purchases mortgage-related securities from banks in a reverse auction. Currently, these securities are not being traded even though they clearly are worth something (they give holders the right to a fraction of mortgage payments, which is worth some amount greater than zero unless homeowners will default immediately and their houses are worth nothing in foreclosure). It is a bit of a mystery why no one will buy or sell them; apparently, they are too hard to value and holders don't want to dispose of them for minimal amounts because their price might rebound. So the toxic waste remains on their balance sheets, making it hard for outsiders to evaluate the solvency of financial institutions and thus reluctant to advance funds to them.

There seem to be two distinct objections to the bailout plan:

1. It's inefficient. If Treasury buys up an entire class of securities, it will buy them from solvent institutions as well as insolvent institutions. These solvent institutions don't need help from the government; only the insolvent institutions do. It would make more sense for the government to lend money to the insolvent institutions, or allow them to fail and take on (some of) their liabilities, while leaving the solvent institutions alone. To be sure, if the government pays the "right" amount for the mortgages, it doesn't subsidize the solvent institutions; but then it will also not help the insolvent institutions which will remain insolvent.

2. It's unfair. If Treasury wants to help insolvent institutions, it will have to overpay for the securities. But the government gets nothing in return for this money, which will end up in the pockets of shareholders to the extent that it exceeds what is necessary to return these firms to solvency. Meanwhile, the solvent institutions that sell their securities at a high price get money for nothing, which ends up in the pockets of rich shareholders (of course, not all of them are rich).

Under the nationalization approach, the government gives money to institutions in return for equity, which makes the government a part- or full-owner of the institution. The government doesn't buy up healthy institutions, just insolvent or near-insolvent institutions. If these institutions recover, the government makes a profit; if not, at least their shareholders get nothing. Meanwhile, as institutions become healthier, they will become more willing to trade their mortgage-related securities (why, exactly?) or at least they can hold them until maturity without failing. The nationalization approach is more efficient than the bailout because it focuses government resources on the institutions that need help. And it is fairer because taxpayers don't subsidize healthy institutions and they obtain a return if failing institutions recover.

I have two questions about this argument. I haven't found answers on the web or in the academic literature, and would grateful be if commenters would answer them or point me to relevant discussions.

1. In both cases, the degree of unfairness and inefficiency is a function of the competence of the government regulatory authorities, not the design of the law itself. If the government pays the correct prices under the bailout, it won't end up subsidizing the healthy institutions; if the securities are worth more in the government's hands, then taxpayers will make a profit when they mature. To be sure, the correct pricing won't help rescue insolvent institutions; it will just make them easier to value; but the government retains the option to lend to these institutions, buy them, or help them in other ways, under its existing legal authority. So the bailout has to be accompanied by equity infusions, but no one has claimed that it wouldn't be. If we can't trust regulators to price securities correctly, that bodes ill for nationalization as well. The government has to price the equity correctly. The government has to supervise the firm competently. And it has to sell the firm eventually. If the government can't determine the correct prices for purchasing mortgage-related securities, why do we think it can determine the correct prices when it sells off businesses? If it charges too little, it will end up transferring taxpayers' money to a class of rich investors. Bottom line: do the critics of the bailout make assumptions about the competence of regulatory authorities that is inconsistent with their support for a nationalization plan?

2. As I noted above, the government already has authority to conduct rescues of failing financial institutions, which makes one think that the critics overstate the contrast between the bailout plan and the nationalization alternative. The bailout plan gives Treasury (new) authority to buy certain securities. Otherwise, the Fed would have to buy and dispose of these securities (under existing authority). I gather that Bernanke does not think the Fed should get into this business and thinks Treasury could handle the job more efficiently. The various descriptions of the nationalization plan that I have seen do not explain why existing statutory authority is inadequate for nationalization at some level. The Fed (and FDIC) already can (in effect) take over financial institutions, as we saw with AIG. Does the nationalization proposal boil down to the parallel claim that Treasury rather than the Fed should be handling this business? Otherwise, can't nationalization or some version of it proceed alongside the bailout, with more AIG-like transactions? If so, what exactly are the nationalizers unhappy about? As far as I can tell, they don't seem to oppose the bailout in principle, just the idea that it is the only thing to do. But no one claims that it is.

Perhaps, critics of the bailout plan are mainly distressed that the Bush administration has been insufficiently aggressive about nationalizing firms, and the whole question of what the statute says is a red herring. From what I can tell, it seems that the Fed and Treasury are taking an ad hoc approach. They want to buy up mortgage-related securities and take over firms, as circumstances dictate. Of course, they can't nationalize in the old-fashion sense of coercively taking over solvent firms, but that course was not taken even in Sweden. In Sweden, it was not the case that all banks were nationalized; only those that accepted the government's terms were, and not all did. These were the insolvent banks—the same type of institution that the Fed and the FDIC can take over under current law. Bottom line: I can't tell whether the critics of the bailout statute are criticizing Congress for failing to compel regulators to take a more aggressive line; are criticizing regulators for failing to ask Congress for authority that they need in order to take the optimal course of action; or are criticizing regulators for failing to take the optimal course of action even though they already have authority to do so. I suspect that the last alternative is most likely, in which case they should leave off criticizing Congress, and stop criticizing Paulson and Bernanke for failing to ask for authority they don't need, and tell us which institutions the Fed and the FDIC should take over now. If it is the first or second alternative, then the critics should point out the gaps in existing law and how they should be plugged.

A final point. Many opponents of the bailout compare it to bailing out the software industry after the Internet bubble popped or bailing out the steel industry or the automobile industry. If it's unwise to bail out industries generally, what's so special about finance?, they argue. But these same opponents have no problem with FDIC insurance or the Fed's historical role of pumping liquidity into the financial system when lending freezes up. The argument that the financial industry should be unregulated was lost long ago, and the argument now is just about means.

