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Tilting at Windmills

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March 22, 2009
By: Hilzoy

The Geithner Plan, Part 2

In my last post I argued that the auctions Sec. Geithner is (by all accounts) about to propose as part of his plan to solve the problems with the banking industry might not work at all; that if they did work, they would do so by giving buyers an incentive to overpay, with both their dollars and ours, for troubled assets; and that the plan therefore represented an enormous gamble, with our money, on the proposition that those assets are presently undervalued.

In what follows, I want to describe a different and more troubling way in which these auctions might tempt people to overpay. This is a problem I have not seen discussed elsewhere, and I have wavered about whether or not I should write about it: it might be that the reason it hasn't been discussed elsewhere is that I just don't have any idea what I'm talking about, and this really won't be a problem. I decided to go ahead and write it up, but bear in mind: I'm a philosophy professor, not an economist. That said:

A lot of the "toxic assets" are very hard to value. They are not traded all that often, and there are not a lot of comparable sales to use as a guide. This means that the prices arrived at in an auction might serve several different functions. One function is obvious: when a buyer and seller agree on a price for some asset, that asset will change hands at that price.

In addition, though, for any asset of a kind that is (a) both rarely traded or otherwise hard to assign a price to, and (b) in some way comparable to other assets, the price that emerges from an auction might also be used as data for setting values for other, similar assets. If the auction price is low, regulators might force the owners of comparable assets to write those assets down. Thus, the owners of comparable assets would seem to have an interest in those prices being as high as possible.

If the private parties to the auction had to put up 100% of the money, then we wouldn't have to worry as much about those owners' trying to bid up the prices of the assets in order not to have to write down comparable assets: it would probably cost them too much and be too risky. But the less money they have to put on the line, the more likely it becomes that the amount they need to risk to drive prices up is less than the amount they would stand to lose if they had to write their comparable assets down.

We are about to ask private parties to put down very little money to participate in this auction. Worse, in some cases we will guarantee against losses, which would seem to remove the risk from bidding too high. This seems like an invitation to banks that are worried about the prices that might be discovered in such an auction to bid higher than they would if they had no concerns about the value of comparable assets. Possibly quite a lot higher.

The most obvious way to deal with this is to create rules about who can participate in the auctions. Clearly the original owners of the assets should not be allowed to bid on them. But it seems to me that for the reasons just outlined, no one who owns comparable assets should be allowed to bid on them either. Those people have a conflict of interest: as owners of comparable assets, they have an interest in having those assets seem to be more valuable than they actually are.

It would be fairly easy to exclude these two kinds of firms, and people employed by them, from participating in the auctions. But consider a third group: firms that do not own any such assets, but that do a lot of business with firms that do, and that stand to lose a lot if any of those other firms go under. Those firms also have an interest in overpricing those assets. They would probably be pretty hard to exclude. But if they overpay for these assets, we are all on the hook.

Moreover, excluding people from firms who own comparable assets, let alone people from firms with substantial exposure to those who do, would exclude a lot of the people who would, offhand, seem most interested in participating in such an auction, and most knowledgeable about the assets being auctioned off. I, for instance, have no conflict of the kind I've just described, but that's because I have no experience whatsoever in this kind of investment. For that reason, I'd be a terrible person for the government to invite to participate in these auctions. It's worth asking just how many unconflicted firms with the expertise to make this kind of investment and do well at it there are.

As I said at the outset: I'm sure you all normally bear in mind the possibility that I might be wrong, but I'm especially likely to be wrong about this point. I'd love to hear any views about whether, and how, I am. If I'm right, though, this is one more reason why we should expect the prices set by the auctions to be too high. And if they are too high, that means we, the taxpayers, are paying too much.

Hilzoy 2:44 PM Permalink | Trackbacks | Comments (58)

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> and I have wavered about whether or not I should
> write about it: it might be that the reason it
> hasn't been discussed elsewhere is that I just
> don't have any idea what I'm talking about, and
> this really won't be a problem. I decided to go
> ahead and write it up, but bear in mind: I'm a
> philosophy professor, not an economist. That said:

I really don't think you, or any other clear-sighted analyst of political-economic events, need to be so defensive about analyzing the Obama plan or any other. First, the self-styled "experts" have clearly been very wrong very intensely for anywhere between 1.5 and 13 years (depending on how charitable you want to be) so their "expertise" quite rightly should be called into question. No matter how much math they claim backs up their theories the proof is in the overall results for US and world citizens, and the results are not looking good for the experts.

Second, these deals from the start have been shot through with conflict of interest, self-dealing, and heaps and heaps of real in-the-flesh moral hazard on the part of the big players involved. I don't have any expectation that the Wall Street big boys will tell the truth about any of this, and I personally think Larry and Timmy are pretty badly tainted themselves.

It is no different from trying to parse out a statement by the CIA: the CIA is, um, in the business of lying professionally, so you can't trust or not trust anything they say. Same here. And more analysis from sharp taxpaying Citizens who do NOT stand to reap $1 million bonuses from the disaster can only help.

Cranky

Posted by: Cranky Observer on March 22, 2009 at 3:07 PM | PERMALINK

I am a former Wall Streeter myself (floor trader in options) and I think you've raised a very valid argument here. With the interconnectedness of nearly every financial firm in the world now, it seems unlikely that you could even find a participant disinterested enough to bid on these without significant conflicts.

