I Changed My Mind

By definition, the fair price of a risky asset is one that allows a high return. Therefore, if the Treasury intends to buy distressed assets at a fair price, it must intend to get a high return, which is to say, it must intend not only for the taxpayers to make a profit, but for them to make a large profit. If the Treasury doesn’t intend to pay a fair price, then it is intending to recapitalize banks by giving away money without receiving any equity participation, which is merely a program of welfare for the rich. Thus, either the Treasury intends for taxpayers to make a large profit, or it intends to engage in a program of welfare for the rich. Which is it?

I just looked at the Congressional map, and it turns out that Barney Frank is not my Congressman. He is from my state’s Congressional delegation, though, and I think he represents the district in which my vacation condo is located. Anyhow, here’s the question I would like him to ask Hank Paulson:

Do you intend for this plan to be highly profitable for taxpayers? Mind you, Mr. Secretary, I don’t mean that your intentions will necessarily be realized. I know there is a lot of risk, and even if you intend for taxpayers to make a large profit, they may end up losing nearly the whole $700 billion. But I’ll repeat my question: Do you intend for this plan to be highly profitable for taxpayers?

Unfortunately, when I do this thought experiment and consider the possible outcomes, my estimate of the expected value of the Secretary’s answer contains only about 10 basis points of “yes.” There are 90 basis points of “no,” and the remaining 99% consists of not really answering the question. Of course one can press him if he gives a weasely answer, but most successful people in the District of Columbia are very good at continuing not to really answer a question when they are pressed for an answer.

So we have to guess why he doesn’t want to answer the question. Is it because he doesn’t want to get people’s hopes up by admitting that this Plan is intended to make a large profit when he knows that outcome is subject to risk? Or is it because he intends to overpay for the distressed securities with taxpayers’ money? In my estimation, most of the weight of probability goes to latter motive.

I should also say that I’m becoming increasingly skeptical about the proposed mechanism for setting prices. In principle, if the mechanism results in the Treasury repeatedly taking losses on the securities, it should be replaced with a better one, but I worry that it will not be. The problem with a reverse auction is that bankers who have taken inadequate write-downs on their distressed assets, and who are already undercapitalized on their books, may have little incentive to make fair bids.

This is essentially the usual moral hazard problem for corporations. Bankers facing a potential endgame have no incentive to protect their creditors (or depositors, who are mostly FDIC-insured anyhow). If they run out of capital, even if they just barely run out of capital, that’s the worst case outcome. If they run out of capital and end up deeply in the red, that outcome is equivalent from the banker’s point of view.

From a creditor’s point of view (or from the FDIC’s point of view, in the case of most commercial banks), the optimal action is to take a fair price for the security even if that uses up all your capital. From the banker’s point of view, the optimal action is to gamble on the possibility that the fair value of the security will later rise to its book value or higher. That way you have at least a chance of coming out ahead. But you’re gambling with creditors’ money (or with the FDIC’s money). If the gamble doesn’t pay off, the value of the asset goes down, you end up in the red, and your creditors (or the FDIC) are stuck with the bill. Thus the banker has no incentive to bid fair value: instead she will bid book value, or possibly even more. If the bid wins, she gets a windfall. If the bid loses, she gets to gamble with creditors' money. But if she bids fair value, she is assured of losing.

Accordingly, while I stand behind the logic of my "Bailouts for Fund and Profit" post, and I continue to bristle at the suggestion that liquidity is not really an issue, I have concluded that the actual primary purpose of The Plan is recapitalization at taxpayer expense. Accordingly, until such time as my vacation condo’s Congressional representative should actually ask my question and get the “yes” answer or something roughly equivalent, I am herewith withdrawing my support for The Plan. As per my "Recapitalization" post, it is the wrong plan.