Gabriel McCall (mail):
Many opponents of the bailout compare it to bailing out the software industry after the Internet bubble popped or bailing out the steel industry or the automobile industry. If it's unwise to bail out industries generally, what's so special about finance?, they argue. But these same opponents have no problem with FDIC insurance or the Fed's historical role of pumping liquidity into the financial system when lending freezes up.

Some of those opponents do indeed object to the FDIC and the Fed. Some even go so far as to suggest that Jefferson and Jackson were right all along.

The argument that the financial industry should be unregulated was lost long ago, and the argument now is just about means.

Being louder and more numerous than your opponents is not the same as winning the argument. Even successfully implementing your policies as casting your opponents as fools is not the same thing as winning the argument. When the facts come crashing down on you along with the rubble of your economic model, that suggests that the argument is far from over... or, perhaps, that's it's been resolved the other way. Certainly, it's true that the Hamiltonians and Keynesians have captured the economic thinking of our people and government to a very great extent... but the question of "should" is not a democratic one, unless one takes the stance that everyone deserves the outcomes of the policies the majority prefers, even if those outcomes are much worse than they might otherwise be.
10.5.2008 5:28pm
Paul Allen:
The advantage of buying preferred-share equity is that it does not necessarily require accurately valuing anything in particular. You merely need to discount the aggregate to compute the dividend rate that would cover losses+fair return and invest what funds are available.

The objection to #1 is not that Treasury would monopolize a class of securities. They don't have nearly enough money to do that. The purpose of the Paulson plan is not to buy the distressed paper wholesale. The purpose is to buy just enough of it to establish a higher price that can be observed for mark-to-market purposes.
10.5.2008 5:36pm
Mahan Atma (mail):

"Currently, these securities are not being traded even though they clearly are worth something (they give holders the right to a fraction of mortgage payments, which is worth some amount greater than zero unless homeowners will default immediately and their houses are worth nothing in foreclosure). It is a bit of a mystery why no one will buy or sell them..."


I don't think this is quite right. A non-negligible chunk of the securities are literally worthless because they will never result in any income.

To see why, you have to understand how collateralized debt obligations work. Once defaults in the underlying portfolio reach a certain level, income flow to the junior tranches is cutoff completely and the remaining income is diverted into the senior tranches.

So it's no "mystery" that there are some securities nobody wants to purchase at any price.
10.5.2008 5:45pm
Paul Allen:

But these same opponents have no problem with FDIC insurance or the Fed's historical role of pumping liquidity into the financial system when lending freezes up.

There is a gulf between those two things and particular industries. For one, monetary instruments are considered fungible. The Fed's purchases do not (in theory) alter the distribution of production only the volume. Supporting particular industries favors the production of certain goods even when people don't want them. e.g., Teens prefer to spend money on cell phones but the government sees the music industry losing money. The act of government giving money to the music industry is a VERY different thing. Its playing favorites and distorting market signally of consumer preferences.
10.5.2008 5:49pm
Paul Allen:

So it's no "mystery" that there are some securities nobody wants to purchase at any price.

The banks hold almost entirely senior and super-senior tranches. These they retained when they underwrote the CDOs. The junior tranches are held by many different real-estate investment trusts, bought by individuals through wealth management divisions, etc. I've read but have not see substantiation that European banks are major junior holders. Remember: most of the capital in the world is immediately in private hands or held by privately held companies.
10.5.2008 6:02pm
Alan Gunn (mail):
I think the answers to why many economists favor taking control of failing banks are that the FDIC has experience doing that and is pretty good at it; it would likely be cheaper than the bailout; it doesn't have nearly the moral hazard problem the bailout presents; and--most important--it's a specific plan, as opposed to "let us politicians have hundreds of billions to give to people we decide should have it."

As for the "government competence" point, you say that "If the government pays the correct prices under the bailout, it won't end up subsidizing the healthy institutions." The problem here is that nobody knows what the "correct price" is. The market can't figure it out; so politicians will do better?

The only argument for the bailout that makes any sense is "Bernanke is very smart and he says we should do it." Naybe so. It's also the case, though, that Bernanke has said nothing in public either to explain what the current problem is or to justify the bailout as the cure. On process grounds alone, this convinces me that we shouldn't have done it.
10.5.2008 6:04pm
desert vision:
...unless homeowners will default immediately and their houses are worth nothing in foreclosure....


The Mojave Desert:

Twenty years ago, the only people who moved to this unloved chunk of inland California were misfits and military and the poor trying to escape the crime and horror of L.A. slums. Then, improbably, absurdly, stupidly, the High Desert on the other side of Cajon Pass became an "exurb," one of those ugly stucco grids dropped on the ground with feeder roads to the I-15, instant fake luxury, only two hours from the office, when traffic's good.

And every little chunk of non-government-owned sun-blasted creosote -- from the prison-covered hellscape of Adelanto to the trailer-park junkyards of Yermo -- suddenly became valuable real estate. Dirt lots you couldn't give away in 1999 were selling for half a million in 2005, at the insane peak of the bubble, complete with a three-bedroom cardboard castle in the middle of the scraped-bare lot.

There are dozens of these abandoned new houses around me, in these desert foothills that deserved a better fate. The financial wizards could've predicted the entire apocalypse had they simply walked around the Mojave and watched the sad routine that's been going on since at least last year.

. . .

One sad stretch of nearby road -- really a beautiful walk through a small forest of stubby Joshua Trees and gnarled Juniper -- has seven vacant houses in a row, nobody around for a mile on either side. Where did they go? What about the kids and their schools? Who even owns the mortgages, if the mortgages could even be pieced together from the "collaterized debt instruments" that brought down everything from mighty Wall Street investment houses to chickenshit little construction firms in the grandly named Inland Empire?