As cranky says above, don't apologize for not being in the business (I'm not anymore either).

Posted by: jprichva on March 22, 2009 at 3:12 PM | PERMALINK

You're right on the money, and this is an issue that's really at the front of the problem.

What assets are we talking about? If it's actual properties and actual loans, there's a real and very tangible market, with professionals and software for evaluating this stuff. If it's a hedged bet guaranteeing a tranche of a pool of liars loans, well what interest does the government have in that, other than guaranteeing the assets of some over-leveraged financial firm?

What's to prevent the guys who caused this crap from buying these assets from creating new pools of leveraged assets to buy this?

The government needs to get down to dealing with real assets, real banks, real customers, not the zombies. The vacant house down the street in foreclosure with $750,000 in mortgages is still only worth 450 in today's market, and 375 in next year's market. And there are transaction costs to move it. Until housing prices revert to the mean where the average house is affordable to a middle income buyer, we're just reinflating the bubble.

I like the idea of putting good assets into a good bank, and letting the bankruptcy judges settle the rest.

Posted by: OC Progressive on March 22, 2009 at 3:14 PM | PERMALINK

Hilzoy, I'll second the two previous responses in their sentiments about your not being in the business. That said, I don't find any fault in your reasoning. Many years ago, before I switched careers to IT, I was an accountant. You raise some very valid points, and I agree with them. I'm not up on all the changes in the banking industry and tax law since I left the field, but any known or apparent conflict of interest would be verboten in previous times.

Posted by: Michael W on March 22, 2009 at 3:16 PM | PERMALINK

I decided to go ahead and write it up, but bear in mind: I'm a philosophy professor, not an economist.

As a philosopher professer, you are probably aware of the ouevre of one Robert Zimmerman who opined that, "You don't need a weather man to know which way the wind blows."

My English teacher taught me to avoid saying, "I think that," when writing argumentive essays. It's redundant and detracts from your authority. And in a debate, you can put your position forward; and the other is allowed to question it. I almost always read the comments here (and on Eztra Klein's blog) because there are often counter-arguments; some of them are weak, some of them are strong. When several regular commenters call Ezra Klein an ignorant asshat masquerading as a policy wonk, I know he's probably made a mistake.

I think it would be worth an entire post in itself to describe that emotional anxiety about economics that you experiences writing this post. Financial instruments have gotten so complicated and convoluted, that nobody understands them. And since nobody understands them, a group of people have been able to claim sorcerer-like knowledge.

If a financial system is going to work in a general sense, it has to be explainable to at least an average college professor. Otherwise it's going to be controlled by a cabal of unscrupulous greed heads who are beyond regulation merely because nobody understands what they are doing, not to mention that stock holders won't have any idea about the basic financial soundness of the very companies they have a stake in. How can you have a free market, much less responsible corporations, in that environment?

You shouldn't be anxious; you should be ANGRY. If someone can't coherently address your concerns about their plan AND YOU ARE PAYING FOR IT, you can tell them to stuff their plan.

Posted by: inkadu on March 22, 2009 at 3:25 PM | PERMALINK

Thanks, everyone. -- I normally try to get things right, obviously. But here, I was both aware of the fact that I was talking beyond my expertise, but also that it *did* seem right to me, and I hadn't seen this point elsewhere. So writing it up while flagging my ignorance seemed like the best way to go.

Posted by: hilzoy on March 22, 2009 at 3:28 PM | PERMALINK

I think the entire premise is wrong... liberal commentators I normally really enjoy are throwing up endless straw-men. The purpose of any plan is to clean the balance sheets and re-capitalize the banks as cheaply as possible. Nationalization isn't free... maybe it's cheaper, maybe it isn't, but until I see someone like Krugman or whomever make that case and show the analysis as to why nationalization would achieve those stated aims better... it all seems like a bunch of b.s. predicated on the fact that the plan is lacking in social justice... which is a fair, but fundamentally unrelated point.

Posted by: J.W. Hamner on March 22, 2009 at 3:40 PM | PERMALINK

let me play devil's advocate for a sec, just so everyone can tell me why this is wrong, because it seems far too easy given that no one like the Geithner plan.

assume people do overpay for the toxic assets at auction (even though, or perhaps because, they are doing so with taxpayer dollars that are free to them). doesn't that instantaneously help the books of every financial institution who took massive mark-to-market write downs? to a large degree, a lot of the "crisis" is on paper, a matter of accounting entries -- and the ripple effect those cause through credit calls, intrest rate adders, collateral requirements, etc., and a lot of that was causes as mark-to-market rules made entities carrying CBOs and CDSs look insolvent, even though in fact they were no more or less solvent than they were the day before.

a friend of mine hypothesized that if we just did away with mark-to-market, most of the banks would suddenly appear profitable, the triggers in their various counterparty contracts would go away, and confidence would return to where it was before - the "magic wand" theory of recovery. doesn't overbidding on the toxics do the same thing but without scapping mark-to-market?

fire when ready. . .

Posted by: zeitgeist on March 22, 2009 at 3:44 PM | PERMALINK

to a large degree, a lot of the "crisis" is on paper, a matter of accounting entries -- and the ripple effect those cause through credit calls, intrest rate adders, collateral requirements, etc.,

That's like saying a lot of a "heart attack" is on an EKG, a matter of peaks and dips written on a scrolling piece of a paper.

