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Plan B (C?).

The original TARP idea was to hold reverse auctions for mortgage-backed securities. The government would hold them to maturity or resell them. Whatever one thinks of this plan, it puts relatively little burden on government decisionmakers. However, one criticism of the plan was that government agents would not be able to set the price correctly, whether through the auction mechanism or in some other way, and therefore end up underpaying (in which case the plan would not work) or overpaying (enriching greedy investment bankers).

It is now clear that Treasury will take a more aggressive approach. Not only will it buy commercial paper; it will buy equity in banks. It may well be that liquidating the market in MBS's would not have been adequate, and more aggressive measures are needed. But if one has doubts about the ability or incentives of government agents to price correctly MBS's, then one ought to have even more doubts about the new agenda. To buy commercial paper, you need to distinguish among the various companies that offer it, and pay no more than its value, which requires a good knowledge of the balance sheet and operations of the seller, not to mention the market in which it operates and the health of the economy and financial system. Sure, it's short-term and therefore safer than other forms of debt, but it still needs to be priced correctly in light of its risk. To buy equity, you need to make similar judgments. And to exercise one's rights responsibly, one needs to monitor the company, its market, and the economy, and exercise any rights one has -- in the case of equity, to control the operations of the company. Good luck!

As the financial system collapses, the banks are increasingly becoming ventriloquist's dummies for the government. They remain as shells but the government calls the shots. In the case of the commercial paper market, the fiction is not even being maintained: firms borrow directly from the government. People call this process "restoring confidence" in the financial system; but it really just replaces one financial system (a more-or-less private one) with another (a government-run system). It's as if a hurricane hit a city and the national guard took over food distribution. We don't say that the government is restoring confidence in the private food distribution system; we say that it is operating the food distribution system, and will do so until the private system recovers on its own.

Related Posts (on one page):

  1. Bailout Analogy:
  2. Plan B (C?).
Tracy Johnson (www):
How long before large house properties are subdivided into apartments and run by commissars as in "We the Living" ?
10.9.2008 10:25am
Anony:
Now are you worried about the risk of socialism?
10.9.2008 10:48am
justareader (mail):
Where did you get the idea that the "original plan" was a reverse auction?

Nothing, and I mean nothing, in the TARP legislation said anything about any reverse auctions. The original plan was to prevent a stock market collapse. Didn't you see Nancy Pelosi's press conference?

I intend to take over your economy and run it into the ground.

Congratuations suckers!

Signed,
Hank
10.9.2008 11:13am
Perry:
If anyone doubts the tenuous hold that we all have on our rights and way of life, just wait for the next 'disaster event' to happen. 9-11 and we 'give up' some of our civil rights; cmbs collapse and we dance towards socialism. Whats next?

Just remember.. whats bad news for the people is always GREAT news for the government.
10.9.2008 11:27am
bc (mail):
Finally, some truth to power. Fundamentally, our economy was in such bad shape that banks couldn't find enough valid places to loan. As a substitute they took on crazy risk in the form of leverage out the wazoo and stupid loans. This is not a process or regulatory problem, it's economic cancer and it can't be cured by process changes.
10.9.2008 11:28am
Salaryman (mail):

It's as if a hurricane hit a city and the national guard took over food distribution. We don't say that the government is restoring confidence in the private food distribution system; we say that it is operating the food distribution system, and will do so until the private system recovers on its own.


Here, though I'd change "will do so until the private system recovers on its own" to "will continue to do so." The chances of the people in charge of this ever saying "Oh, look! The financial markets recovered all on their own! We can stop now" are prohibitively slim, no?
10.9.2008 11:31am
Cornellian (mail):
Socialism. Brought to you courtesy of a Republican president. The amazing thing is this could never have happened under a Democratic president. Congressional Republicans would filibustered until the last Congressman and last Senator dropped dead of exhaustion.
10.9.2008 11:40am
ed (mail) (www):
Hmmmmm.

How will private banks recover if the government is the 800lb gorilla in the same market?

And the government, in the interest of recovering the economy, underprices the private banks?
10.9.2008 11:44am
justareader (mail):
"As the financial system collapses, the banks are increasingly becoming ventriloquist's dummies for the government. They remain as shells but the government calls the shots."

This is close, but it's a flawed analysis. The banks are incresingly becoming ventriloqueist's dummies of the Fed ... a private bank.

The Fed isn't the government. For example ... President Bush could not prevent Mr. Paulson from spending $700 billion buying equity in banks.

President Bush is the government. We held an election of which he was a participant.

