Monday, September 29, 2008

Not Time to Affix Blame

So let me get this straight. The reason the stock market crashed today is that the Republicans in the House were so immature that a little grudge about something mean that Nancy Pelosi said was more important to them than saving our financial system. Shame on you, Speaker Pelosi!

The US Treasury Needs a Better Marketing Department

Whether or not Secretary Paulson intended it, the phrase “troubled asset relief program” (TARP), from his original speech describing the program as he envisioned it, lent the standard acronym to his plan to provide liquidity to the financial system by buying illiquid distressed assets. Not a good name for the program, if you want to sell it to the American people. Relief? The banks will be on relief? After getting us into this mess? (The banks are hardly the only culprit, but in the public mind they seem to be the main one.) No way.

If it’s handled well, the program ought to make a profit. And in its current form, even if it doesn’t make a profit, the banking industry is supposed to pay for it after the fact. But even in its original form as proposed by Secretary Paulson, it should (again, if handled well) have produced a profit (although there was, of course, considerable risk of loss). Sell it as a plan to provide “relief” to banks? Why? Granted, that is its primary purpose, but it sure doesn’t sound good if you say it like that.

How about one of these alternative names?
  • Distressed Assets Marketability Effort
  • Public High-yield Asset Trust
  • Taxpayer Opportunity Program
  • Hidden Asset Value Effort
  • Committee for Liquefaction and Appreciation of Illiquid Mortgage Securities
  • Fund for Asset Value Extraction
  • Fund for the Realization of Undervalued General Assets through Leverage
  • Government Asset Trading Effort
  • Fund for the Utilization and Trading of Undervalued Real Estate Securities
  • Hope to Earn the Liquidity Premium on Undervalued Securities
  • Organization for the Revaluation by the Government of Assets such as Securities and Mortgages.
OK, maybe not that last one. Probably wouldn’t go over very well with the “family values” crowd. depends on what you mean by “family values.” In order to have a family you need to....hmm....

Anyhow, those were my ideas for the original proposal. But in its current form, it’s a particularly sweet deal for the taxpayers: zero risk, and the potential for substantial profits. It’s as if an insurance company were make its policyholders pay back any losses that the company took on their claims. I must say: that feature rather soothes my concern that the program would overpay for the assets it purchases (although, of course, the good banks are potentially being asked to subsidize the bad ones, but I don’t really have a problem with that). Under the circumstances, I have a better name for the program:
  • Program to Cheat Banks Out Of Money


From an email I sent, dated 9/12/2008
I just can’t see the Fed and the Treasury sitting idly by while Lehman starts to go into default. The argument for inaction would be that they don’t want to create incentives for risky behavior in the future, and certainly (if it comes to a bailout) they will try to hit the equity as hard as they can. But letting Lehman fail would create even worse incentives, in that people will be afraid to do business with major investment banks. There is some point at which the issue becomes not “Do you trust Institution X” but “Do you trust the system.” (I’m recalling the old anti-freeze slogan, “If you can’t trust Prestone, who can you trust?”) I think Lehman is big enough to be over that line. Most of the casualties of a Lehman failure would be “innocent bystanders” rather than entities that could reasonably have been expected to realize they were taking excessive risks. And at this particular time, with the Fed running out of monetary policy ammunition and commodity prices falling, I think they would be foolish (and they know it) to risk the kind of economic effects that might follow a further loss of confidence in the financial system.

From another email I sent, dated 9/15/2008
Guess I was wrong about that.

I still don't think I was wrong about the "they would be foolish" part, but clearly I was wrong about the "they know it" part.

From the Wall Street Journal, front page, column 1, dated 9/29/2008
The consequences of the government's decision two weeks ago not to step in to prop up Lehman Brothers Holdings but instead let it collapse look more dire than almost anyone imagined.

I guess the bailout bill, as it turned out, was not nearly as bad as I imagined it might be. But I kind of wish somebody other than Henry Paulson were managing the fund.

Wednesday, September 24, 2008

Incentives for the Dictator

If Congress insists on passing something like the Paulson plan, it should have the following feature: The Secretary of the Treasury will no longer get a salary. Instead, he will be paid entirely in the form of a performance bonus. If the TARP makes a loss, he gets nothing. If it makes a profit, he gets a percentage of the profit.

Latest Idea to Fix the Banking System

Offer to buy $700 billion in preferred stock in a single auction (where banks quote dividend yields to bid on funds, and the bids are accepted starting with the highest until all the funds are used up); put a tax (temporary in principle but with no specific time limit) on bank profits; and regulate banks aggressively to make sure they don't make excessively risky loans.

The tax serves a triple function: first, since banks have an incentive (due to the moral hazard of stockholders with limited liability) to bid too low, the tax recoups the additional risk premium that taxpayers ought to receive (essentially an after-the-fact insurance premium); second, the tax encourages banks to participate in the auction and to bid higher, since they are going to be paying part of the price for the funds whether they get any or not; third, by effectively taking part of the payment as equity, it reduces the incentive for banks to take excessive risks.

The preferred stock will tend to give banks an incentive to take risks, since they need to make a high return on their assets before they get to keep any of the return. It's not clear whether encouraging banks to take risks is a good thing or a bad thing. On the one hand, we want to protect the banks' creditors (mostly the FDIC in the case of commercial banks). On the other hand, we want banks to lend, so as to keep the economy going and enable maximum private investment. To the extent that the FDIC -- effectively the taxpayer -- is the primary creditor, this is essentially a type of fiscal stimulus, although you only have to pay for the stimulus if the banks fail. Considering the likely weakness in the economy over the next few months, it is arguably a good idea to encourage banks to take risks.

UPDATE: More details. Banks should be allowed to make multiple bids, so a bank, for example, might be willing to sell $1 million worth of preferred stock with an 8% dividend and then another $1 million worth at a 7% dividend. Then for any bank that has more than one winning bid, the dividend yield would be the average of the bids, weighted by the size of the bids. The minimum bid would be the 30-year Treasury yield. Every bank should be willing to make some bid, since the minimum bid would be a very good deal for any bank. (Imagine selling a CD that yields the 30-year Treasury rate; you don't ever have to pay back the principal; and if you're a year or two late with the interest payments, it's just fine as long as you've got a good reason. If I were a bank, I sure would be interested in selling that CD.)

Another issue. One (perhaps inevitable) flaw in this plan is that it requires good banks (those which don't need additional capital or liquidity and therefore won't submit winning bids) to pay in part (via the tax) for the sins of their prodigal brethren. Of course, just about any kind of bailout is going to reward the bad banks relative to the good ones, unless (as in my earlier plan) the Treasury can force terms on the banks. To the extent that the good banks are "good" because of good lending and investment practices over the past 5 years, it's unfortunate that they get penalized. On the other hand, to the extent that good banks are "good" because they have been hoarding cash during a crisis (and therefore don't need additional cash), we actually should be penalizing the good banks. During good times, we hope that nobody expects to be bailed out, so they won't take risky actions. During a crisis, we hope that everybody expects to be bailed out, so they will be willing to lend. Given that we are more than a year into the crisis, it's arguable that, overall, penalizing the good banks is not such a bad thing.