Ever since we started trading paper currency, a lot of the financial system has been "meta." There is always a risk that financial systems will become unmoored from fundamentals (aka, reality). If your entire business is moving money around, and you have no money, you have no business.

and a lot of that was causes as mark-to-market rules made entities carrying CBOs and CDSs look insolvent, even though in fact they were no more or less solvent than they were the day before.

Well, by the definition of "solvent," I think you would be wrong. I think if you mean, "viable companies," you'd be right. GE still makes stuff. Hospitals still treat patients. Universities still educate students. They have a service to offer.

But imagine if you're only business is handing money out to people. That's the financial system -- greasing the wheels with short and long term loans. If you have no money, if you are "insolvent," there isn't anything for you to do. You have no business. Your only function is loaning money, and you no longer have any. And that means the financial eco-system has just lost a necessary component... and that hurts companies that offer services.

And, yeah, I don't know much more than an average brainless layman, but whatever. We're all friends here. So far. So we can learn from each other. Or at least pretend we are.

Posted by: inkadu on March 22, 2009 at 3:57 PM | PERMALINK
My English teacher taught me to avoid saying, “I think that,” when writing argumentative essays. It’s redundant and detracts from your authority.

While your English teacher may have done you a vocational service in teaching you this, she has done the rest of us a civic disservice. We need fewer unqualified people who assume the mantle of authority in civil discourse, not greater.

It’s true that Plato slandered or misrepresented the Sophists; but his criticism of valuing rhetorical skill above truth, at least in the civil realm, was correct and always timely.

Where the context is well-understood to be persuasion for its own sake, such as in art, then privileging persuasive rhetoric over truth is acceptable (though Plato disagrees). When the context is rational civil discourse intended to discover the truth of matters and achieve justice, then truth must be privileged and cherished above all else.

It is commendable for Hilzoy to qualify her writing as she does. If you want subjective opinion built upon questionable command of facts and self-serving rationalization presented as authoritative wisdom and simple truth, then you can find it in abundance on cable news television. Among other places.

Posted by: Keith M Ellis on March 22, 2009 at 3:59 PM | PERMALINK

Just some facts here, make of them what you will.

I'm consulting to a very large, very conservative investment fund. That fund is at the moment drawing up plans to take on a huge chuck of TALF money purchase a huge chunk of securitized loans.

1) Yes, this is a GREAT deal for the fund: 9:1 leverage, 1:9 on the losses. It sucks, but get over it, because the whole point is to get this stuff away from the banks.

2) This fund isn't going to buy junk without getting the best look possible at it and performing credit evaluations. Doesn't mean they won't probably overpay a bit under the circumstances. What it *does* mean though is they're going to take the best pieces they can lay their hands on, leaving the real crap for the banks, and they're going to manage these pieces using their very significant expertise in order to try to maximize their value.

3) There's a very important provision in TALF as it's currently written (as of 3/19) that no one mentions. It's this: "Eligible collateral will not include ABS that obtain such credit ratings based on the benefit of a third-party guarantee."

Trust me, this eliminates the truly toxic stuff (the really crappy paper out there got AAA ratings only via 3rd party guarantors [Read: AIG]). The paper that was rated AAA w/o a 3rd party is MUCH better stuff. It is my belief that this paper is in fact going to ultimately turn out to be worth a lot closer to (or above) $.60 on the dollar than $.30.

Again, fwiw...

Posted by: crater on March 22, 2009 at 4:03 PM | PERMALINK

"The purpose of any plan is to clean the balance sheets and re-capitalize the banks as cheaply as possible..." without rewarding the people who created the situation and setting ourselves up for another round in 7 years as we did with the filthy LTCM bailout.

There, fixed that for you.

Cranky

Posted by: Cranky Observer on March 22, 2009 at 4:22 PM | PERMALINK

From what I have read so far on other sites, there are already many financial insiders who know how to game this bailout scheme and leave the taxpayer holding the bag. I haven't even touched on that yet because 1) it takes me time to follow these guys and 2) it's not the whole picture in my view.

We need to bite the bullet and attack the problem head on. How are we going to deal with the collapse of the shadow banking system? My answer has always been to force the zombies into bankruptcy because that is the normal process, and let that process sort it out. The answer I always here is "that will end the world" which really means "that will break our financial system". Given what our financial system has done over the last thirty years, I'm pretty sure it's already broken, and we just need to get on with changing it.

Posted by: Glen on March 22, 2009 at 4:25 PM | PERMALINK

Toxic assets are hard to value because they're so convoluted it's hard to know what will happen to them and how that will affect others.

Wouldn't it be easy to make this kind of thing illegal?

Isn't there a mathematical way of determining how much about a problem is not known?

Posted by: alan on March 22, 2009 at 4:34 PM | PERMALINK

I was under the impression that putting up taxpayer dollars to encourage private interests to overspend on these assets was considered a "feature", not a "bug," (though it's still unclear to me how that would help yours truly, Joe Taxpayer.)

My best understanding is that Sec. Geithner is using 'Wile E. Coyote economics' - it doesn't matter that we've run off a cliff, as long as we don't look down. His new plan seems to involve paying private investors to join him in looking sideways, by promising to be the one who falls in the event they are actually standing on thin air right now. Again, it is unclear how that would really help yours truly.

