Home > financial crisis, Treasury > In Paulson We Trust?

In Paulson We Trust?

September 23, 2008

The root cause of the liquidity freeze on Wall Street is clear:  Financial institutions, for various bad reasons that have been discussed at length elsewhere and are beside the point here, made huge bets that house prices would continue to defy gravity.  They didn’t.  Now the losses from those failed bets keep on popping up in unexpected places; no one knows who can be trusted.  For a bailout to solve the trust problem, it has to reveal who just got singed by the housing fallout, and who is still hiding third degree burns.  Until that uncertainty is resolved, investors are going to be justifiably cautious about putting their capital at risk.

Will the Treasury’s buying distressed assets reassure investors that the financial institutions are creditworthy?  I don’t see how it could, unless the intention is to overpay massively for mortgages.  How is the public to know that enough of its problem assets have been sold for a bank or brokerage to be viable?  And if institutions are not selling now because they don’t want to fess up and mark to market, why will they want sell assets at a fair price to the Treasury?  Sure they will be motivated if Treasury offers such a large premium over fair value that big losses are written down as little losses.  But the administration claims this will not happen, that taxpayers are to be protected.  So we’re back to square one – how can this solve the trust problem?

What would seem to be much less expensive for taxpayers, and ultimately less intrusive, would be for the government to address the transparency problem directly.  Instead of legislating a bailout, compel companies to open their books to government auditors.  Authorize Treasury and/or the Fed to muster up a sophisticated crew of experts to examine the books of financial institutions and report on which are fundamentally solvent, which are close enough to be viable with just a shoring up of capital, and which need to be dissolved or reorganized.  Some kind of certification or temporary guarantee could follow for institutions deemed reasonably sound, or the government could even choose to make targeted capital infusions based on this information.  Done properly, this would reveal very little proprietary information.  In economist speak, the government would be creating a “positive information externality,” an idea that should have some appeal across party lines. Granted this sounds intrusive, but it pales in comparison to counter-proposals to the Administration’s plan that call for the government taking large equity stakes in the companies they purchase assets from.

Also problematic is what will happen to the mortgage assets once the government owns them.  Pundits have been throwing around comparisons to the RTC.  The RTC bought the assets of failed S&Ls, but the RTC had an infinitely easier job.  What brought down the S&Ls was interest rate risk, not credit risk.  The RTC bought good mortgages, not distressed ones, so reselling them posed no special challenges.  This is not the case here.  Will private buyers be interested in what will surely continue to be opaque assets?  And in the mean time, what is the Treasury supposed to do with distressed mortgages?  Evict delinquent homeowners?  It is one thing for banks to try to enforce their contractual rights, but quite another for the government after they have already broken all the rules by bailing out Wall St. to be taking away people’s homes.  All of this is to say that one way or another, it will likely turn out to be extremely expensive for taxpayers if the government becomes the direct owner of distressed mortgages.

Categories: financial crisis, Treasury
  1. Josh
    September 24, 2008 at 9:28 pm

    Since as you say the various derivative assets in question are too opaque to allow for accurate risk assessment and valuation, why do you think the proposed bailout doesn’t focus on the underlying assets (distressed mortgages) which are much easier to evaluate? It would seem these would be much less costly to support, and would restore value up the asset chain as well as providing the reassurance the market requires.

  2. Stephen Carlson
    September 27, 2008 at 11:28 pm

    Excellent points, as always! The only problem I see is that the “bank auditor” proposal makes way too much sense for a broken institution like the federal government to ever implement.

    I am no expert but I fear we’re heading down a slippery slope with all of this government intervention. Analysts are saying that a $25 billion bailout of GM, Ford, and Chrysler is now virtually certain—even though it’s not being called a bailout and is cleverly disguised as an energy plan. The only thing that the money will do is delay the inevitable. And what’s next? Related to Professor Lucas’ point about evicting homeowners, when default rates rise—as they inevitably will—will Uncle Sam refuse to bail out companies that are the mainstays of Main Street after it has so eagerly bailed out Wall Street? Where will it draw the line?

    I think it’s ironic that China now allows short selling, while the guardian of capitalism—the good ole US of A—continues to add to the no short sale list. CVS Pharmacy was added to the list the other day! I didn’t think that CVS was a crucial puzzle piece of the U.S. financial complex, but perhaps I was absent the day we discussed that in my Kellogg class.

    I suggest us 30-somethings do the patriotic thing and start having lots of kids so that someone can pay for all of this debt we’re racking up…hey, that plan worked after World War II didn’t it?

  1. October 27, 2008 at 9:17 am
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