Editore"s Note
Tilting at Windmills

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October 14, 2008
By: Hilzoy

Bailout 2.0

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From the WSJ:

"The U.S. government is expected to take stakes in nine of the nation's top financial institutions as part of a new plan to restore confidence to the battered U.S. banking system, a far-reaching effort that puts the government's guarantee behind the basic plumbing of financial markets.

To kick off Tuesday's expected announcement, the government is set to buy preferred equity stakes in Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. -- including the soon-to-be acquired Merrill Lynch -- Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp., according to people familiar with the matter. (...)

Other elements of the plan, which will be announced Tuesday morning, include: equity investments in possibly thousands of other banks; lifting the cap on deposit insurance for certain bank accounts, such as those used by small businesses; and guaranteeing certain types of bank lending. It builds on an earlier plan to buy up rotten assets dragging down banks, which failed to calm investor fears, and follows similar moves by major European countries.

Formulated jointly by the Treasury Department, the Federal Reserve and the Federal Deposit Insurance Corp., these moves are designed to keep money flowing through the financial system, ensuring that banks continue lending to companies, consumers and each other. A freeze in these markets rippled through the economy and helped cause stocks to crater last week.

Along with the government's involvement come certain restrictions, such as caps on executive pay. For example, firms can't write new employment contracts containing golden parachutes and their ability to use certain executive salaries as a tax deduction is capped. These restrictions are relatively weak compared with what congressional Democrats had wanted when they approved this spending, a potential flash point."

Two big caveats before I go on. First, this reporting is preliminary; the report tomorrow should have more details. Second, I am not an economist, so take my opinion for what little it's worth. That said:

This sounds a lot better than the original plan to buy up troubled assets. In fact, it sounds so good to Brad DeLong that he wants to start singing hymns of praise in Latin. And that's a wonderful thing. So this post is not meant to detract from the fact that as best I can tell, this is a very, very good thing.

However, I note a couple of things that have generally been part of discussions of this kind of plan. First, there is no triage: no attempt to separate banks that are basically solvent from banks that are not. Second, there are no forced writedowns. I would have thought that either would be a very good idea, under the circumstances.

One of the things you really, really want, under the circumstances, is for everyone to know that the banks are now trustworthy: that no more big unpleasant surprises lurk in their balance sheets. One of the things that I gather you do not want is for banks to put off unpleasant revelations as long as possible. To do this, people seem to think that one should figure out which banks are insolvent, "and like Old Yeller, "gently" put them down." Then:

"Before they get new equity, banks must be forced to write down the value of their assets to nuclear-winter levels. And they must disclose, in detail, the carrying value of their assets so the market can make sure they have done this.

Why?

Because the goal of investing taxpayer equity in banks is threefold:

*Improve the banks' capital ratios, so they can start lending again

*Persuade private investors to invest in banks again

*Flush all the crap so we can start fresh...unlike Japan.

If the government does not force banks to write down their assets before injecting new equity, we won't have fixed the problem. Instead, the US taxpayer will just be the lastest sucker to fall for the banks' assertions that all the bad news is out of the way. Private investors, meanwhile, will stay on the sidelines and watch the taxpayer get sandbagged. Lastly, and most importantly (for the economy), banks won't start lending again. Why not? Because they'll want to keep all that new capital as a cushion for the next wave of writedowns.

Japanese banks played this game for a decade...and we know where it got them (NIKKEI Index is currently one-fifth of the peak value 18 years ago.) In Sweden, meanwhile, the government insisted on writedowns, and the economy recovered almost immediately."

I suspect that Paulson and others in the administration have a hard time accepting the need for this sort of policy. They are, after all, conservatives, and this is, after all, partial nationalization of banks. But if my reading is correct, hanging back is a bad idea. If you're going to do this sort of thing, you should be quick and aggressive about it. As I understand it, that's the best way both the get the economy back on its feet and to get the government out of the banking business as quickly as possible.

But for all that, the plan sounds like a big step in the right direction.

PS: Image from here.

Hilzoy 12:12 AM Permalink | Trackbacks | Comments (14)

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Comments

so what happened to the old bail out? is it replaced by a newer, better, cheaper version? Does that vindicate the critics of the old bail out who said that congress was wrong to proceed the way they did?

Posted by: Gaucho Politico on October 14, 2008 at 1:16 AM | PERMALINK

Another diff? The Eurozone ponied up 3x as much to backstop its as Paulson sought here.

Posted by: SocraticGadfly on October 14, 2008 at 1:18 AM | PERMALINK

More of my thoughts on how the strength of the eurozone is now the dog and no longer the tail.

Posted by: SocraticGadfly on October 14, 2008 at 3:16 AM | PERMALINK

Question:

What (if any) are the brokerage fees involved in purchasing these equity stakes, to whom are they to be paid, by whom, and at what ratio (or at what per share fee) in relation to the percentage of equity being transferred?

Posted by: NotMax on October 14, 2008 at 3:45 AM | PERMALINK

I'm not me, either!

In fact, it sounds so good to Brad DeLong that he wants to start singing hymns of praise in Latin. And that's a wonderful thing.

But Brad also said:

Henry Paulson is performing a dread magic: creating zombie banks in the hope that they will do his will. Voting common stock seems to me to be a better idea.
I would say this isn't quite right, except I think he means Paulson is trying to get dead banks to rise up and do his bidding by turning them into zombie banks.

The obvious preexisting condition is that the banks are all dead to start off. (It's The Adventures of Henry Paulson, necromancer at Large!)

One of the things that I gather you do not want is for banks to put off unpleasant revelations as long as possible.