Posted by: biggerbox on March 22, 2009 at 4:35 PM | PERMALINK

Your observations, hilzoy, seem highly pertinent. But let me ask you this. In your heart of hearts do you really believe this mess can be fixed by fiddling around within an already manifestly defective and dysfunctional system?

You may believe so, along with numerous worthy, well-intentioned, highly educated and experienced experts - but the best I can say is : Good luck!

Posted by: Goldilocks on March 22, 2009 at 4:39 PM | PERMALINK

Isn't drawing the regulators from the body of those regulated like hiring prison guards from retired mafiosi?

Posted by: alan on March 22, 2009 at 4:39 PM | PERMALINK

While your English teacher may have done you a vocational service in teaching you this, she has done the rest of us a civic disservice. We need fewer unqualified people who assume the mantle of authority in civil discourse, not greater.

I get your point. I take out the "I think's" when I write -- when I remember -- because they are just noise. Anything other than a bare fact implicitly "I think." So on those Strunk & White grounds, I think it's a good idea. Wait, I mean it IS a good idea.

Secondly, it's OK for people to raise questions without falling all over themselves apologizing for their ignorance. I don't mind that Hilzoy put a little disclaimer, it does bother me how apologetic it was.

You say that we need less unqualified people opining on these things. But that assumes we can tell the unqualified people from the qualified people. It assumes that "qualified" people have a better grasp of the truth, a better idea of problems and solutions, and don't have a vested interest in a given outcome. It also assumes that "qualifications" won't be used as a rhetorical weapon, or that the "qualified" individuals will be making bare-bones arguments without their own use of rhetoric.

If this were science, with peer-reviewed research and experimentation, I'd agree with you 100%. Unfortunately, economics is quite a bit muddier and politics more so.

Posted by: inkadu on March 22, 2009 at 4:51 PM | PERMALINK

Which are just some of the many reasons why this is a bad idea. Throwing money around in the dark will only aid those wearing night vision goggles. Nearly everyone involved are the same ones who caused this disaster. Makes one wonder...is there anybody running anything here or all they all just running around in it.

We could start our own banks with the amount of money we're throwing at these failed institutions. It ceased being a private enterprise once the entire nation's economy began collapsing. Now the only institution large enough to cope with it is our collective government so hopefully Obama and his Treasury sec will take charge of these institutions and stop allowing them to make the decisions. AIG and the rest of them are now under federal control with all assets (including the holdings of its employees) are now frozen. No money changes hands without government approval until the situation is straightened out. Now let's begin.

Posted by: bjobotts on March 22, 2009 at 4:52 PM | PERMALINK

On the note of pertinence:

The fifth of the Twelve Labours set to Heracles/Hercules was to clean the Augean stables, which housed the single greatest number of cattle in the country and had never been cleaned, in a single day. The reasoning behind this being set as a labour was twofold: firstly, all the previous labours exalted Heracles in the eyes of the people and this one would surely degrade him; secondly, as the livestock were a divine gift to Augeas they were immune from disease and thus the amount of dirt and filth amassed in the uncleaned stables made the task surely impossible. However, Heracles succeeded by rerouting the rivers Alpheus and Peneus to wash out the filth.

Augeas was irate because he had promised Heracles one-tenth of his cattle if the job was finished in one day. He refused to honour the agreement, and Heracles killed him after completing the tasks and gave his kingdom to Augeas' son, Phyleus, who had been exiled for supporting Heracles against his father.
Posted by: Goldilocks on March 22, 2009 at 4:52 PM | PERMALINK

Yes absolutely.

Now my impression (based no not having read the articles on leaks about the proposal) is that the invited private partners do not include banks which have (well until recently had) to mark to market and have a lot of toxic sludge on their books. I thought the private partners of the Treasury and the FDIC are to be hedge funds.

However, they are definitely firms which do a lot of business with the banks and a mutually beneficial arrangement can definitely be worked out. Hedge fund A overpays for toxic sludge owned by Bank B as part of the Geithner plan and, in exchange, Bank B overpays for some asset on Hedge fund A's books (separate from A's joint venture with the Treasury) or undercharges for some asset it sells to fund A (and not to the Treasury at all).

This is very clearly explained here
http://angrybear.blogspot.com/2009/03/brad-delong-desperately-tries-to.html

Geithner knows all about possible conflicts of interest and normal Treasury rules. Like all TReasury employees, he is not allowed to do business with banks, manage his investments or, well, do anything that would enable banks to quietly give him money. He can participate in a really blind trust where someone else who works for the Treasury but who he can't fire and who doesn't report to him (except to tell him how much money he has) handles his money. He is proposing private partners of the Treasury who can separately do business with banks.

I think it is clear that the purpose of the plan is to make banks' balance sheets look better by any means necessary (except nationalizing them). The conflict of interests which you describe, between not losing the Treasury and FDIC money on the one hand and making the market to which one marks better for balance sheets is not a bug, it is the whole point of the plan.

p.s. I have a PhD in economics. My PhD supervisor was this guy named Larry Summers.

Posted by: Robert Waldmann on March 22, 2009 at 5:03 PM | PERMALINK

Otherwise it's going to be controlled by a cabal of unscrupulous greed heads who are beyond regulation merely because nobody understands what they are doing" - inkadu.

Everybody totally understands what they are doing. They are graciously plunging the financial system into chaos, driving the economy into the ground and probably instigating a second Depression. We don't need to be sorcerers to know that. We experience it, right down to our toes.