Avantages of this plan over those being considered in Congress:

  • It's simple -- much simpler than any of the plans currently being considered.

  • It's quick. Since the initial disbursement requires only one simple auction of a well-defined instrument, it will get the cash to the banks much more quickly than a plan that would require auctions on many difficult-to-define asset classes.

  • It's cheap. Taxpayers are likely to make more profit with less risk. Perhaps more important than the interest of the taxpayers is the reputation of the US Treasury and everyone else who borrows in dollars. With so much government borrowing already, every dollar that the Treasury can save is a larger cushion against the point where its (and the dollar's) reputation is in peril and it (along with all other dollar borrowers) has to pay uncomfortably high interest rates.

  • It's effective. It's more effective than plans currently being considered, because it solves both the liquidity problem and the capital problem (and does so without deliberately overpaying for assets).

  • It's Constitutional. It does not give dictatorial powers to a single cabinet officer.

  • It requires less bureaucracy.

  • There is less potential for favoritism. There won't be billions of dollars worth of business that Secretary Paulson can give to his former employer. (There may be hundreds of millions, though. This would be the biggest business deal in history by an order of magnitude -- and by several orders of magnitude if you exclude the AIG deal. It's not something that the Treasury department has the resources to do on its own.)

UPDATE2: To mitigate the problem with the tax, there should be a time delay before the tax becomes effective. That way, hopefully, you wait until the bad banks become profitable again, so a greater share of the tax is paid by those who are taking advantage of the benefits.

UPDATE3: The preferred stock should be callable, to facilitate the unwinding of the whole mess once banks become profitable again. Note that banks which have reserved conservatively (as GAAP requires) are more likely than not to make substantial profits as some of their assets turn out to be worth more than book value, and as those assets mature they will be taking in substantial amounts of cash with which to retire the preferred stock.

Tuesday, September 23, 2008

A Simpler Solution

I just got an email that proposes a simpler solution to the financial crisis. Just use the $700 billion (or more) to buy preferred stock in shaky financial institutions. That solves both the capital problem and the liquidity problem (the latter by deferring indefinitely the need to sell the illiquid assets) and does so in a way that doesn’t obviously cheat taxpayers. And it avoids all the problems associated with having the Treasury buy and own complex illiquid assets. (And of course the Treasury could sell off some preferred stock in one institution and use the proceeds to buy stock in another institution, so just like under the current plan, money can be reused.)

There is still, though, the moral hazard problem for stockholders with limited liability, so banks have an incentive to overcharge for the preferred stock (i.e. the dividend rate will be too low). So actually taxpayers do get cheated a little bit. There should be some provision for declaring a financial institution shaky and then forcing it to issue preferred stock on terms that are not its own choice. I guess there’s still a place for my idea of making aggressive write-downs and then forcing institutions to sell stock at book value.

UPDATE: My next post refines this idea.

Monday, September 22, 2008

I’ve Solved the Banking Crisis

Now if I can only get Congress to listen :)

Here is the KNZN-II plan
  1. Give the Treasury authority (or does it already have the authority?), on an ad hoc basis, to make commitments to insure the liabilities of individual financial institutions, so as to prevent “runs” by creditors. (Obviously it will seldom be necessary to invoke this authority for commercial banks, since most of their liabilities are already insured.)

  2. Mandate regulators to be aggressive (in a sense that I will make somewhat more precise later) in forcing write-downs of illiquid or troubled assets.

  3. Mandate financial institutions to accept any bid above book value for an illiquid or troubled asset.

  4. Prohibit the Treasury from bidding more for an asset that it has to in order to be certain of having the bid accepted. (In other words, given 3 above, it can only bid slightly above book value for illiquid and troubled assets – unless it is bidding against a competitor, in which case why would it be bidding in the first place?)

  5. Subject to the above, give the Treasury unlimited authority and discretion (but with certain guidelines) to use TARP funds to buy assets held by financial institutions, including the right to arbitrarily choose institutions from which to buy any given category of asset.

  6. Give the Treasury authority to take over lines of credit and purchase all types of loans from financial institutions that are inadequately capitalized or at significant risk of falling below capital requirements.

  7. For financial institutions that are undercapitalized but solvent and cannot present a credibly reliable plan to achieve adequate capitalization, give the Treasury unlimited authority to use TARP money to take equity positions on its own terms and without the consent of stockholders.

  8. For financial institutions whose capital is adequate from a regulatory point of view but judged to be at significant risk of falling below the requirement given the institution’s current balance sheet (after using any cash obtained from the Treasury’s purchases to retire liabilities to the extent that adequate liquidity can still be maintained), or that are not subject to a regulatory capital requirement but are judged to have too little capital, give the Treasury the authority to use TARP money to take equity positions, subject to the requirement that current equity cannot be valued below book value, but otherwise on the Treasury’s terms and without the consent of stockholders.

  9. For insolvent financial institutions, give the Treasury limited authority to take them over and supply necessary capital so as to avoid bankruptcy, if it is judged to be in the overall interest of taxpayers (where “taxpayers” is understood to mean “concrete people who happen to pay taxes” rather than “abstract people who own an interest in the Treasury”).

Details and Explanation

  1. The point of the ad hoc insurance is primarily to calm creditors who are worried that mandated aggressive write-downs will render an institution legally insolvent.

  2. First of all, from what I remember from when I studied accounting, asset valuations are supposed to be conservative, which is equivalent to saying write-downs are supposed to be aggressive, so it seems to me this point is just saying that regulators have to respect GAAP and do their job correctly. But maybe they need to be reminded. In particular they may need to be reminded that it is someone else’s job to prevent the banking system from collapsing due to banks’ having inadequate book capital.

    I would include the specific mandate that regulators should apply appropriate risk premia in valuing risky assets. And set up an oversight board to make sure that they do so. And, in cases where there is a question, require them to produce explicit economic/financial analyses to justify the premia they have applied.

    My impression is that inadequate write-downs tend, in most banking crises, to be much more frequent than excessive write-downs. The mandate to be aggressive, while it may be implicit in GAAP anyhow, is meant primarily to correct for this apparent bias.

  3. This mandate essentially says that financial institutions have a fiduciary duty to their creditors. If they refuse a bid above book value, they are essentially gambling with creditors’ money, hoping for an increase in value but risking that the asset will become worthless and bring them closer to bankruptcy.

    That’s the theoretical justification. Probably a more important practical reason for the mandate is to prevent the institutions from overcharging the Treasury when it buys assets.

