Recapitalization

Paul Krugman:

Uneasy feelings, by Paul Krugman: Details are scarce on the big buyout; but as a few dribble out, I’m getting uneasy.

Here’s the source of my uneasiness: the underlying premise behind the buyout seems, still, to be that this is mainly a liquidity problem. So if the government stands ready to buy securities at “fair value”, all will be well.

But it’s by no means clear that this is right. On one side, the government could all too easily end up paying more than the securities are worth — and if there isn’t some kind of mechanism for capturing windfalls, this could turn into a bailout of the stockholders at taxpayer expense.

On the other side, what if large parts of the financial sector are still underwater even if the assets are sold at “fair value”? Is there a provision for recapitalizing firms so they can keep on functioning?

Maybe the plan will look fine once we see the details. But while Paulson and Bernanke are a lot better than the people we might have had in there (thank you, Harriet Meiers!), their track record to date does not lead to the automatic conclusion that they know what they’re doing.

Dean Baker:

Questions on the Bush Bailout Package, by Dean Baker: The NYT missed the obvious questions with the Bush bailout proposal. The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won't get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so. ...

The other big question is: how will we get the banks to honestly describe the assets they throw into the auction? ...

Question II is directly related to question I, because a poorly designed auction system will be a fiasco, wasting taxpayers dollars and rewarding the most effective liars. If we have more time to design the auction system, then we can minimize this risk. There would be urgency if the auction system was the mechanism that would prevent the sort of freeze up of the financial system that we saw this week, however if the auction system will not accomplish this goal, then we can take the time necessary to get it right.

Here's a proposal. First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

For additional recapitalization, I would do something similar. Give the firms a zero or very low interest term loan and, in return, taxpayers get a share of future profits for a period of time, say another 25% (or whatever rate is appropriate, the rates could be set so that, even with expected defaults, taxpayers ought to make a profit). The firm pays back the zero interest loan in full and gives up a share of future profits.

The reason for doing it this way rather than through a private sector debt for equity swap is that we need to stop the crisis as soon as we can, sooner is better than later, and it may take too long if left to the usual procedures. Quoting Luigi Zingales with respect to debt for equity swaps (via a link at Marginal Revolution Marginal Revolution, and I should note that he is not in favor of the Paulson plan) :

So why is this well-established approach not used to solve the financial sectors current problems? The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury.

One of his worries is:

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.

Government intervention can make this happen faster and help with his first concern, and wouldn't profit sharing help with his second worry, that inflated prices will cost taxpayers money?

Would you support something like that? Better ideas?

Comments

[Bruce Wilder]

I'd also like to see some help directed to people, who are losing houses to foreclosure.

One simple approach would be to institutionalize the practice of people staying rent-free in a house destined for foreclosure. People do this anyway, and it gives households that have struggled against too large a mortgage payment a way to recover critical cash balances. If the government is buying up the bad mortgage, there is no reason why the defaulting "homeowner" should not get some small side-benefit.

[a]

It seems to me that you think fair value for taking toxic waste off the books and recapitalization is around 35% of equity. This is too low.

[Bruce Wilder]

One simple way of recapitalizing the banks would be to sell them to the Japanese, the Chinese and the Arabs.

I'm not saying that we ought to sell the banking industry to foreigners, but let's recognize that that is an alternative, here. One of the problems we are trying to solve is how to have a banking industry in a country with zero saving rate, without having that industry owned completely by foreigners.

The other problem -- and it is really a superset of the first problem -- that we will have to face is that if the dollar is to have a forex value sufficient to make Americans competitive exporters of goods and services other that military aircraft and bad entertainment, then we will also be making American assets of all kinds very cheap, for people, who have a lot of dollars and dollar securities that they do not have a real use for.

If the U.S. does not want to be selling its banking industry abroad, and does not want to see all manner of other productive resources and assets, then the U.S. will have to both generate its own positive saving rates and protect against foreign purchases of U.S. business assets.

[SanFranciscoJim]

At some point the government is going to end up owning a bunch of homes with no real idea of what do with them. We should think about that, as well, perhaps sell them back to people who are willing to put some "sweat equity" into fixing them back up.

[Oupoot]

I like the idea of Roubini on this http://www.rgemonitor.com/roubini-monitor/253653/we_need_a_new_holc_-_more_than_a_new_rtc_or_rfc-_to_provide_massive_debt_relief_to_the_household_sector_we_need_to_create_the_home_home_owners_mortgage_enterprise

But I'm not sure if it could be done as speedily as it is required. But the idea is simple enough.

[hari]

In a crisis of confidence - like this one - you simply can't deal with all and sundry policy priorities. You've to isolate and marginalize what's required to move forward and get the fiancial engine moving once again in full throttle - before you can daeal with *other* issues.

