Recapitalization?

I was all set to write another post about “The Great Bailout,” but apparently Paul Krugman has already said about half (the more important half) of what I wanted to say, so I’ll outsource, with my own comments interspersed to supply the other half. Prof. Krugman is leaning against the plan, and I’m generally in favor of it, but our primary concern is essentially the same. I yield the floor:

What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.
First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. [I'll quibble on whether it was actually a housing bubble or just a credit bubble, but it doesn't really matter.] This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

I think Prof. Krugman has missed a couple of things here. Deleveraging and undercapitalization are important, but they're not the whole story. A couple of other important problems, possibly more important, are illiquidity and uncertainty.

Many asset prices are declining, but that’s only part of the story; in many cases the asset prices simply don’t exist, because buyers and sellers cannot agree on a price. To put it in market terminology, there are very few bids, and there are few offers to sell, and there is a wide price spread between what bids and offers there are. Since nobody really knows what these assets are worth, buyers are not willing to take the risk that they may be paying too much, and sellers are not willing to take the risk that they may be asking too little. As a result, these assets are frozen on the books of banks, and the banks have difficulty raising cash when they need it.

Moreover, because nobody really knows what these assets are worth, nobody knows what the asset-holders are worth. Even if you have all the detail of a bank’s balance sheet, you still can’t tell whether the bank has enough capital or not, because you have only a wild guess as to whether the assets on the balance sheet are being fairly valued. This uncertainty makes it impossible to tell a good bank from a bad bank. Since almost any bank may turn out to be bad, banks are afraid to lend to one another.

Continuing with Prof. Krugman:

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

OK, but, if you notice, the plan, provided that it turns out to be large enough, pretty much solves the other two problems that I mentioned. (Well, in a sense it doesn't solve the uncertainty problem; it just makes it the government's problem instead of the private sector's problem. But that's OK with me, because I'm confident that the government is a good bank, given that it has the option of printing new money if it runs out.)

With the illiquid assets off the banks’ books and replaced with liquid, easily valued assets like Treasury bills, illiquidity and uncertainty are no longer a problem for the banks.

OK, now comes the main point I wanted to make, before I was scooped by the Professor:

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk. [Italics his; bold mine.]

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Hit the nail on the head: if the purpose of the plan is to recapitalize banks, then it is the wrong plan. The right plan, as we have already seen in the case of AIG, is for the Treasury (or the Fed) to take equity positions in the undercapitalized companies.

I support Secretary Paulson’s plan if the purpose is to provide liquidity, resolve uncertainty, and end the vicious circle of deleveraging. But, I repeat, if the purpose is to recapitalize the banks, then it is the wrong plan. In effect, the government would just be giving away money – a blatant example of welfare for the rich. If a company needs capital and comes to me for help (well, assuming I had about 100 times as much money as I actually do), I’m happy to consider buying into a stock offering if I think the price is fair. I’m not going to just give them money as an act of charity. And neither should the government.

Possibly, banks that need capital will be pig-headed and continue the financial meltdown by refusing to accept capital on reasonable terms. If that happens, then it may be time to consider the very drastic step of forcing them to accept capital on the government’s terms. Nationalization. Socialism. If it comes to that. That certainly would not be my preferred outcome, but at least it should be a credible threat.