  4. The Treasury cannot overpay. In other words, if it is going to give away money, it must do so explicitly.

  5. The primary guideline for Treasury purchases of assets is to “triage” financial institutions. In other words, give priority to the ones that are illiquid but either adequately capitalized or capable of reducing their balance sheets (once the Treasury’s asset purchases are made) so as to meet capital requirements with a reasonable safety margin, or that are currently thinly capitalized but capable of reducing their balance sheets sufficiently to meet capital requirements comfortably once the Treasury's purchases are made.

    If an institution is liquid and meets capital requirements, then buying its assets is not necessary (although it could be helpful, since more liquidity is better). If an institution cannot achieve adequate capitalization, then buying its assets may not do any good (although, if it is solvent, there is a chance that it could be saved). If an institution is insolvent, of course, there is no point in buying its assets, because it will still be insolvent. (You can’t triage a patient who is already dead.)

    Another guideline is to give priority to institutions whose failure or illiquidity would have adverse systemic effects.

  6. Technically, the authority to purchase loans is implicit in 5, but I have made this a separate point because it has a different purpose. Rather than providing banks with liquidity, the purpose is to avoid the credit crunch that might result from undercapitalized banks’ having to call in loans and reduce lines of credit.

  7. If you can’t save the bank, take it over. If there is still some shareholders’ equity, no resources should be wasted on haggling about how much this equity is worth. Shareholders are at the mercy of the Treasury. In deciding the terms of the takeover, the Treasury needs to balance the obligation to be fair to shareholders against the obligation to protect the interest of taxpayers.

  8. This will perhaps be the most controversial point, and it may be subject to constitutional challenges. (Even if nobody is allowed to sue the Treasury, presumably they can sue the Congress for making the law in the first place if the law is alleged to be unconstitutional. There might, for example, be 5th Amendment issues, although I would certainly argue that book value is “just compensation.”)

    But look, if we’re going to restore confidence in the system, we can’t have a bunch of sick financial institutions refusing medical treatment and risking becoming mortally ill and passing on lethal infections.

  9. It should seldom be necessary for the Treasury to take over insolvent commercial banks, since there is already the FDIC, but in some cases it might be judged appropriate, to better serve the health of the financial system, or to make more effective use of resources, or to ease the financial burden on the FDIC so that it would not require explicit additional funding.

    In the case of investment banks and other kinds of financial institutions, a Treasury takeover might often be be judged worth the cost to the Treasury in order to spare the financial system the costs associated with bankruptcy, including potential broader loss of confidence.

UPDATE: Point 10. Authorize the Treasury to buy preferred stock in financial institutions for the purpose of making additional capital available to facilitate lending. Not sure about the details yet, but reading over the plan, I realize it doesn't do enough to facilitate lending. "Adequate capital" isn't enough if it means that banks have to struggle to maintain adequate capital and can't afford to make many loans. The overall purpose of the plan should be not just to restore the health of the system but also to enable and encourage (prudent) lending, since that's the main purpose of having a financial system in the first place.

Acronym Time

I was a little late to pick this up, but the Paulson plan is now "TARP" -- the Troubled Asset Relief Program, a phrase taken from Secretary Paulson's statement on Friday. Apparently, some commentators had already taken to using this acronym soon after the statement came out. I have to say, the word "Relief" sounds a lot like welfare. Not very encouraging for those who held some hope that the only major objective was to increase liquidity.

I criticized Matthew Yglesias last week for objecting to bailouts in general (and even to the Fed's actions to mitigate the effects of non-bailouts) in the absence of programs to help ordinary people. The more I think about the TARP, though, the more I appreciate his point (at least in this particular case, which didn't exist yet when he wrote that post).

Apparently, we're planning to giving welfare payments (in the form of inflated prices for their assets) to bankers. This isn't really even necessary, but the only alternative might be to compel them to sell at fair prices. As I argued this morning, compelling them to sell at fair prices is a perfectly reasonable policy from a capitalist point of view, but I realize it's not likely to get much support from those who like to minimize government interference in markets. (In this case, though, arguably, it would be government interference for the purpose of mitigating the ill effects of other government interference, so perhaps a minarchist shouldn't particularly object.)

If we're giving welfare to bankers, rewarding them for their imprudent behavior -- well, at least reducing the punishment that markets have visited upon them for their imprudent behavior -- shouldn't we also be giving welfare to people who really need it? There is a moral hazard issue for ordinary people, too, but it's no worse than the issue for bankers. Yes, Democrats, let's attach some aid for Main Street to this Wall Street bailout. Either that or do it right -- make it a fair asset swap and liquidity injection instead of a bailout -- by giving Treasury the authority to force banks to sell at prices it deems fair, and by mandating that it use that authority when the taxpayer's interest so requires.

The Banking Crisis

Some people think the problem is liquidity. Others think the problem is capital. For some reason, both sides seem to insist that their side is entirely right and the other side is entirely wrong. It seems pretty clear to me that liquidity and capital are both significant problems. Why is there such polarization?

Socialism and the Banking System

In one recent post, I came close to advocating the overthrow of the capitalist system. Well, not exactly. But I did suggest that a policy which, at the time, I described as “socialist,” or at least a credible threat of implementing such a policy, might be necessary in order to solve the financial crisis in a way that is fair to taxpayers. At the time I hadn’t thought through, on a theoretical level, why such a policy might be necessary. In the context of a later post, I filled in the theoretical details, and I have since realized that the “socialist” policy is not inherently socialist at all, and if properly implemented, it can be defended as a normal part of capitalism.

Essentially, the policy, as I now imagine it, involves having the government act as an agent for creditors “before the fact” of a default. It is, of course, quite common for the government to act as an agent for creditors after the fact. When somebody refuses to pay his debt to you, you don’t go over to his house with a shotgun; you take him to court and let the government force him to pay. But creditors have issues before the fact as well. If debtors have limited liability, they have an incentive to take excessive risks with creditors’ money. Sometimes creditors are in a position to prevent debtors from taking those risks, but sometimes they are not – for example, when the creditors are widely distributed and cannot effectively police the debtors. In those cases, it makes sense for the government to take on the policing role.

The specific issue is whether undercapitalized banks have an incentive to hold on to securities and overvalue them on their balance sheets rather than accept an offer to buy them at fair value. (I’m talking about securities that are very hard to value, so here uncertainty acts like a smoke screen. Nobody can say for sure that the securities are overvalued on the balance sheet. Nobody can say for sure whether the offer to buy was at fair value. Even producing a rough estimate of the value is quite difficult. This allows banks to get away with intentionally overestimating the value, since a creditor of the bank would require substantial resources to determine whether the bank is overvaluing the assets or not, and even then the creditor wouldn’t be able to prove it.)

From the bank’s point of view, there is no difference whether its equity goes into the red or just goes to zero. Therefore, if the fair value of the bank’s equity is already near zero, the bank has nothing to lose by taking excessive risks that could result in increasing the fair value of its equity. The particular excessive risk I have in mind is holding on to an illiquid asset rather than selling it at fair value. If the fair value of the asset goes down, the fair value of the bank’s equity will go negative, the bank will eventually fail, and its creditors will lose money, but the bank’s owners will be no worse off, since the fair value of their capital was zero to begin with. If the fair value of the asset goes up, of course, the owners will be better off, but the creditors will be no better off than they were before.