Lehman Brothers was out here, with $250 million in exurb developments here in the desert. Two weeks before Lehman vanished, on Sept. 2, those lots were being valued at $29,500 apiece. Guess what they're worth today.


What's an exurb in the Mojave worth?
10.5.2008 6:07pm
Vova S. (mail):
Supporters of the Paulson plan are, at least implicitly, conflating the secondary mortgage market with the financial industry as a whole. For example, you asked "Meanwhile, as institutions become healthier, they will become more willing to trade their mortgage-related securities (why, exactly?)" implying that a scenario where banks continue to operate but the market for mortgage backed CDOs never fully recovers is not acceptable to you.

It's one thing to argue for government intervention in order to maintain liquidity so that borrows can get capital for productive uses. However, there is the possibility that the secondary mortgage market is not productive, in the way that other investments are. Mortgage backed CDOs do fine while a housing bubble is growing, because increasing home prices basically guarantee mortgages will be paid off. However, house prices do not always increase. Maybe mortgages being bundled up and resold hinders transparency and reduces the incentive for diligent underwriting. I'm not stating that to be the case, but there is a possibility that there should be a lot less mortgage backed CDOs, and mortgages at all for that matter, than there have been in previous years. The financial firms that profited so much from that market, and executives such as Paulson who were so successful before the housing bubble popped, might simply not be acknowledging that possibility. I haven't seen it explored in any of the descriptions of the bailout.

Also, the Federal Government has historically subsidized home ownership (or more perversely, mortgages) by way of the mortgage tax education, Fannie and Freddie, and the like. After the government buys hundreds of billions of dollars worth of securities that will increase in value as house prices go up, that may lead to more subsidies in order to prop up home prices.
10.5.2008 6:13pm
rfg:
The main adantage of the bailout proposal is that it attempts to make whole the current equity owners of the institutions holding these securities. The old-fashioned liquidation approach would not, and shareholders would take a significant loss. This was considered to be unacceptable...
10.5.2008 6:25pm
DiverDan (mail):

It is a bit of a mystery why no one will buy or sell them; apparently, they are too hard to value and holders don't want to dispose of them for minimal amounts because their price might rebound.


Actually, the types of securities that are the real problem, derivatives like credit default swaps, IO MSBs and other arcane types of splits may be either impossible to accurately value or almost certain to have no value at all. One of the real problems with the lack of understanding of the current credit crisis is the fact that so few people understand how complex mortgage backed securities have become. In the good old days, before arcane algorithms were developed for hedge funds and interest rate speculators, everyone understood just what a Mortgaged Backed Security was - it was, quite simply, a straight-forward percentage interest in some pool of mortgages that had been securitized. Ginnie Mae or Fannie Mae or Freddie Mac would put together a pool of thousands of mortgages, and sell certificates -- if the total pool consisted of 2,500 30-year fixed rate mortgages, with a note rate of say 6.6% (with a 0.1% fee to the Mortgage Servicer, the company that collected the individual monthly payments, divided up Principal &Interest, maintained Escrows, paid Taxes &Insurance, &forwarded P&I payments to the Bond Trustee, leaving 6.5% for investors), and an average original principal balance of $200,000 (for a total pool of $500 million), someone who bought $100,000 in these particular MSBs owned a 0.02% interest in the total pool, and got a monthly payment of 0.02% of all net P&I payments.

Then, some financial geniuses figured out that there were an almost infinite way of splitting up the cash flows from a pool of motrtgages, and, when some or all of those mortgages were subprime or alt A mortgages, there were even ways of hedging defaults by trading off the some of the risks of default in exchange for the higher return that subprimes generated. The result was a series of complex derivatives, like securities that represented ownership of only the interest portion of monthly payments (IOs, or "interest only" Certificates), securities that represented ownership in only principal repayments (POs), securities that represented ownership in only the LAST 20% or 15% or 10% of principal repayments (accepting essentially all of the risk of the pool in the event collateral values declined), and even credit default swaps, that looked &smelled like insurance against the risks of default, but with none of the protections of true insurance (like reserves for claims and regulatory oversight). The result is derivative securities related to mortgage pools that can vary wildly in value in the event of either a change in interest rates or a change in collateral values or a change in default rates. These are NOT you mother's Ginnie Mae Certificates, they are MUCH more volatile.

Add in to all the complexity the fact that some of the speculation that went on is indistinguishable from betting money at the sports book in Vegas -- except that a Sports Book in Vegas is highly regulated and covers its risks better. It is perfectly understandable for an investor in a pool of higher risk (and higher return) subprime mortgages to want to hedge some of that risk through a Credit Default Swap. However, when you see that the total of all mortgages in the U.s. is approximately $12 Trillion (and most of those are conventional mortgages that met Fannie Mae's or Freddie Mac's OLD credit standards; only a small percentage of those mortgages are subprime or Alt A), but that the total of Credit Default Swaps outstanding is over $54 Trillion, it is clear that a majority of the Credit Default Swaps being issued were not for hedging risk, but were purely speculative wagers. AIG (the huge insurance conglomerate that the Feds had to take over) was a big player in the Credit Default Swap market. If AIG lost $10 Billion betting on the New England Patriots in the last Super Bowl, I imagine that the government takeover might have involved some indictments. But the Credit Default Swaps that AIG lost billions on were really indistinguishable from those hypothetical Super Bowl bets - a wager on the occurrence of future unknowable events.
10.5.2008 6:25pm
Michael B (mail):
The bailout was regrettable in many ways, Barney Frank's and others' profoundly cynical dismissiveness of the bailout's critics (i.e. large sectors of the public, whom these politicians are sworn to represent) notwithstanding. Still, the "bailout" was a stabilization package according to many informed and deeply concerned economists and others, hence both the good and the bad, long term, will benefit. In general terms and without being flippant in the least, that's the way the nation and the economy works.

