Waiting For The Belly Laughs

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:

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:

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.

 

Comments

[Verner]

Great Summanr from WSJ on how this all happened.

LUN

[Verner]

Make that summary

[Barney Frank]

Here's a little off topic, Obama goofing, and at the same time humanitarian jem in case anyone is sick of tranches and CDOs 24/7.

[srp]

I'm reposting this on the advice of counsel (JM)from an earlier thread. I apologize for the length:

I have a general idea for avoiding future liquidity contagion problems with derivative securities, but I'm not sure it's practical. What I was thinking is that securities could have "crisis" or "system failure" clauses. These would be restrictions on how much lenders (in a broad sense) would be paid conditional on some market-wide, non-manipulable indicator of a crisis (spreads over Treasury, perhaps, or volumes of cash withdrawals from predesignated banks and mutual funds, or...?).

These clauses could be set up to give the lender an option--"If spreads over Treasury go over x points and you call your bond or ask for more collateral or whatever, you only get y% of the face value you are owed." (Perhaps this could be enhanced with an encouragement such as "If spreads go over x points and you DON'T withdraw your liquidity at the crucial moment then you get 1+z times your money when the crisis is past.") These haircut percentages could possibly be made nonlinear in the degree of crisis so that their deterrent effect was highest when the panic was greatest.

The idea is to create a counter-incentive to panic by penalizing withdrawals of liquidity that occur just when liquidity is most needed by the system. And if I see that everyone else is facing the same incentives, my own level of panic that everyone else is pulling their money out is reduced and a virtuous cycle is created.

Another way to look at it is that systemwide liquidity risk cannot truly be hedged or insured, yet current contracts (and valuation methods) don't account for this. Everyone getting their money out at the same time is always going to be impossible no matter how we regulate, as long as we have some version of borrowing short and lending long (and I kind of like modern civilization). If everyone agreed (or were required) to only do business with borrowers who included such "crisis-haircut" clauses in all their securities, perhaps liquidity contagions would be less likely and the system more robust.

I welcome any comments about whether this idea makes sense or how it could be implemented or if we already have such things but they somehow don't work. Note that any crisis indicator must be non-manipulable by an individual entity--otherwise they could use manipulation to avoid paying people whenever they felt like it, and no one would do business on that basis.

[Ms]

I am from another planet and have these things for you to show I am a friend: A device which produces infinite energy. A human/alien hybrid DNA sequence that will make humans perfect.

Bill's belly's want free money.

[TCO]

Let them fail. SAY NO TO BAILOUTS.

[TCO]

Paulson's plan has just caused oil to spike $25 in a day. This is insane. Stop the give away to Goldman.

[san]

I found CIA agents(VA constituents he needs so bad) for Obama, but they say they're really just a bunch of Peace Corps people.

http://foreignpolicyforobama.com/

Don't worry, be happy........

How do offshore accounts work?

[baked alaska]

(a) IN GENERAL.—Not later than 7 days after the
11 date on which the Board exercises its authority under the
12 third paragraph of section 13 of the Federal Reserve Act
13 ((12 U.S.C. 343), relating to discounts for individuals,
14 partnerships, and corporations) the Board shall provide to
15 the Committee on Banking, Housing, and Urban Affairs
16 of the Senate and the Committee on Financial Services
17 of the House of Representatives a report which includes—
18 (1) the justification for exercising the authority;
19 and
20 (2) the specific terms of the actions of the
21 Board, including the size and duration of the lend22
ing, the value of any collateral held with respect to
23 such a loan, the recipient of warrants or any other
24 potential equity in exchange for the loan, and any
25 expected cost to the taxpayer for such exercise.

Dodd proposal reference to warrants

[baked alaska]

At some point, one hopes Krugman actually reads the bill.

;-)

[Charlie (Colorado)]

TCO, you may think food riots and a depression are acceptable sacrifices for purity, but the conscious members of the group know you're wrong.

[baked alaska]

Dear American:

I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.

I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transactin is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to wallstreetbailout@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed information about safeguards that will be used to protect the funds.

Yours Faithfully Minister of Treasury Paulson

link

[Charlie (Colorado)]

I have to admit, it's getting past my intellectual bedtime. My first look at this seems to agree with yours, Tom.

The original scheme semmed to be a way to get the securities off the books, while letting the government assume them discounted for risk.

This scheme seems more like loan sharking.

[Charlie (Colorado)]

It's still justa cut and paste job, baked, but at least it's funnier than your usual crap.