[EDIT: Note that this same moral hazard exists, to a lesser extent, even when the bank has adequate capital. It may still be in the bank's interest to gamble on recovering more of an asset's original value -- which will flow directly to the bottom line without enriching creditors -- rather than selling it at the current fair value. Usually holding on to the asset will be against the interest of creditors, since the bank has adequate capital already and there is no reason for creditors to want to take risks with that capital [EDIT2: except for the normal, presumably much smaller, risk that the bank takes in the course of its ordinary business, which is necessary so that it can earn enough to pay the interest due to creditors].]

Somehow, the creditors should have a way to force the bank to sell its illiquid asset if it gets a fair bid. Moreover, in a reverse auction, such as is proposed as a way to implement the Paulson Plan, the creditors (and the taxpayers) should have a way to force the bank to bid fair value rather than some higher value. Unfortunately, these are very difficult things to do, because, as discussed earlier, the asset is very hard to value. The only practical way to do it is for the government (or some neutral party) to estimate fair value and then force the bank to sell at that price. (Note: If all banks are behaving in the interest of their creditors, then each one will bid fair value, or near it, in a reverse auction, because the primary interest of the creditors is to win the auction But it doesn’t work if only one bank is doing so and knows that the others are not, because that bank will realize that it can win the auction even by bidding above fair value.)

For a commercial bank, the real creditor is usually the FDIC. The FDIC should have the right to force banks to accept fair value for their illiquid assets, and it doesn’t make much difference if the valuation is done by the FDIC or the Treasury or, for that matter, some other party. And it also doesn’t make much difference who enforces the required sale – it could be the FDIC, or it could be the Treasury acting as an agent for the FDIC.

Of course the resulting reappraisals may be quite agonizing. Some banks that were believed to be adequately capitalized will turn out not to be. They will have to either raise capital in the private sector (possibly by allowing themselves to be bought out) or make a deal with the government whereby the government gives them an infusion of capital in exchange for equity participation (which, after all, is essentially what would normally happen if they raised capital in the private sector).

In some cases banks that were believed to be solvent will turn out to be insolvent. They must be either liquidated or taken over (by another private sector entity or by the government). It might be reasonable to use public funds to reduce their liabilities so that some other institution would be willing to take them over. In the case of commercial banks with insured deposits, the public will end up getting the bill anyhow, so why not do it in a way that is less disruptive and allows the bank to continue operations?

So there you have it: the Knzn plan. I think Maynard would approve. It involves coercion, and in some cases takeover, of private entities by the government, but it’s not really socialist, because that coercion is ultimately on behalf of other private entities with legitimate interests that they are unable to defend. As a side effect of defending those private interests, the public gets a fair deal.

UPDATE: In a comment, Johnchx points out that the existing regulatory mechanism can (and, if it's functioning properly, will) force banks to write down assets to fair value. What the existing mechanism can't do, though (as far as I know), is to force a bank that is adequately capitalized, but just barely so, to sell its illiquid assets if it receives a fair offer. In many cases, such banks will have an incentive to reject offers at book value, when the asset is fairly valued on the books. (See my edit above.)

UPDATE2: In any case, that regulatory mechanism only works for commercial banks. Investment banks are possibly a bigger problem (largely because there is no insurance to prevent "runs").

UPDATE3: In my plan, paradoxically, the creditors, whose interests are being defended in each specific case, end up with a worse deal (at least if the Treasury promises to buy at the reverse auction price). The moral hazard of the bankers essentially allows the creditors to behave like a cartel and extract monopoly profits -- in the form of greater security due to having larger capital cushions -- from the Treasury. But we do have antitrust laws and such to prevent anti-competitive behavior, so it makes sense to enforce fair competition among banks selling securities to the Treasury. It's still not socialism.

Sunday, September 21, 2008

The Paulson Plan: Summary of My Recent Posts

Providing liquidity is what the government should be doing. Recapitalizing banks (without receiving equity participation) is what the government should not be doing. If the government does the former and not the latter, then, although taxpayers are taking a large risk, they should expect, if things go well, to make a very large profit. Unfortunately, after careful consideration, I have concluded that the Paulson Plan is most likely intended to do the wrong thing. However, no matter which turns out to be the case, the government can afford it.

UPDATE: Upon further consideration, I have come to doubt whether it is even possible to implement the Paulson Plan in a way that doesn't effectively give banks more capital for free. For perfectly rational economic reasons, severely undercapitalized banks would rather hold on to illiquid assets and risk failure than sell those assets at fair value and admit the true extent of their undercapitalization. A better plan would require forcing banks to accept fair value.

That said, given the severity of the crisis we currently face, the Paulson Plan is probably better than doing nothing. But surely doing nothing is not the only alternative.

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.

Illiquidity and Uncertainty

My next post is going to go in a very different direction from my earlier ones, but for now I want to make a point about liquidity. People are telling me that the liquidity issue is bullshit, but they’re wrong, and here’s why.

Mortgage securities have ratings. A couple of years ago, investors thought that those ratings meant something. Given that belief, they were able to outsource most of their research to Moody’s, Standard & Poor’s, and Fitch. That was (or would have been, if it had actually been working) very efficient, because it avoided a lot of duplication of effort in the analysis of difficult, complex securities. Based on the ratings, investors were able to ascertain with a reasonable degree of precision how much they were willing to pay for the securities. Consequently, there were a lot of investors willing to buy and sell the securities, and the market could produce narrow bid-ask spreads.

But sometime in 2007, investors suddenly realized that the ratings were complete crap. Moody’s, Standard & Poor’s, and Fitch were not doing a good job with their research, or at least they weren’t doing the job investors had thought they were doing. Now that ratings were no longer considered useful, the pricing of these securities required a tremendous amount of research by each investor considering buying or selling one of them.

So an investor contemplating buying one of these securities has 3 options: she can forget about it; she can put in a lowball bid just as a shot in the dark, on the off chance that it gets picked up by some desperate seller; or she can devote a lot of resources to figuring out how much the security is really worth to her, and then put in a bid that might have a decent chance of being accepted. Considering all the other possible uses she has for her resources, she is unlikely to choose what's behind door number 3.

Similarly, if an institution owns one of these securities, it has 3 choices: it can hold on to the security; it can take the best bid available, in which case it will almost certainly be selling the security for less than it is worth (if indeed it can sell it at all); or it can devote a lot of resources to figuring out how much the security is really worth to it, and then offer it at a reasonable price which has almost no chance of being accepted, since potential buyers were not willing to do that research and therefore don’t know what the reasonable price is and won’t be willing to pay it. Essentially, except under forced liquidation, options 2 and 3 make no sense. The only reasonable thing to do is hold on to the security. That is illiquidity.