(Barney Frank, one of the pivotal political causes of the crisis in the first place, said something to the effect that if the public did not want the bailout to be politicized then the public should not have given the issue to politicians in the first place. There are layers upon layers of cynicism is that statement.)
10.5.2008 6:30pm
SenatorX (mail):
If the government pays the correct prices under the bailout

It's a complicated problem but I have issues with the concept of the government paying "correct prices". How exactly are correct prices determined again? By committee? It seems clear to me the government (or anyone one actor in a market) will NEVER be able to determine correct prices for ANYTHING. Please someone point me to information showing how a government is able to determine correct prices. If they were, every price fixing socialist state in the history of the world would have been a success instead of a failure in this endeavor.
10.5.2008 6:47pm
Ed Scott (mail):
Paulson intends to populate his new work force with personnel from the bailees. No conflict of interest there.
10.5.2008 6:48pm
JBL:
I think part of the idea is that private equity will recapitalize the system, but that can't happen until the banks are willing to reliably lend to each other and some level of uncertainty in the portfolios is removed.

I also think a lot of the objection to the current plan is that it does nothing to fix the underlying causes of the current crisis. It may reduce the effects, but we need to address the causes as well and tying that legislation to the rescue plan would make sense. The problem is that the causes are many and subtle, and agreeing on a fix would take time.
10.5.2008 6:49pm
Virginia Independent:
Eric zeroes in on a key point when he asks why many bailout critics express support of equity infusion plans. One important consideration is the danger of the government's engaging in numerous securities transactions of extremely low salience. By contrast, when the government buys or sells all (or even a substantial chunk of) a major financial institution far more people and firms are paying close attention, thus reducing the chances the government will cut a bad deal.
10.5.2008 6:51pm
johnbragg (mail):
I think I speak for a lot of the bailout critics. Maybe not. But here goes.

Nationalization severely reduces the moral hazards involved. Nationalization, under say the terms given to AIG, means shareholders lose 80% of their equity and management is all fired. (Everyone is assuming that at some point in the not-too-distant future the nationalized banks get privatized.)

"Bailout", in which the government buys up a category of severely distressed securities, is another word for "Paulson's Wall Street cronies line up to gang-rape the US Treasury and stick Uncle Sucker with the consequences of their malfeasance."

As for the "correct price" of these securities, Ask Dr. Hayek.
10.5.2008 7:09pm
johnbragg (mail):
How will the government determine the correct price of FailedBank when they try to privatize it?

It's called an auction.
10.5.2008 7:11pm
Paul Allen:
DiverDan,

Much of what you say is true, but your tone comes off wrong. You act as if it is self-obvious that these activities were overly complex or reckless. I agree many people do not understand what has happened, but this has led to a panic of ignorance not revealed truth.

Lots of Chicken Littles are wagging their fingers at the unknown. Reality is different. The hedge funds were not the epicenter of armageddon. Many of quietly unwound. Of those that failed their clients took their losses and that was that. Sure, some internal trading programs had high-profile trouble. But these are not Hedge funds in the same sense; they merely implemented Hedge fund strategies--which isn't what people talk about when they talk about the unregulated nature of Hedge Funds (compared to mutual funds).

For all the shouting about derivatives, what we've seen consistently are classic bank-runs. The money markets seized up after 1) the FDIC broke convention by not liquidating WaMu and 2) the very vanilla bonds of Lehman Bros.

As for insurance vs. derivatives: you get your pick in the marketplace. I find it difficult to agree that have choice is bad. Derivatives are cheaper because you acquire additional risks. Pretty simple concept. Pretty reasonable.
10.5.2008 7:23pm
Mahan Atma (mail):

"The banks hold almost entirely senior and super-senior tranches."


Which banks are you talking about, precisely? Are you saying the government isn't going to be buying anything from the less-than-senior tranches?

Doesn't the bailout plan allow the government to bail out those European banks as well?
10.5.2008 7:33pm
Guest12345:
As for insurance vs. derivatives: you get your pick in the marketplace. I find it difficult to agree that have choice is bad. Derivatives are cheaper because you acquire additional risks. Pretty simple concept. Pretty reasonable.


Didn't Congress just demonstrate that when the derivative markets manage to walk off the edge of the cliff, the tax payers get to pay to build a bridge? No risk if you can't lose.
10.5.2008 7:43pm
Gerg:
If Treasury buys up an entire class of securities, it will buy them from solvent institutions as well as insolvent institutions. These solvent institutions don't need help from the government; only the insolvent institutions do.


I think that's exactly backwards. Insolvent institutions should simply go bankrupt and be liquidated to their creditors. End of story. There's nothing to be gained by bailing them out.

Solvent institutions have a problem in that they can't borrow money these days and don't know who else to lend money to. All because nobody knows how much these securities are worth.

By forcing these securities to trade again and pulling them all off the balance sheets of these institutions we expose their true value and make things transparent again people will know which institutions are actually well capitalized and solvent -- and credit-worthy.
10.5.2008 7:50pm
Jon Roland (mail) (www):
The only effective way to sort out this mess is to separate out each mortgage note and evaluate and manage each separately. The problem is the loss of information and control that has come from first bundling mortgage notes into securities, then selling shares of the bundles in further bundles, without conveying the details of each note and the collateral that secures it.

The result of this layered bundling is that it becomes difficult to credit payments to each note, work out delinquencies with the debtors, or execute foreclosures if that becomes necessary. It is not just failures to pay that is resulting in foreclosures, but failures to credit payments made, and having service agents go out of business leaving a question of whether there are uncredited payments, and whether payments received but not credited should be considered unsecured claims of the debtor or the mortgage holder.

Most of this debacle could have been avoided had courts not allowed foreclosures without presenting the original signed note instrument in court, and required the one owner and holder of it to personally appear in court to testify. The practice of accepting "affidavits of ownership" in lieu of the physical original note paved the way for the entire catastrophe.