Posted by: Goldilocks on March 22, 2009 at 5:07 PM | PERMALINK

The key phrase being: "This is a problem I have not seen discussed elsewhere, and I have wavered about whether or not I should write about it: it might be that the reason it hasn't been discussed elsewhere is that I just don't have any idea what I'm talking about, and this really won't be a problem. I'm a philosophy professor, not an economist."

Geee, maybe we could get a carpenter or a bartender or a dancer to weigh in on this.

Posted by: Dalton on March 22, 2009 at 5:18 PM | PERMALINK

Wouldn't it be a tad more prudent to allow the plans to take effect BEFORE lambasting them as being "possibly" wrong?

What exactly do the "experts" here and elsewhere propose as an alternative...and please...be VERY SPECIFIC...with plenty of absolute projections.

Posted by: Dalton on March 22, 2009 at 5:22 PM | PERMALINK

I don't want it to appear from my posts that I am some nutjob advocating some entirely different social and financial system. I am an ardent proponent of capitalism and free enterprise, although it's mighty obvious that regulation is required.

What disturbs me about the bailout schemes is these are NOT normal capitalism, these are NOT the normal way of dealing with these problems, and there is little prior history available as to how this will work out.

The best example that we have for a systemic bank failure is directly from the Great Depression and perhaps from the collapse of the Russian stock market in 1998. A careful examination of both can be very illuminating especially since so many of the people running the current bailout schemes were involved in Russia. (To cut to the chase here - FDR did OK, and Ruben/Summers didn't.)*

I see few people in positions of power currently advocating using what we learned from FDR to fix what we're going through now. This leads to inevitable conclusion that these schemes merely buy us time, and do so at great cost to our government and the taxpayers. We don't have all the money in the world to solve these problems, and we are seriously curtailing our options by pushing out the day or reckoning.

*
http://www.fas.org/news/russia/2000/russia/part08.htm

Posted by: Glen on March 22, 2009 at 5:24 PM | PERMALINK

Well, one other example is the Japanese banking problems of the nineties. Of course, my argument would be that at best, they have just delayed the day of reckoning too (which has been what we have done so far), and now, with a world wide collapse events may be moving past their ability to control them. (i.e. I don't know how well it worked because it ain't over yet.)

My point is, is that you cannot use the same models, techniques, and technology (obviously the quant's risk assessment models were WRONG, WRONG, WRONG!) that got us into this mess, to get us out. We need to reach back into our toolbox, pull out some tried but true tools and get to work. Bankruptcy is that tool.

I'm not saying this wont hurt, it will hurt like hell, but delaying it will hurt worse. Far worse.

Posted by: Glen on March 22, 2009 at 6:02 PM | PERMALINK

Where am I wrong here? The hedge funds have to come up with $30B to take full advantage of this program. They also get $170B in loans. Since the stated purpose is to hold these assets long term, and since Treasury oversees the management of them, the hedge fund investment goes from 30 billion to 200 billion plus a small amount of interest. So how is it profitable to overbid?

Posted by: Danp on March 22, 2009 at 6:09 PM | PERMALINK

Thanks, Hilzoy, for this post. It provided a different perspective than those I've been reading elsewhere, and there were a lot of good, well-informed comments. I appreciate having a site like this to turn to.

Posted by: DevilDog on March 22, 2009 at 6:17 PM | PERMALINK

Yves Smith at Naked Capitalism made this argument from the beginning. Auctioning these off is a bug, not a feature.

Posted by: Walker on March 22, 2009 at 6:20 PM | PERMALINK

Here is an expert who is not trying to blow smoke:

http://www.talkingpointsmemo.com/archives/2009/02/tpmtv_stiglitz_on_the_bailout.php

Posted by: Glen on March 22, 2009 at 6:29 PM | PERMALINK

And more on point:

http://www.talkingpointsmemo.com/archives/2009/03/why_are_we_still_at_this.php

Posted by: Glen on March 22, 2009 at 6:52 PM | PERMALINK

I've read E.R. Beardsley's link to Herman Daly's article at adbusters and DevilDosg's link to Matt Taibbi at Rolling Stone (posted at The Geithner Plan: Take 1). Thanks to both of you for giving us the links.

I feel substantially more edified, and to some extent vindicated in the angle I've adopted in my comments on this topic. Daly bases his analysis on Frederick Soddy's 1926 book Wealth, Virtual Wealth and Debt: The Solution of the Economic Paradox; while Matt does an exemplary eight page rundown, in his unmincing inimical style, of the history, responses to and consequences of the meltdown.

I still hold to the view that the whole system is broke, kaput, and so chronically diseased and disabled that the prognosis is hopeless. Last rites, a quiet funeral (no flowers please), a final obituary and goodbye is the appropriate procedure. It is sick and rotten to the core, riddled with fraud, deceit, stupidity, greed, recklessness, and, worst of all, intransigent secrecy. Just let it sink. Switch off the life support. Re-connect with real wealth and start again, this time with our our heads screwed on, eyes open and feed on the ground. After a few years of mourning, we'll be glad of it.

Granted, this is not an economic plan as such, and, of course, it is decidedly radical, but from what I can see I can muster no other optimism.

Posted by: Goldilocks on March 22, 2009 at 7:50 PM | PERMALINK

Goldilocks --

I was thinking more hydra than Agean stables...
remember when we were only going to bail out one company? Everytime we do something, we just extend the time line. Part of me thinks we should take a hard hit and try to recover as best we can... at least if all the plans seem to do is prop up a business model without legs.

