Kevin Drum has a useful overview of the upcoming bail-out of the financial industry; Krugman provides an interesting hand-wringer, and Dean Baker (as summarized by Mark Thoma) is useless. Let's roll Drum:
It's true that the Bernanke/Paulson bailout is aimed at illiquid debt instruments. And those instruments are illiquid largely because they contain lots of toxic mortgage securities and nobody knows how much this stuff is really worth. It's unlikely that the toxic sludge makes these instruments literally worth nothing, but who knows? The mere possibility that they're worthless means that anyone who owns them might be insolvent, and since everyone owns at least some of them, this in turn means that everyone might be insolvent. Result: no one is willing to loan money to anyone else, because who wants to loan money to a bank that might never pay it back? This has caused the credit markets to seize up. (And if this WSJ tick-tock is correct, the seizure became critical on Wednesday, which is why B&P changed their minds midweek about pursuing a systemwide bailout that they'd opposed earlier.)
The purpose of the bailout, then, isn't to recapitalize the banks, it's to put a firm value on the toxic sludge once and for all. Maybe it's a dime on the dollar, maybe it's 50 cents on the dollar. Whatever. When that's done, some banks will turn out to be insolvent, and perhaps they'll be allowed to fail. Others will turn out to be in bad shape but still solvent, and they'll continue doing business. Once that's sorted out, the commercial paper market will loosen back up since everyone will know who it's safe to loan money to and who it's not.
Well, yes. Suppose Merrill Lynch (to pick a name at random) has marked its sludge down to 50 percent of face value. Let's further suppose that with perfect foresight investors could see that this is the "right" price in the sense that over the life of the assets Merrill will receive that amount in present value, risk adjusted terms.
Does this mean that Merrill's financial statements are reliable and lenders will lend to them? Not in the current environment. Fannie Mae and Fredddie Mac went poof; Lehman was rumored for months to be in trouble and finally went bust; AIG was rumored for days to be in trouble and disappeared; one of the oldest and largest money market funds had to suspend withdrawals and pay out at 97 cents at the dollar.
Lacking perfect foresight, investors have no idea whether 50 cents on the dollar is fair but even if they suspected it was they also have an excellent idea that lightning could strike and Merrill could go bust tomorrow, which means they won't lend to Merrill today. Or, if the idea of a lightning strike seems too abstract, investors might believe that, although 50 cents is the mean expected value of the assets in question there is a high enough probability that they will ultimately be worth 25 cents that a loan to Merrill is too risky.
However, if Merrill sells those assets at 50 cents, they have not received a subsidy but they have removed a major source of volatility from their financial statement - there is no possibility that Merrill will later mark those assets down to 25 cents because they have been sold. Of course, they will never mark them to 75 and book a profit, but lenders were hardly worried about that (This reduction in volatility is a bummer to equity investors, who lose the "heads I win tails, the lender loses" option on the sludge. However, the equity investor gains value since prospective reorganizations costs in liquidation or merger have been reduced.)
So why doesn't Merrill and everyone else sell their troubled assets and move on? Well, sell them to whom? Merrill did sell some of this stuff but the collectively the financial firms simply have too much to move. Hence, there is a role for the government as a patient, well-capitalized investor of last resort - it is *possible* that the government can break even or make money on these assets if the purchase price is fair. Obviously, it is also possible that the government will get stuffed with the worst of the worst at inflated prices, or that the government will consider it its patriotic duty to pay inflated prices in order to quietly re-capitalize some of these firms. But this bail-out can be effective without assuming that to be the case. Here is Dean Baker:
The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won't get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so. ...
Well, there are market prices and market prices. If I had to sell my home on Monday Sept 22 for cash in 50s and 100s, the price would be substantially discounted from the value I would receive if I could wait a few months and go through a more regular process. Firms that thought they could hold their troubled assets and earn their way out of trouble have run out of time and there simply are no bids for this stuff. From that it does not follow that these assets are worthless any more than it follows that the "cash price on Monday" value of my home represents its fair value.
From Mark Thoma:
Here's a proposal. First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that.
Well, we don't know that the government will be overpaying, although it is a possibility. A trickier argument would be to wonder whether it is fair to the taxpayers for the government to pay a "premium" price based on its ability to buy and hold in a market where no other major bidders can afford to do so. I'll say this - no private investor would surrender the premium created by the investor's own financial strength. OTOH, no private investor has a particular duty to promote the national economy. And if fifteen years from now the government entity managing these assets has broken even, well, good for them. On a risk-adjusted basis they will have gotten fleeced (anyone borrowing at the risk-free rate *ought* to make money) but the economy will have been stabilized (fingers crossed) and the taxpayer won't be out of pocket.
My key point - this "bail-out" can work (at least conceptually) if the Treasury pays "fair", non-subsidized prices for the problematic assets. An auction mechanism that determines a fair price will be difficult but I'll toss out an obvious idea - run reverse auctions for any of the non-unique bonds held by more than one firm. Start at five cents and work up until a target amount has been purchased by the government, then pay everybody the clearing price. For uniform, widely held bonds approach should be fine (Collusion? These firms wouldn't do that, would they?). For the truly unique (and uniquely awful) fragments and structured tails hanging around, well, get back to me.
Let me close with Drum:
Now, there are obviously all sorts of problems here. How is the Treasury going to value all the sludge? If they value it too high, then we really are bailing out irresponsible bankers who made stupid loans, and the taxpayers will foot the bill when the sludge eventually gets sold off at a loss. Value it too low and the feds are acting as vultures, causing more bank failures than we really ought to have. Furthermore, once the sludge is off Wall Street's books and some big banks turn out to be insolvent for certain, will they really be allowed to fail? Or will Bernanke and Paulson prop them up yet again?
Excellent. Or at least, I completely agree.
BONUS WORRY: Krugman also wonders what happens if, after buying mountains of sludge at "fair" prices we then discover some firms to be insolvent. What indeed. Take heart - Bob Rubin's invisible hand is near the helm.
I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.
...The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.
It is true that paying a premium would help troubled firms (or untroubled ones for that matter). However, as noted in the Merrill-lightning strike example above, reducing the variance of a firm's balance sheet will make that firm more appealing to lenders even if the mean value of the firm does not change (i.e., the assets are sold at fair value, not a premium). Allowing Merrill to remove an asset at 50 that is fairly valued at 50 can make Merrill more attractive to lenders if they no longer have to factor into their lending decision the fact that the assets in question is illiquid and of highly uncertain future value.
Now, if the underlying crisis is due to solvency rather than liquidity (Krugman's guess, but who knows?) then after all the firms have dumped their waste we will see that some firms lack sufficient capital to continue. What then? A possible answer - since the mysteries of their balance sheet have been resolved (and the variance of their future value reduced), these firms ought to be more able to attract new capital than they are at present. Fingers crossed again (and is hope a plan?)
Too bad - the Times readership would probably benefit from some sound economic analysis of this plan. Instead the Times is peddling the hyper-partisan Krugman.