Nobody elected the Fed, because the Fed is a private company regulated by the government, but a private company nonetheless.
10.9.2008 11:56am
David M (www):
The Thunder Run has linked to this post in the - Web Reconnaissance for 10/09/2008 A short recon of what's out there that might draw your attention, updated throughout the day...so check back often.
10.9.2008 12:00pm
r.friedman (mail):
This is not socialism, this is the government coming to the aid of finance capital, only more so than usual. Socialism includes economic planning to meet peoples' needs such as housing (good-bye flippers, good-bye McMansions, good-bye mortgage-backed securities).
10.9.2008 12:04pm
John Burgess (mail) (www):
Eric: Could you please pass on your fiddle tuning? As Rome burns around us, it'd be nice to have a catchy tune to go along with it.

What I don't find in your post is any suggestion of an alternative solution. Bitching from the peanut gallery is fun, but not terribly productive.
10.9.2008 12:06pm
Arkady:

How long before large house properties are subdivided into apartments and run by commissars as in "We the Living" ?


The reference to a work of Ayn Rand is amusing. Here is her most famous living disciple on the crisis:


Today, with the world caught in an economic tempest that Mr. Greenspan recently described as "the type of wrenching financial crisis that comes along only once in a century," his faith in derivatives remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. [My emphasis] A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as "the pharmacist who fills the prescription ordered by our physician."


The naivete is astonishing. Or maybe not.
10.9.2008 12:11pm
David Schwartz (mail):
What I don't find in your post is any suggestion of an alternative solution. Bitching from the peanut gallery is fun, but not terribly productive.
Right, it doesn't matter whether what we do will actually work, or even if it makes things worse, we must do something. This is something. Therefore we must do this.
10.9.2008 12:11pm
Sagar (mail):
Our likely next president said that Healthcare is a right!

Is there a good doctor around here, I 'd like to exercise my right.
10.9.2008 12:12pm
gab:
Or we could let the banks fail, the commercial paper market collapse, the stock market crash - leading to millions out of work.

You make the call Eric.
10.9.2008 12:22pm
SeaDrive:
The government is sticking their fingers into the business of maybe 10 banks out of the thousands of banks doing business in the US and all of a sudden we are socialists.
10.9.2008 12:25pm
wfjag:
Sagar:

While I recall the statement about Healthcare being a "right", I don't recall any promises that it will be high quality Healthcare or that you will be entitled to see a "good doctor". In fact, I don't recall any statement even indicating that you should expect treatment by a M.D., D.O., Physician's Assistant, Nurse Practioner, or any form of allopathic medical treatment. Iowa gave BHO his first big boost and Sen. Harkin (D. Iowa) is one of the major proponents of federal support and promotion of "Complementary and Alternative Medicine." Sounds like you need an adjustment. That will exercise your right.
10.9.2008 12:26pm
Virginia Independent:
The big question: how will the government influence or control the operations of the institutions it acquires a stake in? If the plan is to replace bad managers with good ones, do we have confidence that Treasury (or any other arm of the gov't that might undertake this) is competent to hire, supervise and fire?
10.9.2008 12:27pm
EH (mail):
David Schwartz:
Right, it doesn't matter whether what we do will actually work, or even if it makes things worse, we must do something. This is something. Therefore we must do this.


Well, to be sure, on a self-professed libertarian blog I'm not seeing anybody advocate for not doing anything. Strange, that.
10.9.2008 12:55pm
Tom Perkins (mail):

This is not a process or regulatory problem, it's economic cancer and it can't be cured by process changes.


Absolutely it is. The process the regulations and the regulators encouraged created the specifics of the problem.

To the extent deficiencies in human nature caused the problem, govt won't fix it--it is an expression of the deficiencies.

Yours, TDP, ml, msl, &pfpp
10.9.2008 1:02pm
NickM (mail) (www):
What sort of regulations would have prevented ratings agencies from giving the highest ratings to packages of subprime mortgage tranches that turned out after a couple years to be flooded with defaults and near worthless?

That's where stupid loans turned from a problem for individual lending entities to a problem for the entire financial system.

Nick
10.9.2008 1:11pm
Norman Bates (mail):
To me the really shocking thing about the whole bailout business is that we've seen much of Congress and the Democrat Party spend the last six years castigating the administration for getting us into Iraq by declaring an emergency situation and demanding that quick action be taken. Now we've seen these very same people pushing through an enormous, radical, and essentially unjustified intervention into the private financial sector precisely because the administration has declared an emergency situation and demanded that quick action be taken. It's deja vu all over again.
10.9.2008 1:28pm
Paul Allen:
Professor, I agree with your skepticism over the Fed's direct intervention in the commercial paper market--I wonder why they didn't adopt the more traditional but dormant policy of broad-based discounting of commercial paper.

But you also wrote:

The original TARP idea was to hold reverse auctions for mortgage-backed securities. The government would hold them to maturity or resell them. Whatever one thinks of this plan, it puts relatively little burden on government decisionmakers.