But I think you said that too.

Remember that inn keeper? The one who would stretch you if you were too short for the bed, and cut off your legs if you were too tall? The one that Hercules threw off a cliff and into the ocean, but the ocean would not except him, and the land, having gotten rid of him, refused to take him back, and as a result that inkeeper was suspended there? I like that story best... but I can't think of any way to connect it to the economic crisis.

Sorrow.


Posted by: inkadu on March 22, 2009 at 8:03 PM | PERMALINK

As Robert Reich stated today, let them file for chapter 11, go into receivorship.

They are insurance contracts against prospective losses on bad debts within bundled mortgage bonds.

Let them go under.

Start new banks if the existing ones are insufficiently capitalized. Otherwise, taxpayers money is just going down a drain.

We shouldn't be attempting to prop up bubbles. We should let them reach clarity and a bottom so that there is a market, even if at a loss.

Posted by: Richard Witty on March 22, 2009 at 8:08 PM | PERMALINK

I still hold to the view that the whole system is broke, kaput, and so chronically diseased and disabled that the prognosis is hopeless.

And propping it up is immoral. It's not "change we can believe in." It's more of the fucking same.

If BHO sticks with Geithner and this reprehensible plan, he will piss away his presidency.

Posted by: Econobuzz on March 22, 2009 at 8:38 PM | PERMALINK

... a friend of mine hypothesized that if we just did away with mark-to-market, most of the banks would suddenly appear profitable

And if shit were ice cream, you'd be rich.

Posted by: Econobuzz on March 22, 2009 at 8:44 PM | PERMALINK

Financial problems are easy to fix; economic problems are really, really hard to fix. Obama is right to fix the financial problem so it doesn't become an economic one.

Posted by: Bob M on March 22, 2009 at 8:45 PM | PERMALINK

inkadu -

OK, you've sent me back to Wikipedia.

Here's the thing about Hydra: Her weakness was that only one of its heads was immortal. Could we read that as real wealth rather than proliferating virtual wealth? Matt Taibbi is scathing in his criticism of supporting a business model without legs by gorging the moribund giants with bailouts at the expense of the small, regional bread-and-butter banks that are far less guilty of the kinds of predatory lending that sank the economy. His article is roller-coaster good, and quite funny in parts.

The innkeeper allusion eludes me, though I remember the bit about the bed. Good stuff, since any morally scary story connects with this crisis.

Sorrow indeed, tinged with hints of reckless euphoria.

Posted by: Goldilocks on March 22, 2009 at 8:53 PM | PERMALINK

I thought the problem with the hydra was that if you cut off one head, two more would grow in it's place; none of the heads, as far as i know, were immortal. Hercules' solution was to burn the necks after he cut the heads off. Rather practical, that Hercules. He's really just a greek version of Conan.

And maybe the big financial firms are really more like Norse giants. Greedy, stupid, powerful, unproductive, with a penchant for eating people...

Then there is this real gem of an arabian knights story:

She went up to the pan, to the great astonishment of the cook, who stood motionless at the sight of her. She struck one of the fish with her rod, "Fish, fish," said she, "are you doing your duty?" The fish answered nothing, and then she repeated her question, whereupon they all raised their heads together and answered very distinctly, "Yes, yes. If you reckon, we reckon. If you pay your debts, we pay ours. If you fly, we conquer, and we are content."

When they had spoken the girl upset the pan, and entered the opening in the wall, which at once closed, and appeared the same as before.

When the cook had recovered from her fright she lifted up the fish which had fallen into the ashes, but she found them as black as cinders, and not fit to serve up to the Sultan.

It is a beautiful thing. (http://www.ibiblio.org/ais/sll1001g.htm)

Off to review Andersen's "The Snow Queen."

Posted by: inkadu on March 22, 2009 at 9:23 PM | PERMALINK

Hilzoy, your two posts today are very good.

Posted by: MatthewRMarler on March 22, 2009 at 9:55 PM | PERMALINK
My best understanding is that Sec. Geithner is using 'Wile E. Coyote economics' - it doesn't matter that we've run off a cliff, as long as we don't look down. His new plan seems to involve paying private investors to join him in looking sideways, by promising to be the one who falls in the event they are actually standing on thin air right now. Again, it is unclear how that would really help yours truly. Posted by: biggerbox on March 22, 2009

Don't YOU wish you could walk on air?

Yes, the government is letting and helping banks to ignore looking down for a while. It's a good thing too. Their help lets banks continue existing and loaning money to the economy. You remember the economy, right? That's what reflects business activity which includes employment and selling you food for your table.

But, beyond that they're trying to fix the problem banks have with these 'assets' which don't have current market values. And, if they succeed, that will be a very good thing.

The only question is how to do it so the pain is spread (or placed on the guilty) and done quickly.

Posted by: MarkH on March 22, 2009 at 10:16 PM | PERMALINK

Supposedly the problem with the toxic assets is that they are currently "undevalued" by the market because (A) there are few parties interested and capable of buying them and (B) no one trusts the models used to value in the income streams.

There is a fairly simple solution that would not risk billions of taxpayer dollars:

(1) the government sets up a new publicly traded corporation ("Newco")

(2) financial institions holding toxic assets can contribute them to the Newco and get shares of Newco in return (how many shares determined by some government policy TBD)

(3) Newco publicly discloses all of the assets held and models used to value them.

