Wed Sep 24th, 2008 at 05:09:47 AM EST
Like many people I have been following what has been called Paulson's Authorisation for the Use of Financial Force. One of the most interesting developments around it has been a counter-proposal by Chris Dodd, Chairman of the US Senate's banking committee.
I have found Paul Krugman's blog very useful and I encourage you to read his analysis. Here I'll just quote his reaction to Paulson't and Dodd's plans.
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.
And there's no quid pro quo here -- nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.
I hope I'm wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work -- not try to panic Congress into giving it a blank check. Otherwise, no deal.
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.
Jerome has written against the Paulson plan
today, as have many others which you can see linked in that thread. Here I want to focus on how the Dodd plan plugs the holes in the Paulson plan, how it's supposed to work, and how it might yet fail.
The Paulson plan, in a nutshell, is this: give the Treasury Secretary (that is, Paulson) unaccountable authority to spend up to $700bn buying Big Shitpile™ from the few financial institutions left standing (including his former employer Goldman Sachs, in which apparently he retains a large equity share). One of the sticking points is the unaccountability - despite a provision to report to congress 3 months into the program and every 6 months thereafter, there is the following hair-raising provision
Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
The Dodd plan, in contrast, establishes an "Emergency Oversight Board" and monthly reporting to Congress, as well as the judicial review implicit in the following:
SEC. 8. LIMITS ON REVIEW.
(a) IN GENERAL.--Any determination of the Secretary with regard to any particular troubled asset pursuant to this Act shall be final, and shall not be set aside unless such determination is found to be arbitrary, capricious, an abuse of discretion, or not in accordance with the law.
Funny how Paulson's section is called "review" when the content is total lack thereof.
Now, aside from lack of accountability, I have quoted Krugman saying he doesn't see how that plan is supposed to work other than by overpaying for the assets which is clearly unacceptable. Let's see why this is so.
The problem of financial institutions such as the failed Lehman Brothers is that they have bad assets on their books in an amount which, were they to be marked down sufficiently low, would leave them bankrupt. Suppose that a balance sheet looks like this (in billion USD):
(Krugman's post Doubts about the rescue
, written before he had seen Paulson's proposal, contains a substantially similar example)
Now, suddenly, nobody wants to touch the Shitpile™ with a 10-foot pole. In this particular example, if the Shitpile™ loses 50% of its market value, the company is borderline insolvent:
The company needs to increase its equity - presumably by raising capital from unsuspecting yellow or brown people (also known as Sovereign Wealth Funds).
What Paulson proposes to do is to buy these assets, replacing them with cash
This makes the company solvent and gives it liquid assets (cash!) to face short-term liabilities, potentially solving the liquidity crunch. The problem is that if the company needs to be recapitalised, Paulson will have to pay more than the assets are worth, or else the need for new capital will not have been addressed.
Now, the Dodd plan addresses this problem by giving the Treasury equity (or debt, in the case of private companies which don't have listed shares) in the amount paid for the bad assets. Now, naively this seems even worse than the Paulson plan from the point of view of restoring solvency: if the treasury buys $50bn of Shitpile™ for $50bn, and in addition it gets $50bn of equity, the net effect is to add $50bn to the total liabilities which makes the company even more insolvent. Granted, the $50bn of shitpile have become liquid cash, but you're more bankrupt than before. The magic of the Dodd plan is that the Equity the Treasury would get is in the form of a contingent claim for 125% of the losses realised by the Treasury. This is how it works: as long as the Treasury doesn't resell the Shitpile™ it has bought, the contingent claims are off the balance sheet of the company:
Now, if and when the Treasury disposes of the $50bn of Shitpile™ it bought, two things can happen:
- the Treasury sells the Shitpile™ at a profit; then the contingent claim expires as the contingency (realised losses) didn't take place. In this case, the company's balance sheet stays as above and the Treasury has made no loss!
- the Treasury sells the Shitpile™ at a loss; then the contingent claim becomes realised as equity in the amount of 125% of the losses.
For instance, if the Shitpile™ is sold at $30bn the realised losses are $20bn and the Treasury immediately gets $25bn of equity in the company.
In that case, the shareholders get wiped out (The Dodd plan makes the Tresury equity "senior" and has non-dilution provisions) and the company is again borderline insolvent. If the losses exceed this threshold, then the company becomes actually insolvent.
Now, the treasury has a choice as to when to sell the Shitpile™. This means it can hold them until
- the price is high enough to sell at a profit (this will take a few years for the economy to get out of recession, or inflation to catch up)
- the company, now solvent, has healed its balance sheet to the point where exercising the contingent claim from selling at a loss doesn't bankrupt it - the Treasury now owns a stake in a profitable company, in an amount exceeding its losses by 25%.
These are win-win situations. You can also get to 2) by simply waiting for inflation to catch up with the 125%.
There is a catch: if the Treasury sells the Shitpile™ before these conditions hold, then the company goes bankrupt (and presumably the Treasury nationalises it). That is, the Tresury has the management of the company by the balls. For this reason, I don't expect the management of financial corporations to be keen on being "helped" this way. Because the management is protected, unless they own shares in the company they might prefer to just let it go bankrupt. Lehman's CEO didn't have a problem with that last week...
Another problem with the plan is that the contingent claim held by the Treasury doesn't make ordinary shares in the company very attractive to hold as there is substantial risk involved. So even if the solvency of the company is assured, a collapse of its share price is a real possibility, especially after the Treasury has published its holdings and the company it financial reports.
Finally, it is possible that $700bn won't be enough to capitalise the US financial sector sufficiently. And, as Jerome points out in his diary and Krugman does in The Humbling of the Fed this means you cannot fund the bailout without creating inflation.
But in March, and again this week, interest rates on T-bills fell close to zero -- liquidity trap territory. What does that do to the Fed's role?
You still see people saying, in effect, "never mind the zero interest rate, why not just print more money?" Actually, the Bank of Japan tried that, under the name "quantitative easing;" basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn't have any other advantages. As a result, monetary base and T-bills -- the two sides of the Fed's balance sheet -- become perfect substitutes. In that case, if the Fed expands its balance sheet, it's basically taking away with one hand what it's giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there's no market impact. That's why the liquidity trap makes conventional monetary policy impotent.
So, I think the Dodd plan is as close as it gets to a workable solution, but it might not be sufficient. And even if a systemic meltdown is averted, the stocks of financial corporations may still drop and the economy may remain in a recession for a while.