How does the Paulson program put relatively little burden on the government? As many people had discussed before, Paulson claimed that a mysterious reverse auction would work, but the reality is that the treasury would have to review each MBS product--and the army of accounts would be under pressure to not overvalue the instrument.

The argument behind equity purchases is that they would be fewer, larger transactions with more individuals reviewing each bank's balance sheet and the terms of each deal--which under the provisions of the TARP must be disclosed specifically an individually to Congress, the Fed Board of Directors, and the TARP Committee.
10.9.2008 1:50pm
BobVDV2 (mail):
I'm not so sure that the "equity positions" contemplated by Treasury come with the power to "control the operations". The bailout bill says the Secretary may purchase "a warrant giving the right to the Secretary to receive nonvoting common stock or preferred stock in such financial institution, or voting stock with respect to which, the Secretary agrees not to exercise voting power, as the Secretary determines appropriate". Sec. 113(d)(1)(a).

And, justareader, "reverse auctions" are expressly mentioned in the legislation, and I believe in the original House bill as well as in the Senate bill that became law.
10.9.2008 1:55pm
Houston Lawyer:
I'm not nearly so upset about the government propping up the banks as I am them stepping in and forgiving debt for mortgage holders. This is just a mass transfer of wealth from the prudent to the prodigal. Can't we just hand out crack pipes and hooker coupons with that?
10.9.2008 2:09pm
D. F. Linton (mail):
Nominal private ownership + effective government control = fascism not socialism. In keeping with its bipartisan origins, perhaps "populist fascism" would fit.
10.9.2008 2:29pm
Fub:
Houston Lawyer wrote at 10.9.2008 1:09pm:
Can't we just hand out crack pipes and hooker coupons with that?
Well, maybe at last they'll have a place to store all those pipes and coupons when the distribution plan fails.
10.9.2008 2:36pm
Smartest guy in the panic room:
Coupons?! I've been doing it wrong all this time...
10.9.2008 2:51pm
PC:
This is not good. U.K. Used Anti-Terrorism Law to Seize Icelandic Bank Assets. Interesting times folks.
10.9.2008 3:05pm
Salaryman (mail):

Can't we just hand out . . . hooker coupons with that?


At the next debate, somebody should ask the candidates whether that's a right too.
10.9.2008 3:07pm
ken in sc (mail):
The financial market is essentially the buying and selling of promises. The derivitives market is buying and selling bets on these promises. Everything goes fine as long as the overwhelming majority of the promises are kept--and as long as most investors think they will be kept. That's why so many financial institutions have the word "trust" in their names. The problem now is that trust has been compromised. It will take time for it to be restored. What needs to happen is after the market is stabilized, the government needs to divest--that is get out. I am an MBA and a retired history teacher--not an ignoramous on this subject.
10.9.2008 3:15pm
Nunzio:
The hard thing about buying assets and commercial paper when it's the gov't is the market distortion it creates.

If the gov't buys GE's commercial paper is that signal that GE's stock is a good buy or that it's a bad buy. If Warrent Buffett buys it, then people think it's a good buy.

When the gov't buys this stuff is it going to have to disclose its reasons for doing so? I.e., we're buying GE's commercial paper because GE is really struggling and is poorly run but everyone be calm and don't dump your stock in GE?
10.9.2008 3:50pm
Arkady:

Can't we just hand out crack pipes and hooker coupons with that?


Nice touch.
10.9.2008 3:52pm
PLR:
I'm not nearly so upset about the government propping up the banks as I am them stepping in and forgiving debt for mortgage holders.

Link? (Sorry, I'm not a trusting person).
10.9.2008 4:30pm
Houston Lawyer:
McCain Plan

And Obama wants to do the same.
10.9.2008 4:53pm
Theodore M. DeBettencourt (mail):
This discussion has broken down. Everyone in the news is talking about confidence. While confidence may be an issue it is more than that. There is irrational panic and rational panic. I am afraid of heights, it is irrational to panic when I get on a plane. If I were forced to walk on a trip line across two skyscrapers I would have reason to panic. Our economic situation is the later example, regardless of what the optibulls are telling you.

I think the analysis on what the government is doing assumes that they know the problem. They aren't really addressing the problem they are fighting the hottest fires. Paulson talked of banks that will close in the future. He was sure of that. This is now the derivative problem that everyone feared. Check out the Comptrollers report Here: http://www.occ.treas.gov/ftp/release/2008-115a.pdf

97 Trillion in notational value on the books for JPM alone. This does not mean anything itself because it is like trying to figure out how much insurance you have on a car by only looking at the car(but its even less accurate than that). The problem is a few other banks namely BAC have tons of derivative contracts out there as well. No one knows the triggering events for these contracts, no one knows the total amount this exposes the banks too and no one knows how much counter party risk is attributed to each bank.

Anyone wonder why JPM was allowed to eat Lehman? The counter-risk that Lehman posed to JPM could have ended it all (at least that was the fear) or not - problem is no one knows.