One of the potential advantages of government involvement is that the government should be able to do the necessary research with reasonable efficiency. As a huge, huge potential buyer, the government isn’t wasting its resources by doing a large amount of research just to value one little security. If it intends to buy up an entire tranche, it can afford to expend the resources necessary to figure out how much that tranche is worth.

Unfortuantely, the more I read and think about The 700 Billion Dollar Plan, the less I think that is what the government actually intends to do. More later.


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.

Why the Cost of the Bailout Doesn’t Matter, part 1

Let’s suppose that, as some people seem to insist, the government will not recover a cent from the distressed assets it buys in the big bailout. What will the bailout cost the taxpayers?

As I argued in my previous post, it will not cost today’s taxpayers anything. But what will it cost future taxpayers? I suggested in my last post that perhaps the government could roll over its debt indefinitely, and no taxpayers would ever have to pay it off. That might sound ridiculous at first blush. You will say, perhaps, that investors will be unwilling to refinance the debt once they catch on to the government’s strategy of rolling it over forever. I would agree, if the result of the rolling over the debt were a debt-to-revenue ratio that went up over time. In that case, investors would see that the rollover strategy was unsustainable, and they would refuse to lend. But, I will argue, we should not expect that to be the case. In all likelihood, provided that the primary deficit (i.e. deficit before interest payments) can be brought under control in subsequent years, the debt-to-revenue ratio will fall over time.

The key to my argument is that the long-term growth rate of the economy should be higher than the (expected long-term average) interest rate paid by the government. In that case, revenues will keep rising at a growth rate that is higher than the interest rate, so if you discount those revenues at the interest rate, the present value of the stream will be infinite. Thus the government effectively has infinite assets, so whatever debt it takes on, it can keep rolling over that debt and financing the interest payments with new debt, and the debt will still be a smaller and smaller multiple of revenues every year.* (This works as long as the new debt is a one-time thing. If the government keeps running large primary deficits year after year, then its debt may grow more quickly than its revenues, and that would be unsustainable.)

But will the growth rate be higher than the interest rate? Yes, I will argue, it normally will be. My argument relies on the premise that most capital income is reinvested. It’s reasonable to expect that most capital income will be reinvested, since people saving for retirement will typically reinvest their capital income and then add some new savings, whereas retired people will consume their capital income to an extent likely to roughly offset the extra saving by younger people. (OK, I'm working on a better argument, and I'm sure there is one that somebody has written a paper about -- probably a paper I read years ago and then forgot. Actually several arguments, each of which has produced several papers, all of which I either have not read or have forgotten. But let this argument do for now. In any case, to me, it seems intuitively likely that most capital income will be reinvested.)

If capital income is reinvested, then the growth rate of capital (due to that reinvestment) will be equal to the return on capital (which provides that income). In a steady state, by definition, the growth rate of capital has to equal the growth rate of labor. The economy will always tend toward that steady state because, if capital is growing faster than labor, then the amount of capital per worker is growing, which means that the return on capital must be falling (since over time, every unit of capital has less and less labor to work with and therefore becomes less productive), which means that the growth rate of capital must be falling, so it will eventually fall to the growth rate of labor. (That argument applies in reverse if capital is growing more slowly than labor.)

So here’s why the growth rate will be higher than the interest rate. The overall return on capital, as discussed above, should roughly equal the growth rate. At the level of the whole economy, there is a capital structure, where some capital is risky and has a high return, while some is safe and has a low return. Since government bonds are the safest type of capital asset, they have the lowest return. That means that the average return on capital across the economy must be higher than the return on government bonds. Since the average return on capital roughly equals the growth rate, that growth rate must be higher than the return on government bonds. Thus the growth rate is higher than the interest rate paid by the government.

Consequently, the government, in effect, has, in the capitalized stream of future tax revenues, an infinitely valuable asset, which it can put up as collateral for anything it wishes to borrow, no matter how much. It will only be a problem if the borrowing is perceived as part of an ongoing pattern, in which case the government’s asset will no longer be infinitely valuable (since future revenues have to be sufficient to pay off not only the current debt and its interest, but also all future primary borrowing, which, in the “ongoing pattern” case, is expected to be too much for the expected revenue stream to ever pay off).

Maybe you think that we are in the “ongoing pattern” case, since the government has been running fairly large deficits for several years now. Personally, however, I believe that these primary deficits will, at least in the short run, come under control. We will either have a Democratic president who promises policies to raise tax revenues, or we will have a Republican president who will be working with a Democratic congress and will thus have great difficulty extending the expiring tax cuts or instituting major new expenditures. In the longer run, we do have to worry about the effect that an aging population and rising health care costs will have on entitlement programs. I’m worried about that, but I’m not much more worried than I was a week ago.

Now, perhaps you will try a reductio ad absurdum by saying, “If any amount of one-time borrowing can be financed by rolling over the debt indefinitely, why stop at $700 billion? Why not borrow $700 trillion? Or $700 quadrillion?” It does get absurd when the numbers get ridiculously high, because it gets to the point where the debt will be huge relative to revenues and it will take a ridiculously long time before revenues catch up. In other words, mathematically speaking, the present value formula (which gives the value of the government’s revenue stream) is not very useful if it takes many centuries for the cumulative sum to come close to its theoretical limit. But with the national debt already well into the trillions, and with investors obviously willing to refinance the current debt at very low interest rates, I seriously doubt that another $700 billion – or even another $2 trillion, should it come to that – will make the difference between a reasonable level of debt and an unreasonable one.

Yes, Virginia, when it comes to financing government bailouts of financial assets, there is a Santa Claus. I should make clear, though, that Santa Claus is not omnipotent. He can come down the chimney and deliver a financial bailout on Christmas Eve, but he can’t make something out of nothing. If the government were to attempt some type of bailout that involved the production of large quantities of real goods and services, Santa Claus could only help to the extent that the economy had slack resources (as it does now and likely still will in the immediate future, but probably only a few hundred billion dollars worth, at most). When the economy runs out of resources, no bailout can make more of them.

*See Michael R. Darby, “Some Pleasant Monetarist Arithmetic,” for a more precise version of this argument in a different context.

Bailouts for Fun and Profit

OK, this pisses me off. David Stout, writing a Q&A in The New York Times (“The Wall Street Bailout Plan, Explained”):
Q. Who, really, is going to come up with the $700 billion?

A. American taxpayers will come up with the money, although if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion. After the Treasury buys up those troubled mortgages, it will try to resell them to investors. The Treasury’s involvement in the crisis and the speed with which Congress is responding could generate long-range optimism and raise the value of those mortgages, although it is impossible to say by how much.
First of all, today’s taxpayers are certainly not going to come up with the money, not by any stretch of the imagination. There are no plans to raise taxes to pay for this bailout, nor, in my opinion, should there be. (That’s not necessarily to say that taxes shouldn’t be raised, just that this bailout should not be the deciding factor.) People (and institutions mostly, really) who buy Treasury securities will come up with the money. The Treasury will issue new Treasury securities to raise the money to pay for the distressed securities that it buys. Most likely the banks that sold those distressed securities will buy the new Treasury securities with the proceeds from the sale, so nobody really has to come up with the money, except for a few minutes while the deals are being done. In effect the Treasury will be paying for the distressed securities by creating its own securities to use as payment.

