The Volokh Conspiracy - More Bailout News:

Today's news brings further cause for concern on almost every question about the bailout that has bothered me. A brief review.

More on unintended consequences--the ban on short-selling threatens to bankrupt hedge funds. While it might be fun for us taxpayers to own a hedge fund or two in addition to everything else we are buying up, it is not obvious that our new planning Commissar Paulson has thought about all the unintended consequences:

Of all of the tumultuous events of the past week on Wall Street — which included the bailout of the nation's largest insurer, conversion of investment giants Morgan Stanley and Goldman Sachs into bank holding companies, and the promise of a $700 billion rescue package from the government — the biggest source of problems for hedge funds was the temporary SEC ban on shorting financial stocks.

Industry groups say the ban, if made permanent, could make it difficult for some funds to survive because their entire trading strategy was based on the practice. Hedge-fund managers said shorting plays an important role in the markets because it helps them properly price securities.

Another unintended consequence is that by exploding the national debt the bailout plan has ignited inflation fears and threatens to ruin the dollar while gold and oil prices skyrocket.

We also have more on Paulson giving away the store in his negotiations with Wall Street by basically telling them that the government was desperate to buy up their garbage paper. Did he really think that the Wall Street creeps who caused all these problems and then asked the taxpayers to bail them out were really going to show self-restraint and put their selfishness aside as a show of gratitude for all of us saving their hides? Instead, it appears that the Wall Street billionaires will deign to participate in the bailout only if it doesn't threaten their house in the Hamptons or private jets:

Another point of dispute is Democrats' insistence that the government be given authority to cut the salaries of executives and restrict their severance packages if they take taxpayer money. Paulson has said such a move would be "punitive" and deter companies from participating in the bailout.

Heaven forfend, we wouldn't want to be "punitive" toward these guys by taking away their golden parachutes, would we?

Also more on the mark-to-market accounting issue.

Finally, we have more on the question of how the government will value these assets and the lemons problem they raise:

As the government weighs how to bail out the financial sector, the plan's engineers face a dilemma.

The higher the prices the government pays for troubled mortgage securities held by banks, the more the rescue will bolster those banks and sustain the lending that is vital to the broader economy. But higher prices would also mean a worse deal for taxpayers.

In other words, the more effective the plan, the more expensive it will ultimately be.

The Treasury Department has provided only broad outlines of how it intends to set prices, saying in a fact sheet that it will use "market mechanisms where possible, such as reverse auctions." In a reverse auction, the government could agree to purchase a specific amount of assets and buy those that are offered at the lowest price.

But that may be harder than it sounds, economists said.

The problem is that there are thousands of kinds of mortgage-related securities. If the Treasury just opens the door for banks to sell those securities to the government, firms will offer up the very worst ones, possibly leading to huge losses for taxpayers. But if the government specifies exactly which securities it will accept, the Treasury secretary will have unusually broad authority to decide which banks get bailed out and which don't.

Imagine that the market for used cars had fallen apart and the government decided to restore order by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its investment and would lose money.

In an alternate scenario, the government could have separate auctions for Pintos and BMWs. But in choosing how many of each to buy, the government would be deciding which kinds of car owners to bail out and which to let suffer.

Note a few closing points about the need or wisdom of the bailout.

First, we now live in a global capital market--perhaps Wall Street is down, but Japan is flush with cash and is ready to invest. I'm sure they aren't the only ones.

Second, Paulson and Bernanke admit that the bailout is not doing anything to actually stem the crisis. In this vein, it is worth reminding ourselves that much of the frantic activity of the New Deal to "do something" about the Great Depression probably did nothing to end the Great Depression and may have even delayed and worsened the eventual correction. There were, of course, many causes of the Great Depression and many counterproductive policies that worsened and lengthened it including Smoot-Hawley, deflationary monetary policy, and liquidity problems caused by bank failures. And there were some interventions, like deposit insurance, that may have helped at least in the short run (although perhaps not in the long run). But much of the frantic and ad hoc interventions of the Great Depression like the NRA and others simply spawned uncertainty and unintended consequences and in so doing worsened the problem. See here and here for some sense of the question. "Do something" is plainly not a sensible policy if doing something is something stupid and counterproductive. The ad hoc and chaotic interventions by the government in the current crisis, plus the whole stream of unintended consequences that have already arisen and inevitably will arise, has simply increased market uncertainty and unpredictability. Now proposals to allow consumers to modify mortgages are back on the table after being pushed back a few weeks ago.

Yet Paulson and Bernanke is convinced that despite the fact that what they've done so far hasn't made a difference the solution is to double-down with more of the same:

The nation's top economic policymakers acknowledged this morning that an already extraordinary series of government actions has failed to stabilize global financial markets and said that Congress must act quickly on a proposed bailout plan to avoid dire consequences for the U.S. economy.

Money is flowing out of the market to investments in commodities like gold and oil, and I suspect will continue to do so. So long as the government is making this stuff up as it goes along, bailing out some industries and firms but not others, why would anyone put money back into the banking sector? I mean seriously--how idiotic is it that in trying to save money market funds they threatened to destroy deposit accounts? Or that in trying to save investment banks they end up destroying hedge funds? What industry will they destroy next? And when they are blundering around like this why do they think this will lead to investor confidence?

Perhaps in the end the situation is so dire that a blunderbuss bailout is appropriate notwithstanding all of the unintended consequences, problems in the details of the plan as implemented, and uncertainty about whether it will work. But the more I learn about it and the less impact it seems to have (or even potentially counterproductive impact) the more skeptical I'm becoming.