(4) Voila! Market problem solved. Instead of a few illiquid, untrustworthy assets, we have millions of shares of Newco being traded publicly and investors can better evaluate the performance of the aggregate pool of assets.

Best part: if this plan is a total failure, we have not burned billions of taxpayers dollars (although the government could easily step in with a rescue package by simply buying up shares of Newco.)

Posted by: Oberon on March 22, 2009 at 10:28 PM | PERMALINK

(2) financial institutions holding toxic assets can contribute them to the Newco and get shares of Newco in return (how many shares determined by some government policy TBD)

suppose the number is based on banks statement of what assets are worth; with a provision that the assets will be tracked (there are computers after all) to determine their value when Newco subsequently sells them or holds them to maturity/net proceeds of realization upon foreclosure. Determine present value, if realized at profit, bank shares in gain; if realized at a loss bank shares in loss.

Posted by: Johnny Canuck on March 22, 2009 at 11:28 PM | PERMALINK
The only question is how to do it so the pain is spread (or placed on the guilty) and done quickly.
Exactly.

This is what the proposed plan fails to do. This plan just postpones the pain at great public expense, by pretending there is something other than thin air beneath the banks at risk.

Posted by: biggerbox on March 23, 2009 at 12:06 AM | PERMALINK

Johnny Canuck: (2) financial institutions holding toxic assets can contribute them to the Newco and get shares of Newco in return (how many shares determined by some government policy TBD)


"How many shares ... ." Is equivalent to "how much are the toxic assets worth" (the first is a proposed answer to the second.) In other words, your solution assumes that the solution to the main problem is known. If the TBD government policy overvalues the assets (gives the banks too many shares of Newco), then the taxpayers lose a lot of money.

According to Hilzoy I today, banks want 60% of par for the toxic assets, but the market only offers 30% (I am sure that the numbers are illustrative, not "typical".) A simple solution is for the government to buy the assets at 60% of par and then slowly sell them in the market at auction. The advantage is that all uncertainty is resolved, the maximum likely loss is known, and the weak banks get recapitalized. The disadvantage is that the taxpayers are absorbing a huge loss, unless the assets eventually sell for more than 60% of par -- which nobody believes will happen. Banks do not get off Scot-free because they absorb 40% losses on the toxic assets that they have bought. Other buyers still have some risk, because the assets might eventually be worth less than what they bring to the government at auction. Another problem is that, during the transition while the government holds the properties, pressure will be brought to bear on the government to treat those properties nicely -- giving up mortgage income, not evicting tenants who are damaging the properties, etc., etc. It's a problem shared by any plan in which the government has a period of ownership of the assets.

The people with the most information are the people who now hold the toxic assets. This is a classic case of "asymmetric information". I see no way for the government to intervene that can save the banks without losing enormous amounts of taxpayer money almost for sure. Hilzoy's two posts highlight a liability of the Geithner plan -- collusion by bidders at auction is not rare, is hard to prove, and requires very little communication among them.

Posted by: MatthewRMarler on March 23, 2009 at 12:48 AM | PERMALINK

bjobotts says:

Which are just some of the many reasons why this is a bad idea.

Agreed - it seems like the best course of action is nationalization, where we can force open the banks' books. Since we're on the hook for the losses anyway, let's see everything.

Posted by: Andy on March 23, 2009 at 2:48 AM | PERMALINK

It appears to be open season on Geithner. Everyone is pointing out holes in his plan, but alternatives will have just as many holes. There is no clean way out of a shithole and everyone should just pipe down and accept that there's going to be a lot of pain.

My semi-professional opinion on Geithner's plan is that it is a calculated gamble. The toxic assets that need to be sold is underpriced partially due to fear and partially due to fundamentals. The weakness of capitalism... or perhaps the human condition is that fear becomes fundamentals and visa-versa. Geithner is trying to have the government shoulder the fear discount so that assets will be priced based on fundamentals. That way, the private sector will foot much of the bill. Otherwise, it's nationalization and the you and I foot all of the bill.

Posted by: Joe Bu on March 23, 2009 at 3:34 AM | PERMALINK

I don't much about the economy, but I'm investing in torches and pitchforks

Posted by: inkadu on March 23, 2009 at 4:15 AM | PERMALINK

What is getting lost in the details is that the most important part of the cleanup is the punishment of the guilty. If we had hung the bastards in 92/93/94, we wouldn't be talking about this in 09.

Go to bankrupcy, have the electorate take their lumps, use to the bailout money for regular people, but have the money class take bigger lumps. Pain has to be felt at the top as well as the bottom. No more of the top feeding off of the bottom; let them earn their keep.

Posted by: says you on March 23, 2009 at 4:38 AM | PERMALINK

I agree, this is all so complicated and who the heck understands derivatives, and overall, this sounds like a bad idea but I know probably LESS than what you do about economics.

But what Roubini and Krugman says makes sense. I don't udnerstand why we don't nationalize the banks temporarily, fire the CEO's, put in new folks, break them down to small size, then the govt. gets out of the bank biz again.

And yeah, folks SHOULD wind up in jail. Maybe some of the fired CEO's. We'd all appreciate that!

Posted by: clem on March 23, 2009 at 6:31 AM | PERMALINK

I'm an academic economist, and what you've written makes my head spin.