Someone is going to say, “Well, of course today’s taxpayers aren’t going to come up with the money, but the Treasury securities eventually mature and have to be paid off, and when that time comes, those future taxpayers will have to come up with the money.” I will attack that straw man immediately by pointing out that the debt can be rolled over. Maybe eventually, after rolling over the debt several times, the government will be forced by circumstances to raise taxes to make those payments. But maybe not. I’ll have to do another post on why the “maybe not” case is more reasonable than you might think.

But let’s suppose that those Treasury securities do eventually have to be paid off with taxes and cannot be rolled over indefinitely. Does that mean that future taxpayers will have to come up with $700 billion plus interest? There is a tiny chance that that will be the case. Which brings me to what mostly pisses me off. I repeat from above:
...if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion.
Reason to hope? That the tab will be less than $700 billion? Holy crap! I would sure as hell hope that at least a few of the mortgages in the pools bought by the government don’t default! OK, I’m being a little disingenuous, since much of what the government buys will be lower tranches that can become worthless even if there are only a moderate number of defaults. Some of the securities very likely will become worthless. But in all probability, unless there is a severe, prolonged recession (which is to say, a depression) and a much further decline in housing prices, the government’s whole portfolio will still be worth something.

And – here’s my main point – the Treasury will not be paying full price for these securities. It won’t be paying anything remotely close to the price that the securities were issued at. It will be paying whatever price desperate banks are willing to accept in order to get the securities off their books and replace them with things that can be easily sold when they need cash. These are motivated sellers we’re talking about. In all probability, many banks will be willing to sell these securities for less than they think the securities are really worth. Because they don’t want to take the risk that, when the government bailout is over, they will have some need for cash and won’t be able to sell the securities then.

Granted, there may be some banks that figure out ways to game the system and sell their securities for more than they are worth. But all in all, we should expect the Treasury to get these securities at something close to fair value. The Treasury is not just throwing money away; it’s buying valuable (though quite risky) assets and paying roughly what those assets are worth. [EDIT: I was wrong about this, because I didn't take into account the moral hazard faced by bankers who can fudge their asset values. I discuss this among other topics in the post where I change my mind about the bailout. It is still true, though, that the Treasury will not be paying full price, and it is likely to recover much of its investment and possibly even turn a profit, but unfortunately not a large enough profit to justify the risk.]

And it’s important to understand that “fair value” includes the expectation of a substantial risk premium. The fair value of a junk bond is considerably less than the fair value of an otherwise similar investment grade bond, but when they mature, both bonds are redeemed at par. The junk bond has a larger chance of default, but even when you take that chance into account, the expected return on the junk bond is considerably higher. People don’t buy junk bonds because they’re stupid; they buy them because they expect, on average, a high return. Similarly, the Treasury should expect, on average, a high return from its purchases of distressed securities.

So, while there is (in theory, at least) quite a large risk to (future) taxpayers (a risk of up to $700 billion – plus the meager interest that the government has to pay), the expected return is not only positive but rather large. And since the interest paid on Treasury securities is quite small, that return, if it materializes, will be a huge windfall for whatever future taxpayers get the benefit.

So this “bailout” is not about the Treasury paying $700 billion and hoping to recover some of it in a best case scenario. It is about the Treasury paying $700 billion dollars, risking losing up to the whole amount, but expecting not just to recover the entire amount but to emerge with a large profit. The Treasury is, in a sense, gambling with taxpayers’ money, but the gamble is a good bet, kind of like if you had inside information about the horse. Of course, making a profit is not the point of the operation, but it might be a pleasant side effect.

Saturday, September 20, 2008

Why Short Selling Matters

Arnold Kling (hat tip: Matthew Yglesias) argues that short-selling can’t “destroy a good company” because if the company is good, someone will always be willing to pay a good price for it and will be willing to buy it from the short-seller at that good price. But his analysis fails to account for uncertainty and imperfect information. We don’t really know which companies are “good.” Everyone has their own guess about how much a company is worth, but how much is it really worth? We won’t know until we see its results. Actually, we won’t even know then, because it will have more results in the future that we still won’t know about.

In general, since the market value of a company depends on an uncertain guess as to its true value, a good company can be destroyed simply by bad opinions, if people wrongly judge that it is a bad company. And, as I will explain, short-selling can exacerbate this problem in the case of a company that is in fact good but that, in terms of market opinions, is on the margin between being considered good and being considered bad. The “margin” idea applies when there is only one “marginal” short seller, but if there are many, they will effectively widen the margin, so that a clearly “good” company can turn into a clearly “bad” one.

For any given company, the market does not have one opinion, shared by everyone, about the value of its stock. Rather, everyone has a different opinion. People use different methods (including subjective ones, which differ from any one individual to another) to evaluate a stock. Those different methods lead to different conclusions about the stock’s value. One person may think a stock is worth $10; another may think it’s worth $9.99; another may think it’s worth $9.98; and so on down, and maybe, at the other extreme, there is someone who thinks it’s only worth $2.

So suppose the stock is trading at $10, and a large short-seller appears on the scene. The short-seller will satisfy the demand of the person who thinks the stock is worth $10, and then there will be no more demand at $10, and the stock will trade down to $9.99. Then the short-seller (who is, by my construction, “large”) will satisfy the demand of the person who thinks the stock is worth $9.99. Then the stock will trade down to $9.98, and the short-seller will satisfy the demand of the person who thinks it’s worth $9.98, and it will trade down to $9.97. And so on. If there are a lot of large short-sellers, they can bring the price down by quite a lot by, for example, satisfying the demand of everyone who thinks the stock is worth more than $7.

So let’s take that $10/$7 example, and let’s suppose that the definition of “good” requires the stock to be worth $8 or more (in a sense that will become more precise in later paragraphs). By sending the price down from $10 to $7, the short-sellers have effectively shifted the company’s “market reputation” from the “good” category into the “bad” category. No individual has actually changed their opinion, but because of the aggressiveness of the short-sellers (who obviously believe the company is quite a “bad” one), the “market” has changed its “collective opinion.”

Now let’s suppose that the company is (in actual fact rather than opinion) a “good” company but that it needs to raise more equity capital in order to stay good. (When you’re talking about a bank that is solvent but undercapitalized, this might be a reasonable description.) When it offers new shares, the company faces the same demand curve as the short-seller did, and since the price is now down to $7, the company will have to offer the shares at a lower price, say $6, for the offering to be fully subscribed, because it will satisfy the demand of everyone who believes the company is worth $7, $6.99, $6.98, and so on, down to $6.