I really like this site but someone desperately needs to address the underlying issues. If I am wrong about the derivative thing please God provide me something showing me that I am wrong.
10.9.2008 5:13pm
Chem_Geek:
Ah, so mortgage forgiveness is merely a [i]proposal[/i]. You might ought to have mentioned that.

I think it's a good idea. If executives can spend bailout money on spa visits ([i]vide[/i] AIG), then the little guy ought to have some relief too.
10.9.2008 5:16pm
PLR:
Ah, so mortgage forgiveness is merely a proposal. You ought to have mentioned that.

Also shouldn't have used the term to begin with, because the proposal is for restructuring, not for total forgiveness.

And the one thing stupider than spending $700b on mortgage-backed securities would be allowing the loans in the portfolio to remain non-performing or defaulted so that (a) Treasury loses any prospect of an economic recovery on resale, and (b) Uncle Sucker Sam winds up being the country's biggest residential landlord.
10.9.2008 5:24pm
Theodore M. DeBettencourt (mail):
I just found this out. Tomorrow the Fed is unwinding Lehman's OTC derivative contracts. This is expected to result in a paying out of up to 400 Billion by numerous banks and institutions.

I wonder why banks weren't lending each other cash?

Now here is the scary point. According to the Comptrollers office Lehman's Derivative play was the 25th largest in the country! What would be the payout if the number 1 or 2 derivative player were collapse?
10.9.2008 5:33pm
PLR:
I really like this site but someone desperately needs to address the underlying issues. If I am wrong about the derivative thing please God provide me something showing me that I am wrong.

This isn't the site for those kinds of issues, most of the macroeconomic analysis posted here comes from kibitzers and amateurs on the subject, PLR not excepted.
10.9.2008 5:34pm
justareader (mail):
What sort of regulations would have prevented the problem?

Glass-Steagal prohobited banks from selling insurance (credit default swaps) and from owning stock (mortage-backed securities).

This is the regulation which prevents the banks from needing a rating agency to tell it what to safely invest in in the first damn place.
10.9.2008 5:54pm
A Law Dawg:
most of the macroeconomic analysis posted here comes from kibitzers and amateurs on the subject,


I first read this as "kibbutzers" and thought "Really?"
10.9.2008 5:55pm
wm13:
"Glass-Steagal prohobited banks from selling insurance (credit default swaps) and from owning stock (mortage-backed securities)."

None of which rules would have improved the solvency of Bear Stearns, Lehman, or AIG, since none of them is a bank. Conversely, it is bad mortgage loans, not credit default swaps, which have put WaMu and Wachovia out of business.

And mortgage-backed securities are not stock. Words have meanings, and it isn't allowed to just label tails as legs to improve your argument.
10.9.2008 7:15pm
Sagar (mail):
wfjag,
So are you saying that is what the pitiful poor and uninsured people will be getting under an Obama presidency? an "adjustment"?
10.10.2008 12:52am
Theodore M. DeBettencourt (mail):
MBS was the fuse while the CDS and the other OTC derivatives are the bomb. This is a multi-faceted problem. Today at 9:00 AM they start Auctioning off Lehman's OTC Derivatives or maybe just CDS's (I'm not sure if people are wrongly using CDS to talk about otc derivatives) either way there could be MAJOR counter party risk. Or it could be small. No one knows, and there is no way to tell until the auction happens. Major media has not covered this and it is sad. Regardless of what happens you'll be hearing about it soon enough.

The institutions that failed might not have if all the other banks weren't fearing the impending derivatives implosion. The thing is no one knows for sure. To say you can KNOW that WaMu and others failed solely because of MBS presumes A-L-O-T. While I like the tail as a leg argument, I am not sure if you can summarize the failure of three multi-billion institutions in two sentences.
10.10.2008 9:14am
pdq:

To buy commercial paper, you need to distinguish among the various companies that offer it, and pay no more than its value, which requires a good knowledge of the balance sheet and operations of the seller, not to mention the market in which it operates and the health of the economy and financial system. Sure, it's short-term and therefore safer than other forms of debt, but it still needs to be priced correctly in light of its risk.


In the case of publicly traded companies, financial statements are available online. Heck, even privately owned companies have to file income tax returns. That is a one-step task to determine the very basics like profits and losses. This seems a lot less iffy than buying MBS for which the identity of the borrowers in a particular security, much less income and expenses of the borrowers, aren't even known. Commercial lending has been going on, apparently successfully, for decades. MBS has been going on, with little scrutiny, for about a decade AIUI.

I can understand folks having heartburn that .gov getting into the CP lending game is competition to commercial banks. But its a pretty tough sell, I think, to claim that CP lending is as risky for Uncle Sam as MBS purchases.
10.10.2008 10:14am

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