Saturday, October 4, 2008

Channeling the Bulk of Economists...

Alex at MR points out that many noted economists, from both sides of the aisle, do not support the Paulson Plan, which passed after the addition of many sweeteners

But, looking through the links, I see a serious misconception that could kill many ideas, and a fatally flawed assumption that would sink most of the others:

1. Krugman and his ilk appear to be ignoring the significant adverse selection process going on. He suggests that instead of purchasing assets, we should instead focus buy preferred stock. This gives us a permanent equity stake, acts directly on the balance sheet, and should even hurt stockholders. However, it does nothing to actually reveal which banks are exposed to bad debt, and which are solvent. That's the biggest problem we have in the financial sector right now: no one really wants to lend out money to someone who can't pay it back, and you don't know if the other guy can't pay it back if you don't know how many assets he has that are linked to the subprime market.

The Paulson plan, in theory, avoids this by buying up a lot of those assets, and creating a market for others to buy them (follow the leader, so to speak?). We can theoretically make money by paying the "Hold to maturity value." Bankers can't hold these assets to maturity because they have significant problems with upholding certain capital ratios: they will have to sell the bad assets at firesale prices.

That's the misconception

2. Because of that, a lot of economists, like Tyler Cowen, state that we need to figure out which banks are insolvent. The problem is that, even knowing which banks are insolvent won't actually help...hence the need for speed bankruptcy. A bank that goes through "speed bankruptcy" can have a payment plan forced down its throat and can force its creditors to accept it through the force of law, and have it done relatively fast: this means that someone new can take over the business, and market operations can return to normal.

The important bit is the "speed" part. Bankruptcy proceedings usually last a very, very long time, and, with all the complex derivatives, will likely take even longer for a modern bank. If you can't get a speed bankruptcy, we end up totally screwed, like in the LDC debt crisis: people fight for years over who gets what, and, in the meantime, the bank can't get capital. So, operations are hampered, and the economy suffers.

But, even if the "speed" part works, we will still have to wait for the banks to fail...even a failing one can keep itself afloat for a while, since not everyone knows that it is in danger and someone is still going to be do we solve that?

The Paulson plan, for all it's flaws, addresses those two fundamental concerns. It may not do anything, being a drop in an ocean of debt, but it's a lot better than nothing, and a lot better than most alternatives.


J Thomas said...

How about this idea -- take $700 billion and start up somewhere between 350 and 700 new banks.

Two billion dollars isn't a whole lot to start a bank on, but remember that they wouldn't have a lot of competition because nobody knows which of the old banks is in serious trouble. (Maybe they all are.) The new banks could turn over a whole lot of business, and if they particularly concentrate on the quick trades that are a big problem to have frozen up, they might make money pretty fast. And they can call on the Fed for liquidity, too.

And if people take assets out of old threatened banks and put them in the new banks? That's just fine! The new banks don't have an toxic waste, we know they're OK unless they do something stupid they haven't had a lot of time to do yet. They can use their new assets to generate even more liquidity. If this tends to drive the old banks into bankruptcy even faster, that's fine too. We don't need them.

And if an old bank is really solvent but people don't trust it because they don't know? Let it find a way to show the public that it's solvent after all, and it can join the new banks as a safe resource.

So, who should get to own the new banks? Tremendous room for profit there. How about having them be totally owned by the Social Security administration! If SS owned a few hundred successful banks it might very well wind up solvent when we need it to be.

So what does the Paulson plan do instead? As near as I can tell, he gets to buy toxic waste from his friends at whatever price they agree on, like maybe the highest value they could hope it could be worth if everything had gone well. And he can offer to buy toxic waste from nonfriends at whatever price he wants, maybe 10% of what they paid for it, and he can also demand equity. If they don't want to deal with him he doesn't lose by it. And Congress has "oversight" meaning they can make sure this is what he does and not something else like pocket the money.

If Bush came to you and said, "Give me $3500 so I can buy booze and cigarettes for my friends, no questions asked," would you do it?

Would you say "OK, here's your money, but I'm going to follow you around and make sure you only spend it on booze and cigarettes for your friends. No guns, no bombs, no kiddee porn, no cocaine, only booze and cigarettes"?

Robert said...

If the idea were somehow feasible, I would be all for it. The major difficulty would be the continuing meltdown of the banking industry, at least for a while, and the fact that "solvent" banks might not be able to effectively signal their solvency, short of spraying money around NYC. If signaling were that easy, then there wouldn't an adverse selection problem to begin with.

The second problem would be recruiting workers, capital, etc for the banks. Who gets ownership is actually a pretty big deal: having SS run the banks would...uhhh...well, let's just say I am not sure if a behemoth agency like that could make the transition easier. And if you want to recruit PRIVATE run right back into "no helping out the people that got us into this mess anyways!"

Then there's the issue of brand value and building trust...a lot of these companies have been around for a long time. Lehman, for instance, was around since before the Depression. That kind of brand equity can't be built up overnight.

Then there's the question of scale: can 300 small banks do the same job as one big bank?

And then there's the question of immediacy: most businesses do not turn a profit in the first few years, and we're going to be introducing these banks in a BAD time in the financial what are the chances they actually help?

It's an intriguing idea, I will say that. To say whether it would work for sure would require a lot more real-world experience than I presently have, though.

J Thomas said...

Robert, I can answer one of your questions. Right now nobody knows which banks are OK because they don't know which banks are carrying a lot of toxic waste, or which banks are carrying a lot of obligations from banks that have toxic waste, etc.

But brand new banks don't have any of that. So long as they do business with actual customers instead of collecting obligations from insolvent banks, that will stay true. They might lose money on brand new deals but they won't take on the unknown risks the old banks have unless they stupidly buy those risks.

And I can answer the third issue, about brand names and trust. Look around and see how much trust the old banks have. The credit industry has seized up because nobody has much trust in any of the old banks. Their brand name recognition is worth less than nothing.

And for the fourth question, 350 small banks can do a lot of the business that needs to be done. And they can grow. But if we just dump money into existing banks we still won't know whether we can trust them. Presumably the Treasury will choose to save some banks and choose to destroy others. Presumably it will try to save the strongest ones and then save progressively weaker ones down to the point it runs out of money. Who knows how many it can save that way? Or how long it will take to find out which ones it can save. My way we get 350 to 700 good banks right away.

I didn't suggest that SS should run the banks, I said it should *own* the banks. Currently most bank stockholders don't run banks, they just collect dividends. If we were to charter new banks we could, for example, put federal money into them and then auction off the stock to the highest bidders, and let the highest bidders collect dividends from then on. But why not instead give the profits to SS?

About turning a profit, right now there's such a problem of trust that business is not being done. If people trust the new banks (as they'd have every reason to) then the new banks would get all the business that was getting done. That's a powerful impetus to early profit, though in the short run they'd probably be investing their money back into the business.

You have a point about the start-up problems. We can't train efficient new bankers from scratch very easily, and yet the competent existing bankers are the ones who made the crisis. We could perhaps choose the best, by whatever standards we think are best, but that's another detail problem. "The devil is in the details."