OK, but suppose that the amount of capital raised at a $6 share price will not be enough to keep the company good. And let’s also suppose that it would have been enough if the offering price had been $9, which it would have been (approximately) if the short-sellers had not become involved. So the company still doesn’t have enough capital, and it needs to raise more. So it offers more shares. But again, the company faces a downward-sloping demand curve for its shares. Suppose it offers additional shares, which satisfy the demand of everyone who thinks they are worth more than $5, so the company offers these new shares at $5. But suppose that still is not enough to keep the company good. It has to offer more shares. But now that it has done two separate offerings, and it attempts a third, it probably won’t have the confidence of the market. Market participants will say, “If we pay $4 now, who is to say that the company won’t come back and offer shares at $3? We’ll wait for that.” And if they wait for $3, why not wait for $2? And if $2, why not $1? Of course at some point everyone is going to realize that the company is going to be unable to raise sufficient capital at any price.

In practice, potential buyers will have realized that much earlier. If they have a reasonable guess as to how much capital the company needs, and a reasonable guess as to what the demand curve for its stock looks like, then they will be able to come up with a reasonable guess as to whether the company can raise the necessary capital. Of course, there will be a variety of guesses, and opinions will differ. But at some point (as the declining stock value makes the problem clearer), only a few people (or none at all) will be of the opinion that the company can raise enough capital. At that point, the company is effectively ruined, the price goes down to near zero, and the short-sellers profit handsomely. If there are enough large short-sellers, not only can they destroy a good company, they can make a lot of money doing it.

UPDATE: Another way to argue that short-selling doesn't matter would be to argue that the person with the $10 opinion has an infinite amount of capital available, and therefore they will demand an unlimited number of shares at $10. Of course, it's rather silly to think that anyone has infinite capital. And for someone with limited capital, the more they pay for the shares, the more risk they are taking. So they will be willing to buy a certain number of shares at $10, but after that, the risk become too high, and the price has to go down to get them to buy more. Essentially, my argument above still applies, except that you can construct the demand curve from just one person's opinion. If there are many potential buyers, each of whom has limited capital and limited risk tolerance, but who have different opinions, the demand curve will still slope downward, and again my argument applies.

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Thursday, September 18, 2008

WSJ Factual Error

From the top story in today’s Wall Street Journal:
At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured....That’s never happened before.
Actually it has happened before, not in the easily available data, but it has happened – in 1938 (and apparently several other times between 1935 and 1941).

My only source is a talk by Paul Samuelson, for which I cannot even point to a transcript, but I’m confident that primary sources will bear me out. I’m too lazy to go check old copies of The Wall Street Journal on microfilm, but take my word for it.

It’s actually pretty obvious if you look at the monthly data from the Fed. For example, in February 1941, the average yield on 3-month T-bills was 0.03 percent. Considering how the yield fluctuates from day to day and from hour to hour, it’s impossible to believe that it was not negative at certain points during that month. (Technically the Journal was referring to one-month bills, but it’s a safe assumption that, if 3-month bills were selling above maturity value, so were one-month bills for at least part of the time.)

UPDATE: Paul Krugman makes the same claim (hat tip: anonymous commenter)....and I continue to believe it is wrong. I'm not sure his claim is independent: he may have gotten his information from the Journal, or they may have gotten it from the same source, which I hope they will cite so we can follow it up and judge its reliability.

UPDATE2: Reuters and the AP, both citing Los Angeles-based Global Financial Data, report that the last time the 3-month T-bill was at or below zero was January 1940. (Could it merely have been "at" zero? It seems unlikely that the bid would have stopped at exactly zero.) Another AP report says that demand sent "the yield on the 3-month Treasury bill briefly into negative territory for the first time since 1940." Friedman and Jacobson, in A Monetary History of the United States, 1867-1960, say in a footnote that "yields on Treasury bills were occasionally negative in 1940." (Apparently my "obvious" conclusion about 1941 was not correct, buy my main point stands.)

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How many people have lost their jobs?

According to Barack Obama, 600 thousand Americans have lost their jobs since January. Actually, he's wrong: something like 20 million Americans have lost their jobs since January. It's just that most of them found new jobs. Probably the new jobs generally weren't as good as the ones they lost. And almost certainly, more than 600 thousand of them were unable to find new jobs, because many of the new jobs created were filled by new entrants to the labor force or by people who were already unemployed when the year began.

Like almost everyone else I've ever heard, Senator Obama is making the mistake of using a net job loss figure with language that, if taken in its plain sense, clearly implies he is talking about gross job loss. And it seems to me that gross job loss is the appropriate concept: losing your job is a pretty serious bummer, even if you are able to find a new one after a few months.

There has been a lot of talk about Senator McCain and how he has been saying things that aren't true in order benefit himself politically. It turns out that Senator Obama is also (obviously unintentionally) saying things that aren't true, but in this case they benefit his opponent.

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Wednesday, September 17, 2008

Moral Hazard for Corporations, part 2

I agree with Mark Kleiman's main points here, but this one, as my previous post would suggest, I think is a mistake:
Why shouldn't the government bail out a private company that isn't a regulated bank? Moral hazard. You don't want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a "heads I win, tails you cover my losses" basis.
(Just to be clear, he isn't defending his own overall position with that statement; he's just discussing one consideration to be weighed.) As I argued in my previous post, whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation. In a failure, their stock might become entirely worthless; in a bailout it just becomes almost worthless -- not an important distinction. Prudent stockholders have portfolios of stock, so it's not like a stockholder is someone who will personally be left with nothing in the case of a failure but still have a little bit to keep in the case of a bailout. Typical stockholders will just see changes in the values of their portfolios, and the difference between a 90% drop and a 100% drop in one stock will make only a tiny difference to the value of the portfolio.

Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.

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Tuesday, September 16, 2008

Moral Hazard for Corporations

With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. (Well, a “recommendation” after the fact is known as a “criticism,” but I would have recommended the same thing before the fact. The main reason I didn’t talk about it before the fact is that I expected officials to do what I would have recommended anyhow.) Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

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Monday, September 15, 2008

Third Rant of the Day

When it rains, it pours. This one is really sort of a repeat of my first rant, but with more explanation and less sarcasm. Well, more explanation, anyhow.

Here’s Treasury Secretary Paulson at a press briefing this afternoon:
I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.
When I first read this, I interpreted it to mean, “I never once considered the possibility that it was appropriate...,” and I was ready to write a somewhat more obnoxious rant about how Paulson was either a liar or irresponsible, and I hoped he was a liar. But a more careful parsing reveals that he is neither lying nor being irresponsible; he is just engaging in doubletalk. I don’t fault him for that, since it’s pretty much part of the treasury secretary’s job description. He never considered it to be the case that it was appropriate to put taxpayer money on the line.