If local lending institutions need to raise capital to make more loans, their proper solution is to continue to be the owner, holder, collector, and manager of each note, and sell stock in their institution, or at least in bundles they retain, not selling the notes, bundled or otherwise. It has never made sense to trade in bundles containing assets that come and go as they are paid off or not. What is the value of a bundle containing paid-off notes? Or of another consisting entirely of foreclosed properties being torn apart by vandals?
10.5.2008 8:32pm
Jon Roland (mail) (www):
The Origination Clause Art. I Sec. 7 Cl. 1 reads:

All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.

Question for the forum: Did the Mortgage Bailout process violate this provision?

According to the Senate site, the official name of the bill passed by the Senate was an "amendment" to H.R. 1424 Bill Title: The Paul Wellstone Mental Health and Addiction Equity Act of 2007.

But the bill passed by the House was H.R. 3997 Bill Title: To amend the Internal Revenue Code of 1986 to provide earnings assistance and tax relief to members of the uniformed services, volunteer firefighters, and Peace Corps volunteers, and for other purposes

If it did not violate the Origination Clause, then explain how it complied with it.
10.5.2008 8:37pm
Michael B (mail):
Editorial from the TimesOnline, excerpting, emphasis added:

"In 1996 the International Monetary Fund noted: "In many countries, a banking crisis is an accident waiting to happen." Few could have imagined that the mother of all banking crises would take place, little more than a decade later, in the world's leading economy. How to deal with it is now an issue of fierce political contention.

"Numerous criticisms were justifiably levelled at the original and abortive plan for a $700billion bailout for the banks. An amended version has been approved by the Senate and will be voted on by the House. Politicians will understandably be sympathetic to constituents' concerns about a bailout. And rescuing bankers from the consequences of their own reckless lending decisions is not a cause of great popular appeal. But for all that, a bailout of the banks is a necessary evil, and the House ought to pass the plan."

[...]

"It is an indictment of governments and central banks that they failed to curb the credit expansion associated with a housing bubble. And it is a scandal that bankers sold financial products that destroyed value and misled investors. But the right course is to learn from the experience, not to reinforce the damage out of ideological purity."

h/t Oliver Kamm
10.5.2008 8:46pm
SenatorX (mail):
As for the "correct price" of these securities, Ask Dr. Hayek.

Indeed, I basically did ask Dr. Hayek (by reading his books) and I agree auctions (price discovery by all market participants) are the path out of this mess. I suppose the government wants to delay price discovery at this point, fine, but get on the right path at least. Create the structure for a functioning market for MBS, CDS, and every other derivative and get out of the way. America isn't going to maintain superiority by some sort of natural ability of its people(or government!). We will do it by adopting the superior ideas and processes, or we will fall behind others who do.
10.5.2008 8:50pm
MarkField (mail):

Being louder and more numerous than your opponents is not the same as winning the argument.


I agree with you about being louder, but in any system of majority rule, being more numerous than your opponents means precisely that you do win the argument.


What's an exurb in the Mojave worth?


Some aspects of the problem can probably best be solved with bulldozers.
10.5.2008 8:54pm
johnbragg (mail):
SenatorX: Of course we're not going to do auctions. Vulture funds are willing to buy at say 20% of face value, banks (etc.) are holding out for say 50%. Paulson is going to produce a number the same way he came up with $700 billion--he's going to pick it out of the air.

Hayek reminds us that prices without markets are arbitrary. There is no way that Paulson will be able to determine the "right" price.
10.5.2008 9:08pm
PDXLawyer (mail):
Eric Posner wrote:

"1. In both cases, the degree of unfairness and inefficiency is a function of the competence of the government regulatory authorities, not the design of the law itself. If the government pays the correct prices under the bailout, it won't end up subsidizing the healthy institutions;"

First, this is hardly an area where competence (in the sense of perfect information about the present and future) can be presumed. Even if the Treasury would be just as good at pricing these securities as private market actors, thats hardly a ringing endorsement, given the recent performance of the private sector. Valuing this stuff is hard. I haven't seen anyone suggest that the government enjoys significant advantages in competence in asset pricing over the private sector.

Second, supposing the Treasury is completely competent - it has exactly perfect information of both the present and future. What then is meant by "the correct prices"? I suppose that depends on what your goal is. Eric Posner seems pretty convinced that propping up insolvent institutions by paying above-market (but below hold-to-maturity value) prices is not the right goal.

I guess the idea is that the government can create a market for these securities by paying the market price (which it alone is able to discover). This will return them to the status of liquid assets, and fix a lot of the problems. Of course, the government doesn't propose to buy anything like all of the securities of this class which are out there, so this only makes a market if there is no panic selling to the government and/or people are willing to buy these securities from the government. In other words, this type of market will last as long as: (a) the Treasury is omnicient; (b) the rest of the world believes the Treasury is omnicient; and (c) the rest of the world believes that the Treasury will be in the market tomorrow, so that the securities they buy today will be liquid. I don't think I'm being a cynic to doubt that these conditions can be achieved by mere human beings.

This is what really bothers me about the bailout plan - I haven't seen any explanation of it which seems remotely plausible. In fact, nobody in the Government seems to have even attempted such an explanation. I've seen a lot of defenses which amount to "don't be cynical." I truly don't believe that bad intentions will play much of a role in the bailout. And I'm sure that the Treasury officials implementing this will be really smart guys - smarter than I am. Will this be enough?
10.5.2008 9:18pm
Charlie (Colorado) (mail):

Indeed, I basically did ask Dr. Hayek (by reading his books) and I agree auctions (price discovery by all market participants) are the path out of this mess. I suppose the government wants to delay price discovery at this point, fine, but get on the right path at least. Create the structure for a functioning market for MBS, CDS, and every other derivative and get out of the way.