Which isn't to say that it's wrong, at all. All the effects you describe are real, at least potentially, to a greater or lesser degree. And they interact with each other, in myriad nonlinear ways.

It's just that your post is infused with the expectation that REAL economists (unlike rubes in the philosophy department) can rationally analyze all of this at once. They can't, for pretty much the same reason that monism is (I am exceeding my expertise here, no doubt) indisputably true and at the same time utterly fruitless: everything is indeed related to everything else, but humans can only realistically aspire to insights that are attained by strategic simplification, which means ignoring all but a very small number of causal pathways.

Posted by: Andy Mc Lennan on March 23, 2009 at 7:27 AM | PERMALINK

Another corollary to your question is, despite the shorthand that we all have adopted, these "toxic assests," AFAIK, are oftentimes bespoke contracts not entirely relatable to others of the kind (to the degree that they are a kind at all). Not only this, but even if the MBS, CDOs, et cetera, are comparable in form, they by definition are comprised of different loans, which almost definitely vary widely in value (see JKG). My question is, are potential bidders going to get a good look at these securities? if so, wouldn't they do so just to see how bad off the owners of them actually are? If they know how much the baks mark them as, then they get to see what they actually are, they are much better poised to see just how desperate the banks will be. I think a potential 10% return on no risk is still less attractive than 30+% return on a little more risk.

Posted by: jhm on March 23, 2009 at 7:56 AM | PERMALINK

jhm - why do you call these "no risk"? The investors stand to lose the money they invest - not only the 30 billion but the money they borrow from FDIC and Treasury.

Posted by: Danp on March 23, 2009 at 8:08 AM | PERMALINK

All, very informative insight and analysis.

Something else to consider -- there are at least three ways to place value on the underlying assets:

1. Market Value (traditional) of the property. The problem with using market value is the oversupply of housing units for sale in the short-run (less than 1 year) and the long-run reduction in demand (resetting the FICO/Income/Down Payment qualifications for obtaining a mortgage). Even with improved economic and employment outlooks the days of "easy" money for home ownership are likely over;

2. Replacement Cost of the property. Irrelevant due to the supply and demand issues described above;

3. Income Value (present value of future rents). To avoid moral hazard mortgage servicers would need to aggressively pursue foreclosure and convert the surplus housing stock to rentals. Values would stabilize as the economy recovers and employment begins to turn around.

Posted by: g on March 23, 2009 at 10:41 AM | PERMALINK

Having formerly made a living in the financial markets and currently doing the same in the real estate markets (barely), I've always pondered why real estate is less of an actual market than the equity market. I think Hilzoy has hit the nail on the head regarding the owners of comparable assets. I think that's why the bubble went as big as it did in the first place. Nearly everyone was an owner of comparable assets.

My thought on the new "legacy" bailout fund is this: If the President changed the way political elections are run through small donations and participation, why does the government now have to run to hedge funds and the like to get "private investment" money?. Why can't it be open to public investment? Like the campaign, but on a much larger scale.

As I see it, many people who formerly rented had a piece of the American dream for a short time before they lost it through foreclosure. The wealth is now being transferred back to the top few percent at 30 cents on the dollar. (It's already happening all over the country, just not on the grand scale of this new proposal) Why not allow the people who don't have extra money to go out and buy up the foreclosed real estate at Mr. Potter prices and stimulate a new type of "savings bond" type of investment in a reverse micro-loan scenario? My bet is the money pool would be a great deal bigger than you think. The President has proven himself as a hell of a salesman.

Posted by: dannyshenanigan on March 23, 2009 at 11:29 AM | PERMALINK

The wealth is now being transferred back to the top few percent at 30 cents on the dollar. - dannyshenanigan

I concur with your analysis. However, who would you have manage the investment pool and who would service the mortgages?

Posted by: g on March 23, 2009 at 11:41 AM | PERMALINK

Excellent points, Hilzoy. The government has a very difficult time making a fair auction that lacks perverse incentives and methods of gaming it.

I am reminded of a spectrum auction a few years back which raised a fraction of what the government hoped. Embedded in the bids, in the low single dollar and cents digits, were codes that bidding companies used to indicate to each other which part of the spectrum they really wanted. Once signaled, the spectrum was carved up before the auction ran its course, and the prices paid were absurdly low.

I agree with the prior posters that what we are witnessing over these years is a massive transfer of wealth in the form of property titles from individuals to corporate banking entities.

Posted by: Quatrain Gleam on March 23, 2009 at 12:35 PM | PERMALINK

Thanks G-There's a large number of unemployed bankers / mortgage brokers / random individuals out there. We're looking to reduce unemployment as well as restart the credit markets. If the ' 08 campaign could produce a team to manage the donations for the election, an administration headed by the same people could use the powers vested in them to do the same on a larger scale. -That's oversimplified and doesn't address the overall management of the assets. Toxic or Legacy, whatever they are called, but I'd pick someone from a small bank that's risen up away from the Citi, BofA, etc. crowd. I haven't yet seen exactly what the President sees in Geithner that inspires confidence, but I still believe he is the most capable man alive to make such a pick. Warren Buffet could be on the board of directors. Maybe Krugman too, but I'd prefer Stephen Levitt.

Posted by: dannyshenanigan on March 23, 2009 at 5:08 PM | PERMALINK




 

 

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