In the course of evaluating the Dodd proposal I had predicted that, although it was nothing like Krugman's call for direct equity investments by the government to support the financial services sector, Krugman would support Dodd anyway. Why? Basically, because Sen. Dodd is a reliable progressive and anything proposed by Bush or his minions is evil and corrupt.
How do Krugman and Dodd differ? Here is Krugman from his column today:
...the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.
Let's move past my point that Paulson's plan address the asset-to-capital problem by allowing firms to reduce assets rather than obliging them to raise capital. Are the direct equity investments for which Krugman is calling anything like what Dodd is proposing? No. Dodd has a mysterious contingent make-whole provision designed to protect the taxpayer from losses, not to re-capitalize the financial services sector or enhance financial stability. It can be illustrated as follows (or see the bill text here):
1. The Treasury buys a troubled asset from a firm for some amount, say $10 billion.
2. *IF* the Treasury later decides to sell the asset and *IF* the Treasury takes a loss, the original seller is on the hook for 125% of the loss. Please note that this loss may simply reflect broad market movements and have nothing to do with whether the original purchase price was fair and transparent. Let's hypothetically assume the sale occurs for $8 billion, for a loss of $2 billion. 125% of $2 billion is $2.5 billion, which is now owed by the seller to the Treasury.
3. To make good on the loss, the seller issues new shares to the Treasury. The key wrinkle - the new shares are valued at the average market price at the time of the original sale, not at the market price when the Treasury realized a loss. So if the seller has become distressed in the meantime and its share price has fallen from $25 per share to $2.5 per share, it will issue 100 million shares shares ($2.5 billion / $25) to the government worth only $250 million. On the other hand, if the seller's shares have appreciated to $50, it will still issue 100 million shares but their value to the Treasury will be $5 billion.
Now, is that anything like the direct equity investments that Krugman advocated? Of course not. First, the Treasury may never formally book losses - if it simply plays a buy and hold strategy with its acquired assets it will never book losses, although it may lose hundreds of billions on a cash flow basis.
Secondly, new capital is not really being provided by the government. Instead, in the above example the government in effect pays $10 billion for the troubled asset. In the fullness of time, and if the asset has both depreciated and been sold, the government in effect revises the original deal - the revised deal is the same as if the firm had presciently sold the assets for $8 billion *and* issued 100 million shares to the government at a discounted price of $2 billion.
Both before and after the revision the firm receives $10 billion from the government, so the revision does not represent new capital. However, although the asset was "sold" the seller was still at risk for future losses and equity holders were at risk of dilution. Hence, the "sale" did little to reassure equity holders or make the firm more able to attract new equity investment. However, as with the Paulson plan, the seller did improve its asset-to-capital ratio by shedding $10 billion in assets.
So - since the Dodd plan does not put new capital into financial services firm on any predictable basis and is almost surely less stabilizing than the Paulson plan, Krugman will oppose it, right? Of course not. Krugman now claims he has had a chance to evaluate the Dodd proposal and (surprise!) he likes it. Well, there are some oversight modifications that Krugman ought to like (I do), but mainly he misconstrues the Dodd plan in order to endorse it. Here we go:
I’ve had more time to read the Dodd proposal — and it is a big improvement over the Paulson plan. The key feature, I believe, is the equity participation: if Treasury buys assets, it gets warrants that can be converted into equity if the price of the purchased assets falls. This both guarantees against a pure bailout of the financial firms, and opens the door to a real infusion of capital, if that becomes necessary — and I think it will.
The Wall Street Journal used the "warrant" metaphor, so maybe he got it from them; that word is not used in the text of the bill to describe this equity scheme. At some point, one hopes Krugman actually reads the bill. Let me copy the key provisions below:
(1) IN GENERAL.—The Secretary may not purchase, or make any commitment to purchase, any troubled asset unless the Secretary receives contingent shares in the financial institution from which such assets are to be purchased equal in value to the purchase price of the assets to be purchased.
...(3) VESTING OF SHARES.—If, after the purchase of troubled assets from a financial institution, the amount the Secretary receives in disposing of such assets is less than the amount that the Secretary paid for such assets, the contingent shares received by the Secretary under paragraph (1) shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to— (A) 125 percent of the dollar amount of the difference between the amount that the Secretary paid for the troubled assets and the disposition price of such assets; divided by (B) the amount of the average share price of the financial institution from which such assets were purchased during the 14 business days prior to the date of such purchase.