That's pretty much precisely what the plan is doing, except that it's also introducing a sort of flywheel. Megan McArdle said something good about it the other day: "There are two rules for understanding markets: (1) they don't handle rapid changes well; (2) see Rule 1." (Paraphrased, I don't have the ambition to look it up right now.)

Paulson's scheme values the securities via reverse auction, holds them, and releases them back to the market slowly. If --- as seems almost certain --- the prices are artificially low now, because of the lack of good information and panic, then over time the securities will, on average, go up. Since they're valued on auction, they by definition will be correctly valued, taking into account risk and time value. When sold, they'll take on a new value, which will at that point have automagically taken into account better information and a different risk profile.
10.5.2008 9:41pm
Paul Allen:

Which banks are you talking about, precisely? Are you saying the government isn't going to be buying anything from the less-than-senior tranches?

Doesn't the bailout plan allow the government to bail out those European banks as well?

The junior tranches were basically given "junk" ratings (obviously). Many of those junior tranches do have zero value as a result of defaults and foreclosures which have already occurred. Where this is the case, they have assuredly been written off the books already.

Most banks hold the senior tranches because these received the AAA ratings--indeed these are the only MBS that the Fed will currently discount (same at the ECB). But the senior tranches are at-risk--this is where much of the panic is coming from.

A critical valuation question now is: how far will home prices drop? How apt are people to default rather than pay once they are under water? Give current average house price declines: 10M (20%) mortgages have negative equity. Were prices to fall another 15%, we have 20M mortgages with negative equity. 5M will have mortgages 130% or higher than the value of the home.

How many will default !?!? If you can answer that, you could make lots of money :)

They idea that a market can value these securities is ridiculous to an extreme. There is no actuarial data that covers this situation.
10.5.2008 9:52pm
scarhill:
I'm trying to decide if Prof. Posner's post is an elaborate parody or if we're meant to take it seriously. "If the government pays the correct prices under the bailout..." What, pray tell, is a correct price and how, in the absence of a market, is the government (or anyone else) to determine it?
10.5.2008 10:10pm
you're kidding, right?:
Since they're valued on auction, they by definition will be correctly valued, taking into account risk and time value.


You have got to be kidding.

We see evidence that the holders of these securities, the class of potential sellers, place a different value compared to the potential buyers. That's why there's no market.

If a reverse auction is conducted, with all the potential sellers participating, but only one buyer —forced at gunpoint to spend tax-dollars— then the securities will be valued by the class that's valuing them too high for a market to exist right now.
10.5.2008 10:22pm
SenatorX (mail):
A pox on both plans as far as I am concerned. The bottom in housing will be set by time and lower prices. For example when home prices drop to the point where it makes more sense to buy than to rent we will see homes start to be bought. Sure rent prices and incomes could continue to drop but we could switch to looking at percentage of income spent on your home and compare to historical averages. There are plenty of people (like me) who can and want to buy a home for raising family, locking in schools for the kids, planting gardens, tired of moving, etc. It's getting there already where it actually would be cheaper for me right now (on a monthly basis) to buy than it is to rent. I rent because I have "saved" about 40k in lost equity renting in just this past year than owning.

Still, eventually prices will be low enough compared to incomes that people like me will start to move in. Lower prices, that's it. I don't see the government helping THAT process, at least not intentionally. For example the 7.5k tax credit (that you pay back!) when buying a new home right now. I fully expect more of the same. Like a new 15k first time buyer tax credit implemented in a bill next year. Yet another reason to delay buying a home. I simply know the government is going to continue to mash its meaty man hands in the market so I need to wait and see what they do before I purchase.

I like what Jon Roland said above too. I think the MBS ship might have sailed and any plan based on waiting for that market to come to its senses is a fools plan. Maybe the government shouldn't just get into the "reverse auction" business but the reverse MBS business as well. I guess there are lots of ways that could be done but it seems pretty clear the MBS model was nothing but financial slight of hand. Cracking all the MBS back into individual mortgages seems like a great idea to me
10.5.2008 11:12pm
Mahan Atma (mail):
"Most banks hold the senior tranches because these received the AAA ratings--indeed these are the only MBS that the Fed will currently discount (same at the ECB)."


Where's the evidence for the proposition that the Fed will only be purchasing senior tranches?

Is there something in the law (or the facts for that matter) that prevents the Fed from purchasing junior tranches?
10.5.2008 11:12pm
Harry Eagar (mail):
'From what I can tell, it seems that the Fed and Treasury are taking an ad hoc approach.'

You got that right.

If your only economic idea is 'taxes bad,' then when something comes up, you are necessarily going to approach it in an ad hoc fashion.

I noticed, with great amusement, that the people who led us into this morass (or some of them) are seeing it as a feature, not a bug, and demanding that capital gains taxes be repealed.

Yeah, that'll work.
10.5.2008 11:29pm
Oren:

Since they're valued on auction, they by definition will be correctly valued, taking into account risk and time value.

While I agree with the sentiment in the abstract, quite a lot depends on the actual rules for the auction.
10.5.2008 11:42pm
Paul Allen:

Is there something in the law (or the facts for that matter) that prevents the Fed from purchasing junior tranches?

No. Just tradition. The Board of Governors sets rules which govern what the FOMC can purchase. Historically those rules meant "Treasuries", in the late 90s when the budget swung to surplus, the Fed revised its rules to allow purchase of other high-grade debt. There was not occasion to use authorization really until now.

This is quite different from what the Treasury may buy as part of the program. To be honest, I don't know what they will do, the law does not restrict them. But as I said, the banks mostly hold senior tranches. So I don't see widespread buying of junior tranches as within the gov.'s objectives.
10.6.2008 12:06am
DiverDan (mail):
Paul Allen, you state in response to my post:


Much of what you say is true, but your tone comes off wrong. You act as if it is self-obvious that these activities were overly complex or reckless. I agree many people do not understand what has happened, but this has led to a panic of ignorance not revealed truth.


