The Paulson plan is not a plan. It's a plan to maybe have a plan at some unspecified point in the future. The basic idea seems to be that we give the Fed a big pot of money, which it hands over to banks in exchange for illiquid securities. Essentially, we're recapitalizing the banks with federal money.
Missing are key details like: at what price will these securities be purchased? Why $700 billion? What is the procedure for deciding how to allocate this gigantic pot of money? Does it go to the weakest banks, or the strongest? How do we avoid the massive moral hazard that no-strings-attached bailouts suggest? This is not a side issue: the Treasury's refusal to communicate is central to the proposal, which is why it explicitly denies courts or agencies any review powers.
Now, I do understand why Paulson thinks he needs broad powers and freedom from normal review constraints. The essence of this whole bailout is not to pick up the pieces, but to stop this mess from crashing the whole credit system. Hence, the Treasury wants to be able to intervene quickly. Having Congress, several regulatory agencies, and about a zillion judges sitting on your neck demanding a say is the enemy of speedy action. Nor has Congress proved exactly adept at handling the financial markets in the past. Still, for my extremely large contribution I'd like to have a little more confidence that there is some well-thought-out procedure for acquiring these securities. Arnold Kling is a must-read on this topic:
I am sure that Henry Paulson, Ben Bernanke, and Eugene Ludwig know more than I do about the current health of the banking system, the state of credit markets, and the potential risks to the economy. Note, however, that the news hour transcript also includes comments by Allan Meltzer, a historian of central banking, who argues that the financial crisis is not as bad as it is being portrayed.
But an issue about which they know less than I do is mortgage credit risk. To them, the problem of pricing mortgage assets is a detail to be worked out later, as when Ludwig sniffs that he is sure that "the plumbing can be taken care of." Well, I'm a plumber, and I don't think so. Based on my knowledge of pricing mortgage credit risk, I believe that the bailout proposal is far riskier than other alternatives.
How did we get into this mess in the first place? We got here because financial executives took on mortgage credit risk without understanding what they were doing. Some of them were new to the business, like the high-flying Wall Street firms who entered the industry during the boom. Some of them thought they were insulated from risk, because of new derivative hedging instruments. Some of the executives never belonged in the business in the first place, including Dick Syron at Freddie Mac, who in 2003 took over a firm where there was lots of knowledge of mortgage credit risk and proceeded to flout the warnings of experienced middle managers and the Chief Risk Officer about the firm's plunge into subprime lending. Congressional and Administration meddling in support of "affordable housing" played a role, and those folks are still around working on the latest legislation.
I am wearing two hats in opposition to the bailout idea. One hat is my libertarian hat, which does not like the power grab. The other hat is the applied financial economics hat, which was my career in the late 1980's and early 1990's. Speaking from the latter point of view, I have to warn that nobody involved in the bailout proposal has sufficient knowledge of mortgage credit risk. They are like Dick Syron--in over their heads without realizing it. The last thing we need in the mortgage market is another large, inexperienced player.
You can say that after the bill is enacted, the big boys will hire technical economists to deal with the plumbing. But that will be too late. Technical economists will not be able to fix a concept that has such poor risk-reward trade-offs built into it.
I would also very much like to know that the bankers do not get to waltz away from the mess they created without so much as a "You boys behave yourselves!" from Uncle Sam. I find it extraordinarily easy to sympathize with the bankers who genuinely believed that they had gotten better at pricing credit risk. I also find it extraordinarily easy to sympathize with people who dropped out of college to start a band. In neither case, however, do I wish to reward this behavior with large stacks of unearned money.
The Dodd plan has better oversight, but no better outline for how this money is to be spent, which is the core problem with the Paulson plan. This morning I listened to Pete Domenici, who is on both the budget and appropriations committees, explain to his colleagues, in tones of wonder, that Ben Bernanke had done his academic work on the Great Depression. These are the people who were in charge of approving Bernanke's appointment to the Federal Reserve chair, mind you, a task to which they seemingly gave less attention than they do to applying their television makeup.
At that, he's a massive improvement over the Democrats; as I write this I am enjoying the site of Byron Dorgan simultaneously illustrating that he knows nothing about financial history, and also lecturing us on how we should regulate the industry. At least the other things Pete Domenici said were factually accurate and logically coherent, even if that logic cohered around a not-very-well-thought-out endorsement of the Paulson plan.
This does not exactly fill me with soaring confidence in Congress's ability to allocate the money. I'd rather trust Paulson.
Half of the Republicans seem to have turned over their consciences to Hank Paulson in the name of party solidarity. Meanwhile, many Democrats seem to be more interested in discussing Wall Street bonuses and struggling homeowners than what to, y'know, do about the banking system.
I feel bad for the homeowners, and outraged that so many people got gigantic sums of money for screwing up the financial system. But that money's gone. The mortgage bankers have already mostly lost their jobs, because their market (and often their firm) collapsed. Much of the outrageous compensation was in now worthless (or nearly worthless) company stock. And even if we dun, say, the top executives at Bear, Lehman, and AIG (I'm not opposed to doing so if it's legal), we will get only a trivial fraction of the money lost in these markets. You know who made most of the money on the subprime bubble? Anyone who bought a house in the last ten years. Yes, that's right, you, with your low fixed interest rate on a reasonably sized house. You're the profiteer who laughed all the way to the bank.
Taking whatever money we can from the executives is worth doing pour encourager les autres. But the bigger concern is institutional. Any bailout plan needs to walk a very, very fine line. It must let straightened financial institutions sell the debt that is dragging down their portfolios. But it must do so in a way that does not convince future bankers that excessive risk taking can be nearly painless. That means paying just enough for the securities to keep the banks from failing, not enough to let them avoid painful losses. One way to do this is to make the deal less attractive, which the Dodd plan proposes to do by requiring equity warrants in exchange for funds.
But it also has to make buying overvalued homes unattractive. People were gambling on the housing market--nice, middle class people who would never carry a gigantic credit card balance or declare bankruptcy. In the face of the housing bubble, they took out ARMs they knew they couldn't afford to pay when the teaser reset, in the hope that rising home equity would let them refinance. (A fair number of them got away with it, too.) When pressed on this behavior, they claimed they had to because otherwise they couldn't afford a house--as if renting were a physical or moral impossibility.
Borrowers were not brought down by predatory lending. The terms that are causing trouble were clearly laid out in their loan term sheets, right on the top of their mortgage package. Borrowers were brought down by a willingness to gamble on rising home prices--exactly the same thing that knocked out Lehman Brothers. At least Lehman Brothers had the excuse that ten years of rising prices had completely screwed up their default models.
Bailing out home gamblers by freezing their mortgage rates, extending their loan terms, or otherwise forcing the banks to give them free money, will teach them the same thing we are trying hard not to teach Wall Street: if you gamble big enough, Uncle Sam will pick up your losses. Moreover, it's not exactly the cleverest idea to levy a huge regulatory taking on an industry that's already really shaky, and threatening to take the rest of us down with it in the event of a collapse.
Any bailout should not aim to help either homeowners or lenders for their own sake--we are helping them because if we don't, the rest of us will suffer more than the cost of the bailout. The health of the Fort Meyer housing market is not the proper province of the federal government, no matter how distressing the locals may find it.
So what do I think we should do? I'm not sure, exactly, except for a couple of broad principles: we should prevent banks from failing, but we should not prevent them from taking heavy losses, and managers and shareholders who require bailing out should have to pay heavily for the privilege. I find both the Paulson and the Dodd plan dissatisfyingly vague as to how we are to achieve this happy feat.
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