	[Todd Zywicki, September 23, 2008 at 12:46pm] Trackbacks More Bailout News: Today's news brings further cause for concern on almost every question about the bailout that has bothered me. A brief review. More on unintended consequences--the ban on short-selling threatens to bankrupt hedge funds. While it might be fun for us taxpayers to own a hedge fund or two in addition to everything else we are buying up, it is not obvious that our new planning Commissar Paulson has thought about all the unintended consequences: Of all of the tumultuous events of the past week on Wall Street — which included the bailout of the nation's largest insurer, conversion of investment giants Morgan Stanley and Goldman Sachs into bank holding companies, and the promise of a $700 billion rescue package from the government — the biggest source of problems for hedge funds was the temporary SEC ban on shorting financial stocks. Industry groups say the ban, if made permanent, could make it difficult for some funds to survive because their entire trading strategy was based on the practice. Hedge-fund managers said shorting plays an important role in the markets because it helps them properly price securities. Another unintended consequence is that by exploding the national debt the bailout plan has ignited inflation fears and threatens to ruin the dollar while gold and oil prices skyrocket. We also have more on Paulson giving away the store in his negotiations with Wall Street by basically telling them that the government was desperate to buy up their garbage paper. Did he really think that the Wall Street creeps who caused all these problems and then asked the taxpayers to bail them out were really going to show self-restraint and put their selfishness aside as a show of gratitude for all of us saving their hides? Instead, it appears that the Wall Street billionaires will deign to participate in the bailout only if it doesn't threaten their house in the Hamptons or private jets: Another point of dispute is Democrats' insistence that the government be given authority to cut the salaries of executives and restrict their severance packages if they take taxpayer money. Paulson has said such a move would be "punitive" and deter companies from participating in the bailout. Heaven forfend, we wouldn't want to be "punitive" toward these guys by taking away their golden parachutes, would we? Also more on the mark-to-market accounting issue. Finally, we have more on the question of how the government will value these assets and the lemons problem they raise: As the government weighs how to bail out the financial sector, the plan's engineers face a dilemma. The higher the prices the government pays for troubled mortgage securities held by banks, the more the rescue will bolster those banks and sustain the lending that is vital to the broader economy. But higher prices would also mean a worse deal for taxpayers. In other words, the more effective the plan, the more expensive it will ultimately be. The Treasury Department has provided only broad outlines of how it intends to set prices, saying in a fact sheet that it will use "market mechanisms where possible, such as reverse auctions." In a reverse auction, the government could agree to purchase a specific amount of assets and buy those that are offered at the lowest price. But that may be harder than it sounds, economists said. The problem is that there are thousands of kinds of mortgage-related securities. If the Treasury just opens the door for banks to sell those securities to the government, firms will offer up the very worst ones, possibly leading to huge losses for taxpayers. But if the government specifies exactly which securities it will accept, the Treasury secretary will have unusually broad authority to decide which banks get bailed out and which don't. Imagine that the market for used cars had fallen apart and the government decided to restore order by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its investment and would lose money. In an alternate scenario, the government could have separate auctions for Pintos and BMWs. But in choosing how many of each to buy, the government would be deciding which kinds of car owners to bail out and which to let suffer. Note a few closing points about the need or wisdom of the bailout. First, we now live in a global capital market--perhaps Wall Street is down, but Japan is flush with cash and is ready to invest. I'm sure they aren't the only ones. Second, Paulson and Bernanke admit that the bailout is not doing anything to actually stem the crisis. In this vein, it is worth reminding ourselves that much of the frantic activity of the New Deal to "do something" about the Great Depression probably did nothing to end the Great Depression and may have even delayed and worsened the eventual correction. There were, of course, many causes of the Great Depression and many counterproductive policies that worsened and lengthened it including Smoot-Hawley, deflationary monetary policy, and liquidity problems caused by bank failures. And there were some interventions, like deposit insurance, that may have helped at least in the short run (although perhaps not in the long run). But much of the frantic and ad hoc interventions of the Great Depression like the NRA and others simply spawned uncertainty and unintended consequences and in so doing worsened the problem. See here and here for some sense of the question. "Do something" is plainly not a sensible policy if doing something is something stupid and counterproductive. The ad hoc and chaotic interventions by the government in the current crisis, plus the whole stream of unintended consequences that have already arisen and inevitably will arise, has simply increased market uncertainty and unpredictability. Now proposals to allow consumers to modify mortgages are back on the table after being pushed back a few weeks ago. Yet Paulson and Bernanke is convinced that despite the fact that what they've done so far hasn't made a difference the solution is to double-down with more of the same: The nation's top economic policymakers acknowledged this morning that an already extraordinary series of government actions has failed to stabilize global financial markets and said that Congress must act quickly on a proposed bailout plan to avoid dire consequences for the U.S. economy. Money is flowing out of the market to investments in commodities like gold and oil, and I suspect will continue to do so. So long as the government is making this stuff up as it goes along, bailing out some industries and firms but not others, why would anyone put money back into the banking sector? I mean seriously--how idiotic is it that in trying to save money market funds they threatened to destroy deposit accounts? Or that in trying to save investment banks they end up destroying hedge funds? What industry will they destroy next? And when they are blundering around like this why do they think this will lead to investor confidence? Perhaps in the end the situation is so dire that a blunderbuss bailout is appropriate notwithstanding all of the unintended consequences, problems in the details of the plan as implemented, and uncertainty about whether it will work. But the more I learn about it and the less impact it seems to have (or even potentially counterproductive impact) the more skeptical I'm becoming.