[ben]

Guess who thinks John McCain has a pretty good record on reform...

http://www.youtube.com/watch?v=AjrSjtdfc_I

[Rick Ballard]

GMax,

Who gets to value the contingent liability? Does it go down on the books at 100% of the value of the MSB sold or would a prudent investor demand that it be marked to 125%?

I'd kinda like to know so that I can make some calculations concerning potential dilution of ownership interest before I risk any money by purchasing shares.

Maybe someone will sell me some sort of an insurance policy protecting me from the contingent liability - maybe we could call it a credit default swap or something like that? There might even be a big market for such an instrument.

I wish someone would mock up a balance sheet for Senator Dodd and have him show us how this all works.

[Ursus]

What I would like to see is the Fed buy the debt in exchange for equity shares now, with the Fed getting preferred dividends until the loan has been repaid. This would wipe the books in the short term, keep the firms responsible for the bad deals they had previously made, and encourage them to pay off the loan quickly. The stockholders would take it in the shorts, but if the firm is able to pay off the loan quickly then the pain will be brief.

[MarkO]

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.

The more artificial this market, the graver the consequences when market lightening strikes. I know, some say shorters are the bane of free markets. That is not remotely true. But, when I short a calf, it stays short.

Anyway, I just wish I had insider information like those who knew in advance that there would be an announcement about MS and the shorters. I could have bought at $11 and sold at $30. If you think any amount of this silly and poorly written regulation will make a difference, you are not a seasoned observer.

[Charlie (Colorado)]

For the purists who are still saying we should have just let it go to smash, Mega is quite good. She doesn't take it as far as I did with seed loans, but then she's a city girl.

[Charlie (Colorado)]

That's "Megan."

[M. Simon]

TCO translated:

Let the system go belly up. $25 to $50 trillion in American losses is nothing compared to having taxpayers on the hook for $.7 trillion.

[Charlie (Colorado)]

Let the system go belly up. $25 to $50 trillion in American losses is nothing compared to having taxpayers on the hook for $.7 trillion.

The survivors will live and the weak will die.

Waß mich nicht umbringt macht mich Stärker.

[baked alaska]

Guess who actively sought to boost minority homeownership? John McCain's campaign manager, Rick Davis.

As The New York Times reported today, Davis was president for several years of the Homeownership Alliance, an industry advocacy organization formed mainly by Fannie Mae and Freddie Mac. The Alliance's core mission is to boost the number of mortgages granted.

But take a look at this picture from the alliance's annual report in 2004, unearthed by a reader, showing Davis at a Congressional reception praising minority homeownership (click to enlarge):

pic

"We have an opportunity in the next decade to increase minority homeownership and significantly reduce the minority homeownership gap," Davis is quoted saying here. "The future of the housing market rests heavily on the economic success of minorities. Homeownership is likely to grow faster among minority Americans in the next decade if all the stakeholders in the housing industry work together to make it happen. The Homeownership Alliance is working toward this goal."

story

[DrJ]

TCO translated:

And here I thought it translated to Totally Confused Onanist. My mistake.

[TCO]

Fuck the RINOs. I'm taking my base and going home. You guys can burn in Hell.

[DrJ]

I'm taking my base and going home.

Promise?

[baked alaska]

Tragedy in Alaska

[Charlie (Colorado)]

I'm taking my base and going home.

Yeah, you said that last time.

besides, all ur base r belong 2 us.

[Charlie (Colorado)]

Baked, I keep telling you, that was a goddamn caribou in that picture. A reindeer.

She shot Rudolph.

Geez.

[DrJ]

all ur base r belong 2 us

Has anyone here actually played that game? I'm no gamer, but then I don't play with myself like TCO.

[TheRadicalModerate]

It occurs to me that the Dodd plan quacks an awful lot like an incentive stock option. Just as with an ISO, I'd assume that the dilutive effects of the future liability would have to be booked at the time of the issuance of the warrant. That sounds like a fabulous way to crater the stock at exactly the moment that the treasury steps in to buy the bad debt. This is what is sometimes known as an "unintended consequence."

[M. Simon]

Food On The Table

[ben]

GALLUP:

"This year, 47% perceive the news media to be too liberal and 13% perceive them to be too conservative, with only 36% seeing media coverage as "about right."

Who are these 13%???? I want to sell them some nice almost dry land in Florida.....

[ben]

Was Biden having trouble sleeping at night?

"Barack Obama's running mate says a campaign ad that mocked Republican presidential candidate John McCain as an out-of-touch, out-of-date computer illiterate was "terrible" and would not have been done had he known about it. ...

"I thought that was terrible, by the way," Biden said."

Asked why it was done, he said: "I didn't know we did it and if I had anything to do with it, we'd have never done it."

[Charlie (Colorado)]

Who are these 13%????