Well, it depends on where you sit. If you believe (or want to believe) that the banks would be ok if everyone would just get over it and buy the crap assets, then any unpleasant revelations are just flies in the soup and should be avoided if at all possible. I think that's Paulson's stance, particularly since he wanted to buy the crap assets and hope we'd eventually make a profit.

Everyone else in the world, reading the tea leaves of the bank actions, believes that essentially ALL the banks are busted, and that we should precede accordingly. In that instance, you want to clear out the unpleasant revelations quickly so there aren't any surprises, but to do so would require taking them over.

First, there is no triage: no attempt to separate banks that are basically solvent from banks that are not. Second, there are no forced writedowns. I would have thought that either would be a very good idea, under the circumstances.

There's a lot of strange handwaving involving the idea that the market will sort things out; meantime, we're going to let it ride to save the system. I can sign on with the latter idea. With the former, I see no evidence that this is going to happen. If we were letting the market sort it out, all the banks would be dead, and we'd be cleaning up the mess, so I don't know what the free market mechanism is supposed to be here.

Which brings us back to unpleasant revelations. Recall: the Federal Reserve accountants have been on the inside of the various banks since March, when the Fed started opening the acronym windows. So the Fed KNOWS what the books look like. It's possible the banks are actually ok, but if so, the actions of both the banks and the Fed and Paulson belie this. (Really, if the banks were a-ok, Paulson could've said in July that he just wanted to take over the crappy broken derivatives, and ponied up a plan to do so. Then he would've personally lead tours of schoolchildren through the bowels of any given large bank to show the world how clean everything was, and that it was safe to drink the Koolaid. Nothin' doin'. Ergo, the bank books are more than a wee bit rodent-infested.)

So there are plenty of unpleasant relevations to be had, but Paulson is primarily concerned with saving the system as is, so he is going to do his best to pretend none of that is a problem. Events have forced his hand, so he's trying to get by with the minimum.

If we were going to do what you (and I!) want to do, then we'd just jack the banks and take them over completely and put the hurry-up order on unpleasant revelations, so we could get them out of the way. Write-downs would be part of this. Paulson doesn't want any of the that, he just wants things to go back to the way they used to be.

But for all that, the plan sounds like a big step in the right direction.

It's movement in the direction we want to go, but not much movement. Various people are still refusing to come to grips with nationalization. I suppose they'll get over it, sooner or later.

max
['Good post!']

Posted by: max on October 14, 2008 at 6:58 AM | PERMALINK

I thought it was ironic that the banner headline for the Washington Post was:
U.S. Forces Nine Major Banks To Accept Partial Nationalization
Really.

I am sure they were all aghast that they had to give something up in order to get something, that the free lunch for them wasn't there. The horror!

Posted by: Carol on October 14, 2008 at 7:04 AM | PERMALINK

Oh, and the LA Times reports that smaller banks might get pissed off because they didn't get first dibs at the goodies.
Really.

Posted by: Carol on October 14, 2008 at 7:06 AM | PERMALINK

Money, with no stock dilution. A socialist bankers' paradise.

Posted by: dr2chase on October 14, 2008 at 8:12 AM | PERMALINK

Uh, I think there IS stock dilution if stocks go UP, 'cuz of the warrants.

But regardless, I THINK I agree that this is a step in the right direction, since the problem right now is liquidity as much as it is solvency, but I definitely agree that the problem of solvency must eventually be addressed.

Now, it could be that people are hoping -- as I was hoping for most of the last year -- that the big banks (now saved from the wave and back on dry land) will continue to let air out of the bubble at a measured rate, an important part of which is writing down the worthless assets. (Have you ever smelled the air coming out of a balloon? Eeew.) If this is done correctly, and people keep their heads and the system doesn't sieze up again, then indeed "the market" can dispose of the garbage without the Federal Garbage Fairy swooping in and making it all magically go away (courtesy of the taxpayer).

OTOH, if the banks drag their feet, I can easily see whomever is given Treasury goosing them good and reminding them that it's not really dry land they're on, it's moderately thin ice, and the Feds have the only snowmobile in town. (In fact, one hopes they were given that message already -- that was a pretty powerful bunch lined up across the table from the bankers.)

So, we'll see, right? As Buffett said, we've bought time.

Posted by: bleh on October 14, 2008 at 8:54 AM | PERMALINK

"The U.S. government is expected to take stakes in nine of the nation's top financial institutions as part of a new plan to restore confidence to the battered U.S. banking system, a far-reaching effort that puts the government's guarantee behind the basic plumbing of financial markets.

So the biggest bank of them all with 10 trillion in debt is buying up 9 other banks that are hip deep in bad debts.

Hooray, we're saved?

Seeya next year for the mulligan.

Posted by: toowearyforoutrage on October 14, 2008 at 8:59 AM | PERMALINK

Take a look at the article "Conservative Analysis of Economic Crisis" at www.realwisconsinnews.com.

Pretty good stuff.

http://www.realwisconsinnews.com/index.php?option=com_content&task=view&id=191&Itemid=32

Posted by: The Beav on October 14, 2008 at 9:20 AM | PERMALINK

So the worlds fiat is worthless and we're all busted.What's the big deal?

Posted by: tom on October 14, 2008 at 9:33 AM | PERMALINK

What will it take for the U.S. to allow rich folks who are compulsive gambles to become poor homeless folks?

These folks who got multiple millions of dollars in compensation while ruining the financial institutions they helmed should be forced to flip burgers for the remainder of their days.

Posted by: bartkid on October 14, 2008 at 1:15 PM | PERMALINK

to bartkid @ 1:15 --

a-freaking-men

Posted by: Chris on October 14, 2008 at 3:30 PM | PERMALINK




 

 

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