Secretary Paulson is drawing his macho line in the sand and saying, “See, Mr. and Mrs. Average American, who faithfully pay your taxes, I’m protecting your money from the whining Wall Street plutocrats. So never think that just because I came from Wall Street, I will put Wall Street’s interests above those of Main Street. And never say that Republicans always help the rich.”

Which is fine if you believe that financial events have no impact on the nonfinancial economy. But most economists (and, I would guess, Secretary Paulson himself) don’t believe that. Let me assert – and see whether I get broad disagreement – that the failure of the 4th largest investment bank in the country can be expected to increase significantly the risks faced by participants in the nonfinancial economy. In particular, when the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

But then there is also the question of whether even “taxpayer money” is really less on the line than it would be if the Treasury had provided loan guarantees. I’ve addressed this question before in connection with the Fed’s Term Securities Lending Facility. Each individual taxpayer who benefits from public services depends on the taxes collected from all the other taxpayers to help pay for those services. If the other taxpayers start losing their jobs, tax receipts will go down, and this taxpayer will eventually have to pay more taxes, or give up more public services, to make up for that loss. If you risk the potential economic effects of a major investment bank failure, you are risking that taxpayers will have to pay higher taxes. That’s just the same as if you had provided loan guarantees, which risk that the loans will go sour and require an increase in taxes to make up the difference. In which case is the risk bigger? Not obvious to me, but if I had to guess, I would say that the investment bank failure risks taxpayer money more than would the loan guarantees. So I would say that Secretary Paulson’s stance on “taxpayer money” is either politically disingenuous or economically naïve.

Let’s consider the possibility that it is politically disingenuous and that his motivation is actually something different than protecting taxpayer money. I’m not suggesting anything sinister; I’m just suggesting that there is a (slightly) more reasonable, but harder to explain, argument for avoiding a bailout. As Secretary Paulson says elsewhere in the briefing:
Moral hazard is something I don't take lightly.
Rather than trying to define moral hazard, I’ll go with the definition used by the AP in the report about the briefing: “the belief that when the government steps in to rescue a private financial firm it encourages other firms to engage in risky behavior.”

But does it? When the government steps in to rescue a firm by facilitating its sale at a small fraction of the price that it fetched a year or two ago, does that really encourage other firms to engage in risky behavior? It’s kind of like when your health insurer requires only a $950 co-payment for a $1000 procedure. Does that give you an incentive to make excessive use of the health care system? If I were a financial firm contemplating engaging in risky behavior, I wouldn’t find the prospect of a fire-sale rescue to be very encouraging.

It’s really not the firm that would be bailed out, but the firm’s creditors. Were the creditors engaging in risky behavior that needs to be discouraged? There isn’t much I can say about that that I didn’t already say this morning. In general, I think that doing business with major investment banks is something that we should encourage. A financial system doesn’t work very well when everyone is afraid to do business with everyone else. Should counterparties really be expected to do extensive due diligence on the 4th largest investment bank in the country before they engage in credit swaps with it? It seems to me that would not be a very efficient use of resources. And in any case, it’s not clear that even extensive due diligence would have uncovered the depth of Lehman’s problems.

End of rant. Executive summary: They should have bailed out Lehman.

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Careless, Disingenuous, or Just Ignorant?

Donald Luskin in the Washington Post:
Obama is flat-out wrong when he frets on his campaign Web site that "the personal savings rate is now the lowest it's been since the Great Depression." The latest rate, for the second quarter of 2008, is 2.6 percent -- higher than the 1.9 percent rate that prevailed in the last quarter of Bill Clinton's presidency.
That sounded a little strange to me, so I checked the national accounts. It's quite true that the savings rate is 2.6 percent in the second quarter of 2008, but the average of the last 4 quarters is less than 1 percent, and in most of the recent quarters it has been 0.5% or less -- which certainly qualifies as "the lowest...since the Great Depression."

Have US households suddenly seen the light and started saving again? A slightly closer look at the national accounts shows where that light shined from. The only thing unusual about the second quarter of 2008 was a sudden drop in "personal current taxes," which resulted in an increase in "disposable personal income," the denominator for the savings rate. Ah, yes, that's what had slipped my mind (and perhaps Mr. Luskin's as well) about the 2nd quarter. (If the reason for the drop in taxes isn't immediately apparent, you might want to check the headlines for January 24. But I'm guessing that rebate check didn't come as a surprise.)

Apparently Americans thought it might be better to save some of of the "stimulus" money for, say, the 3rd quarter or the 4th quarter...or even next year? So, yes, the savings rate did go up. That's one of the usual results of a fiscal stimulus. In fact, a fiscal stimulus is exactly how Franklin Roosevelt managed to get the savings rate back into positive territory during....what was it?...oh, yeah, the Great Depression.

Perhaps Mr. Luskin was in a hurry and didn't notice what the savings rate was in other recent quarters. Or perhaps he was deliberately using a true but misleading fact. Or perhaps he just didn't understand why the savings rate had suddenly risen. Based on past experience with Donald Luskin, I tend to go with the last explanation. I have no particular reason to question his diligence or his intellectual honesty, but his understanding of economics often seems weak, even when the points in question are fairly basic.

Apparently Mr. Luskin now hopes to have some political influence:
I'm an adviser to John McCain's campaign, though as far as I know, the senator has never taken one word of my advice.
If John McCain has indeed never taken any of Donald Luskin's advice, that speaks well for the senator's judgment.

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Moral Hazard and Protecting the Taxpayer

What? You've been doing business with the 4th largest investment bank in the country? How imprudent of you! We can't allow such rashness to be rewarded. No, we must let the market punish you for your imprudence. Otherwise, it will encourage people to do such risky things in the future -- expecting the risks to fall on the taxpayer.

Yes, it is the taxpayer that we are trying to protect. The taxpayer cannot accept the consequences of your imprudent actions. Never mind that, given the possible economic impact, most people who pay taxes will face even greater risks than the they would if the government had facilitated a sale by guaranteeing some of Lehman's assets. The Treasury's obligation is not to the people who pay taxes. It is to the taxpayer!

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Friday, September 05, 2008

Drilling makes us more dependent on foreign oil

Just thought I should point out that US oil reserves are not inexhaustible, and that most of the oil in the world is still elsewhere. If we continue to feed our addiction to oil-based energy by producing more in the US, that means, when our reserves are depleted, we will end up having to feed that addiction by buying more oil from abroad. On the other hand, if we shift to other forms of energy (which unfortunately include coal), we can hopefully break that addiction and really end our dependence on foreign oil.

My title is a bit of an exaggeration, I admit. Drilling doesn't necessarily make us more dependent on foreign oil, but it doesn't make us less dependent either, except in the short run. It shifts our dependence into the future. It makes us more dependent in the sense that we will remain dependent for a longer period of time (but be less so initially).

While I'm on the subject, a nice slogan for the Pigou Club, courtesy of Al Gore, via Battlepanda:
Tax what we burn, not what we earn.

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