I think you are mistaken about my tone - the primary gist of my post was that there is a real misunderstanding among many people (including, apparently, Professor Posner) as to the cause of the current mess. My point is that this current credit crisis was not caused solely by the subprime mortgages or even the conventional mortgage-backed securities based on the subprime mortgages. If that were the case, then yes, the collateral is always going to have some value, even if it is only 60-70% of the loan amount, and no mortgage pool is going to approach a default rate of 100%; even in the worst pools, defaults will almost certainly not exceed 50% -- half of the borrowers (probably more) will continue to pay their loans. The real problem was caused by derivative securities that, by design, were always intended to be more volatile in value than conventional mortgage securities (i.e., "your mother's Ginnie Mae Certificates"). And, at the core of the problem were the Credit Default Swaps. I acknowledged that there was a perfectly good use for the Credit Default Swaps, but it was really disingenuous for the big issuers of these Swaps, AIG, Lehman Brothers, Goldman Sachs, Merrill Lynch, et al., to sell these swaps as protection agaist risk (i.e., as if they were insurance), but structure them to avoid all of the protections that are provided for insurance policies, like requiring capital reserves to cover expected claims. These companies blindly thought that all of the risk was built into their pricing models (even premium pricing on insurance is only intended to estimate risk; insurance pricing can go wrong if there are a string of big claim events, like 3 Category 5 Hurricanes all hitting high population areas), booked all of their payments as income, and never reserved for the claims. And I don't think that the panic (at least the panic within the financial industry -- public panic is a whole other matter) is necessarily a panic of ignorance. When the holders of all these Credit Default Swaps issued by AIG, Lehman, Merrill Lynch, Goldman, et al., see that the issuers are really shaky any undercapitalized, and the contracts they are relying upon to support the value of the risky mortgage pools they have invested in will, in all probability, be nothing more than very large unsecured claims against insolvent issuers, I think it is perfectly rational for those holders to worry about the safety of some very large investments.

While I may have expressed some dismay in my post (Okay, open and hostile frustration), my frustration was NOT directed at the people who think that this was just a problem of the high-risk mortgages. I recognize that finance is complex, and only becoming more complex; I got my MBA in 1982, and I have had to work hard at keeping up with the changes and increased complexity since then. My only real frustration was with the gross imprudence of the issuers of the Credit Default Swaps and the very heavy use of Credit Default Swaps for purely speculative purposes. Even that speculation in Credit Default Swaps would not draw any objection from me, even if it looks a lot like pure gambling to me (as a pure free market supporter, I have never thought that "speculator" was a dirty word, and I recognize the value that speculators bring to many markets), if the issuers had been more prudent and reserved against the risks inherent in these contracts, if the SEC had exercised a bit more oversight and insisted that the issuers treat these contracts as true insurance policies and required adequate capital reserves, and the FED had refused to allow Banks to reflect the "insured" value of their Mortgage Backed Securities (i.e., valuing the MBS's as low or no risk because of the hedging effect of the Credit Default Swaps) without solid evidence that the Credit Default Swap itself was fully collectible in the event of the triggering events.
10.6.2008 12:07am
Paul Allen:

While I agree with the sentiment in the abstract, quite a lot depends on the actual rules for the auction.


It depends a lot more on participants generally having the right default model. This is not likely to be frank.
10.6.2008 12:08am
Barnum's law:
quite a lot depends on the actual rules for the auction.

Never give a sucker an even break.
10.6.2008 12:13am
DiverDan (mail):
Just another thought - Secretary of the Treasury Henry Paulsen came out of Goldman Sachs (he was the chairman) and cashed out stock worth about $500 Million when he left in 2006 to take the Treasury Post. I wonder how much income Goldman Sachs booked on the sales of unreserved Credit Default Swaps in the three years before Paulsen left? And if he didn't recognize the full risk of these contracts when he was Chairman of Goldman Sachs, how can we really trust him to competently run the Bailout?
10.6.2008 12:20am
Paul Allen:

My only real frustration was with the gross imprudence of the issuers of the Credit Default Swaps and the very heavy use of Credit Default Swaps for purely speculative purposes.

What is a purely speculative purpose? I used SKF to hedge my WFC position. I'm not sure how you can distinguish hedging and speculation.
10.6.2008 12:24am
Jon Roland (mail) (www):
SenatorX:

I like what Jon Roland said above too. I think the MBS ship might have sailed and any plan based on waiting for that market to come to its senses is a fools plan. Maybe the government shouldn't just get into the "reverse auction" business but the reverse MBS business as well. I guess there are lots of ways that could be done but it seems pretty clear the MBS model was nothing but financial slight of hand. Cracking all the MBS back into individual mortgages seems like a great idea to me.

It should now be clear the MBS model is fundamentally infirm, and only undoing it will suffice, but that will be a major undertaking and has serious implications for the entire financial sector, which is going to have to get used to not being able to raise unlimited capital using smoke and mirrors.

There is also a problem with how it can be done, constitutionally, without violating the Contracts Clause (and the Tenth Amendment, since the Contracts Clause is only a restriction on the states). I have proposed creating jurisdictions for federal Art. III or bankruptcy courts to challenge foreclosures if the original signed note, a complete record of payments received by the servicing agent, and the owner and holder of the note (not just his attorney) be required to personally testify in court (for a corporation that would be a senior official). That would require disaggregation of all those MBS, if not as securities then as transparent administrative processes that could enable evaluation not just of bundles but of each component of them, in nearly real time.

The federal jurisdictions need not overburden the federal courts, as I would expect it to impose similar judicial reform in state courts, something that has already begun.