A note - in clause (1) the contingent shares are described as "equal in value to the purchase price of the assets to be purchased". My guess is that this is to cover the scenario in which the final asset sale described in (3) occurs at a price of zero. If the actual sale price is higher, the value is reduced as per the 125% formula.
As I hope the example above made clear, this is nothing like a conventional equity or warrant sale; Krugman's notion that "This... opens the door to a real infusion of capital" is simply not based on the text of the bill.
Dodd's objective with this "equity" provision is to allow Treasury to recoup realized losses. It has nothing to do with, and in fact detracts from, ensuring financial stability or infusing capital into the financial system.
And why do I focus on Krugman's misconceptions? Sadly, he has a powerful platform and an influential voice. Here, for example, is TIME's Joe Klein, who is over his head here:
There seems to be a rare harmonic convergence on the op-ed page of the New York Times today, both Paul Krugman and William Kristol--the alpha and omega of the Times' columnist corps--are opposed to the Bush Administration gargantuan Wall Street bailout.
Krugman obviously knows a lot more about economics than Kristol. Indeed, Krugman has been written early and often about the disastrous potential of the housing bubble. And I would trust him here--the taxpayers' stake in this bailout is best protected by the government taking an equity stake in the affected firms...
A lot of the progressive blogs (the "progosphere") will follow Krugman's lead, given his academic and economic credentials. And this Treasury rescue plan is huge and problematic, so having sharp eyes look at it and sensible people debate it ought to be a good thing. Too bad Krugman is shirking his role as analyst and is simply cheerleading and misrepresenting the actual Dodd proposal.
NEXT: Any predictions on how or whether Krugman climbs down? He only has about a week.
HEADSCRATCHER: After a "sale" of their assets to the Treasury firms are still liable for losses (although they do not share in gains). Should firms be hedging this exposure? How? And put your hand up if you think this increases the stability of the firms. I don't see any hands...
IN THE NEWS: I have yet to find a media account that jibes with my analysis (or changes my mind), but this is interesting:
Massachusetts Democratic Rep. Barney Frank told reporters that the administration has accepted some conditions laid down by Democrats, including giving the government a stake in any institution unloading assets under the plan. But sources close to the Treasury said it was opposed to equity stakes and Frank later said: "Apparently I was premature."
Just to plant my flag - I don't have a big problem with some sort of equity provision, as long as we know what we are trying to accomplish with it. If the goal is to add capital to the system, fine. If the goal it to increase investor uncertainty and randomly punish some firms (but not others) for asset price moves that may simply reflect market movements, I am less keen.
The Dow Jones Newswire is sort of on my side:
WASHINGTON -(Dow Jones)- Banking industry lobbyists scrambled Monday to stop Democrats from adding tough new conditions to a Treasury rescue plan for the troubled U.S. financial system.
The industry is balking at proposals to allow the Treasury to acquire ownership stakes in institutions that offload their toxic mortgage assets onto the government and to impose caps on the amount such companies pay their executives....
But on Monday key Democrats moved to heap their own proposals onto the plan, seeking to protect taxpayers against losses and require the government to do more to help strapped homeowners.
The Dodd priorities are described as helping homeowners and avoiding taxpayer losses, not adding capital to the system. The WSJ tells us that the equity piece is fluid:
The Dodd priorities are described as helping homeowners and avoiding taxpayer losses, not adding capital to the system.
The WSJ tells us that the equity piece is fluid:
While details are still being worked out, both sides have also agreed to a measure that would allow -- but not require -- the Treasury to take an equity stake in a financial institution that sells assets to the government. Whether it did so might be dependent on the size of the capital injection the government makes when it buys the assets, according to a person familiar with the matter.
There are precedents for the government taking stakes in private companies, dating back to the bailout of Chrysler Corp. in 1979, when the government got warrants to buy Chrysler shares. Most recently, the Federal Reserve took warrants in American International Group Inc., representing a majority equity interest in the big insurer.
That sounds very little like the Dodd proposal.
METAPHOR MADNESS: From the comments:
METAPHOR MADNESS: From the comments:
I’m just a simple cowboy, livin’ the dream and missing my sheep. But, in my frequently kicked brain this looks a like Yellowstone did just before the entire thing went en fuego. There was so much work put into keeping a fire from starting, much less burning, that the underbrush and the dead wood finally gave us a conflagration devoutly not to be wished. At the end of the reign of that theory of forest management, someone with a modicum of awareness of the implacability of nature realized that lightening was not the enemy of the Park.