They work for Media Matters.

[Tom Maguire]

From baked alaska:

23 such a loan, the recipient of warrants or any other 24 potential equity in exchange for the loan, and any 25 expected cost to the taxpayer for such exercise.

Believe it or not (I am still shaking my head and trying to figure my next move) I did a text search on the Dodd draft and found that use of the word warrant, after which I revised my sentence which had emphatically declared that the word didn't appear in the bill.

However, that revision didn't end up on the page, so now I am wondering what other revisions got dropped. Troubling.

Anyway, I have made a change to get across my notion that Dodd doesn't use "warrants" in describing this contingent equity make-whole mechanism.

The warrants referred to in this passage could just as well be warrants associated with a troubled asset, depending on the scope of Treasury purchases.

[ben]

Whoops, the Obamabot Komisariat has had a little talk with Biden. Update:

"[I]n the statement issued by the Obama campaign, Biden said he had never seen the ad and only read press reports of it.

"Having now reviewed the ad, it is even more clear to me that given the disgraceful tenor of Senator McCain's ads and their persistent falsehoods, his campaign is in no position to criticize," Biden said in the statement."

[Threadhearder]

Tom,

Thanks for the econo-blogging. It's great to get the benefit of your perspective.

[Threadhearder]

Whoops. Must either spell correctly or fix name.

Next time, perhaps.

[perfecor]

DATA/ONE how the US went broke. Maybe if we taxed our GDP/GNP like Canada and England, we'd be okay.

We can't afford to give away 100s of billions a year. We need money back.

Mrs. McCain looks like a dunce. She's got a thing for British.

http://www.data.org/about

http://www.one.org/partners/index.html

Biden and Obama are the same.

[Publius]

Speaking of games, I have this game I'm trying to sell to Parker Bros. It's called Anarchy.

First you play the game, and then you make up the rules. So far, the only people showing any interest are Hank Paulson and Ben Bernanke.

[Elliott]

Ben, I'm afraid I can't help myself:

Guess who thinks John McCain has a pretty good record on reform... did not know the John McCain he thought he knew.

[whencanyoustart]

The Colombians found more anti Obama FARC stuff. Maybe they will trade with us now and let us make a few dollars. Pelosi has figured out trade is good because everything else is just giving the money away.

http://news.bbc.co.uk/2/hi/americas/7630663.stm

[bgates]

Ben, it's the 36% we have to worry about. The 13% wouldn't buy land anyway, they'd insist the government expropriate it in the name of The People.

Re the Biden statement, can you believe those words were committed to paper? "I didn't see the ad before, but now that I have, I'm going to get back on message and say McCain is worse." I'd be embarrassed to use a sentence that read like his statement in a blog comment.

[Pen'soil]

Blair's on the Comedy channel and says he didn't plan any of this even though America is socialist now. Swears he won't attack Argentina again. Converted to Catholicism. They converted to Judaism.

US mint has new penny out.

[Topsecretk9]

Clairice

In case you didn't notice J Street has it's own Astroturf Letter to the Editor generator built in

Here is one printed I found

Middle East progress

I have been reading the latest news coming out of Israel with cautious optimism - the ceasefire with Hamas, an offer to begin talks with Lebanon and the ongoing talks with Syria and the Palestinians. It looks like Israel is heading in the right direction in its quest for security and peace.

I have been struck, however, by the absence of public expressions of support for these recent peace efforts, most notably from the pro- Israel community that is normally such a vocal advocate for Israel and its policies.

As an American who believes that the security of Israel, its neighbors and the United States is enhanced by a peaceful Middle East, I strongly support these initiatives and hope the United States will do more to facilitate their success. I hope that those who consider themselves to be friends of Israel will join me in this strong expression of support.

JOSE MARQUEZ,Topeka

LUN

[duter]

The link is one of those firms agencies hire to get news out.

The Mossad agent going into office set up Olmert for the war.

Rice had a cool propaganda war with the Russians, basically saying they have no balls as they send ships and planes to the Western hemisphere. Maybe we should cut and past that?

[TheDiplomatist]

It's supposed to say Plame where it says Mossad.

[NotSean]

Good write up by Tom Maguire. It's important for those who understand this crisis to keep adding information to the discussion. I'm finding good information from both conservatives and liberals here, and glad to see both sides agreeing that we need to stop and take a look before we write a blank check to bail out Wall Street millionaires. Too bad the comments section is still uselessly clogged with the redbaiting nonsense of all these tin foil hat oldies who still think this is 1970. Great article, useless discussion section.

[Jane]

Great article, useless discussion section.

I guess that explains why you are in it.

Get Lost!