I do not, as a libertarian, favor regulatory interventions in the sense of administrative agents directing the actions of people, setting standards, or requiring them to report on their activities. The Nondelegation Doctrine needs to be revived, not further buried.
10.6.2008 12:25am
Paul Allen:

If your only economic idea is 'taxes bad,' then when something comes up, you are necessarily going to approach it in an ad hoc fashion.

I noticed, with great amusement, that the people who led us into this morass (or some of them) are seeing it as a feature, not a bug, and demanding that capital gains taxes be repealed.

I'm glad that you can find amusement despite the times. "The people who led us into this morass" are the people you likely support if I can read into your remarks the right way. So before you cast too many stones, please reflect on how the donkeys keep managing to run this country into the ground with the same failed policies. Not bad, not bad.
10.6.2008 12:41am
Mahan Atma (mail):
"What is a purely speculative purpose? I used SKF to hedge my WFC position. I'm not sure how you can distinguish hedging and speculation."


That's easy. You're not allowed to buy a life insurance policy on a complete stranger. What's the diff?
10.6.2008 12:49am
DiverDan (mail):
Paul Allen asked


What is a purely speculative purpose? I used SKF to hedge my WFC position. I'm not sure how you can distinguish hedging and speculation.


In my view (and its only my view - I'm open to other opinions), the difference lies in whether or not a buyer has an "insurable interest" in what is being hedged. If I own a portfolio of subprime mortgage backed securities, I would be hedging if I buy a Credit Default Swap that will pay me if the default rate in my portfolio exceeds a trigger. If I don't own any high risk debt, but I just have a gut feeling that the economy is going to tank, then buying a Credit Default Swap in the hopes of a big profit if my guess is right is just too much like betting on a football game.

It is like those speculators that made a fortune buying naked put options before the October, 1987 crash; if you bought naked puts to hedge your risk in your stock portfolio, that is one thing; if you converted all of your portfolio to cash and bought naked puts in the hopes of a killing, that is just indistinquishable from gambling.

And again, I'm not making any moral judgment that speculating is wrong, or ought to be outlawed; I just think the government has no place making good the losses of those investors who decided to just bet on a dice roll and lost.
10.6.2008 12:55am
Nathan Richardson (mail):
You make excellent points, but I'm not sure the support/oppose debate on the bailout package is as nuanced as you propose, perhaps even for economists. There seem like three constituencies:

1) Libertarian or libertarian-leaning people and economists, who oppose any bailout. If assets are valuable, someone will buy them, and if noone does, then they aren't valuable and firms that bought or created them should fail. Government involvement just creates moral hazard.

2) Generally left-leaning people who have no opposition to government involvement, but fear that the bailout is simply a handout to the "rich" or "Wall Street"; essentially this is a view that payouts (cynically, rent-seeking) is OK, but not if the other side gets it.

3) A coalition of, roughly, economic nationalists and big-government conservatives, all of which support the bailout. They support it either because they have a mercantilist, nationalist view of economic policy (what is good for Goldman is good for America, the big-guy sympathy argument) or they believe that a bailout is the only way to protect bread-and-butter red-state americans (the little-guy-sympathy argument, which is closer to the leftist position than many of its proponents would like to admit).

In any case, only group 3) supported the bailout in its original form, and it was only through concessions to group 2) that a constituency for passage was developed. Nobody is excited about the compromise, and, more importantly, it doesn't seem like any of the arguments being presented are as nuanced as those you propose. The explanation for the presentation, rejection, and eventual passage, therefore, may be substantially more prosaic, emotional, and shallow than a real response to your arguments would require.

Disappointing? Yes - but surprising, perhaps not.
10.6.2008 1:31am
Katl L (mail):
Dow 500 pts down. What a good idea the bailout
10.6.2008 11:53am
ejo:
dow goes down after bailout defeated. dow goes down after bailout passed. almost as though bailout irrelevant to the market fluctuations (or already figured in). given that currect problems appear to be global, what are the other countries doing to match the urgency with which we reacted?
10.6.2008 12:45pm
A. Zarkov (mail):
Normally a financial asset's value is determined as the present value of the asset's future cash flows. When the flows are uncertain because of the possibility of a default or a change in the discount factors, the asset becomes risky. But when it comes to certain derivative products bought with borrowed money the whole notion of value becomes abstract. So abstract that no one knows what value to put on the asset. Here in picture form is a diagram of a CDO. This is why the government (meaning the taxpayers) are likely to get stiffed with the bailout plan. There's so much room to fiddle. If a threatened institution is so vital to the functioning of the economy then it should be nationalized, sorted out, recapitalized and then re-privatized. This is how we minimize the damage to the taxpayer and why so many economists prefer this approach.
10.6.2008 1:34pm
Bob from Ohio (mail):

According to the Senate site, the official name of the bill passed by the Senate was an "amendment" to H.R. 1424 Bill Title: The Paul Wellstone Mental Health and Addiction Equity Act of 2007.

But the bill passed by the House was H.R. 3997 Bill Title: To amend the Internal Revenue Code of 1986 to provide earnings assistance and tax relief to members of the uniformed services, volunteer firefighters, and Peace Corps volunteers, and for other purposes



I don't have an opinion on the Origination Clause issue but I find the titles of both of these bills sadly funny.
10.6.2008 3:10pm
Tatil:

The banks hold almost entirely senior and super-senior tranches. These they retained when they underwrote the CDOs. The junior tranches are held by many different real-estate investment trusts, bought by individuals through wealth management divisions, etc.

Unfortunately, even if banks do not hold these tranches, a lot of them loaned money to other institutions to buy them. If these junior tranches lose a lot of value, many of the owners will not be able to pay the loans back. Therefore, most of the risk never really left those banks, even if their balance sheets did not reflect that risk.
10.6.2008 10:19pm

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