I recognize it sounds rather cold and pragmatic. But you simply can't do like the derivative deafult swaps did with their fraudulent slicing and dicing methods; toxic or not, the massacre is going to last a bit longer before it's over.
More banks will default and go under.

So, the priority, at the moment, is to get the engine throttle accelerate (again) to turn the blessed credit markets functioning again.

[gordon]

Song of the US Treasury

Give me your ruined, your poor,
Investment Bankers, yearning to be rich,
Who dream of being "triple-A" once more,
And call the US Government "their bitch";
I'll bail them out beside Hank Paulson's door.

[James Kroeger]

If time is the most important issue, and fairness a close second, then why wouldn't it be a good idea for Congress to simply create a Taxpayer's Bank that is fully capitalized and ready to provide the loans that are needed to keep the economy functioning while the mess is being straightened out? Wouldn't that take care of the most important concern---that money be available for firms that need to borrow at the same time that private banks are too afraid to lend?

And wouldn't that give us the time to follow the 'well-established approach' that Zingales refers to? (debt-for-equity swaps). My great fear is that the Bush administration is going to want to use the crisis to give away more free money to those who deserve it the least simply because we are 'running out of time.' Are there any other quick, simple approaches we could follow that would buy the time we need to do solve the crisis in a way that absolutely refuses to let the risk-takers profit from the situation?

[esb]

Fortunately, Nanci Pelosi has been advised (and understands) that the structure of the Paulson plan repesents a theft of the wealth of the people of the United States of America by a very, very, very small subset thereof.

Which means that next week will be, well, interesting.

[Michael McKinlay]

There is another problem ...

We are not yet half way through this housing crisis. Some securities are still behaving well but are soon to be junk as resets hit.

The subprime portion of the problem is roughly 50% , the rest of the bubble securities are set to start hitting the books next year and won't be done for 36 months after that !

I'm afraid the second tsunami of bad paper will sink the ship. The tax payers shouldn't own any part of it.

Here is the chart for home loan resets :

http://calculatedrisk.blogspot.com/2007/10/imf-mortgage-reset-chart.html

[Gavin]

The credit crises cannot be solved by just by paying market rate for bad mortgages. The investment banks have already had the option of selling their holdings for market rate for the past year and the fact that the crises is still ongoing implies that they haven’t liked the prices offered.

To solve this issue the government will have to pay more than market rate for the bad debt. In return the government should get stock options so it benefits from future upside.

But there is still one aspect Mark Thoma has not addressed in the current post. The future financial sector will be operating at lower leverage ratios at least for the next few years and will require shrinking in size. A few investment and commercial banks will have to be shut down.

[Farrar]

I second James Kroeger's motion -

"why wouldn't it be a good idea for Congress to simply create a Taxpayer's Bank that is fully capitalized and ready to provide the loans that are needed to keep the economy functioning"

with the following amendment: nationalization of the weakest elements of the commercial and investment banking system, which would become the core of the taxpayers bank

Setting up a new bank from scratch could not be done quickly or efficiently, but an existing organization infused with unlimited capital and clear objectives could hit the ground running within a week.

I have been suggesting for the last six months or more that nationalizing the banking system is the only fast and fair way out of this mess. Now we seem to be inching closer to that solution, altho we insist on calling it by other names.

Maybe now we can give up the idea of Rube Goldberg work arounds - such as Mark proposes - and face reality.

[supersaurus]

"...The government pays the firm a fair value for the assets..."

and how does one determine this "fair value"? if not what it can be sold for, then what? how much the bank wishes it was worth?

[gordon]

Once more, I see James Kroeger has come on board with the Commonwealth Bank of the United States, only he has a different name for it.

[Trust]

Whatever the details of the plan, it will have the essential form that our gov de facto borrows money from foreign govs/savers, and loans it out to domestic citizens. Since the loan is to the gov, the gov is responsible for repayment.

Foreign govs/savers no longer trust domestic citizens to repay, or domestic banks/shadow banks to broker sensible loans. That system is over unless trust is restored, and nothing substantial has been done to restore foreign trust in citizens/banks/shadow banks for the last year. To the contrary, super low down payment mortgages are still being brokered, despite the fact that they are used virtually nowhere else in the world due to unacceptable default rates.

[Blissex]

«Foreign govs/savers no longer trust domestic citizens to repay, or domestic banks/shadow banks to broker sensible loans.»

Even domestic ones, that's why Buffett and many others have been investing abroad, in what looks like a classic example of capital flight:

http://blogs.cfr.org/setser/2008/09/19/why-no-dollar-crisis-the-needed-flows-dont-show-up-in-the-tic-data/

and for one example look at the confidence of the USA middle class in their country's institutions:

http://women.timesonline.co.uk/tol/life_and_style/women/the_way_we_live/article4769062.ece
«One single mother I know - an American lawyer - took less than 24 hours to gather financial advice from her circle of well-informed City friends and move her UK cash into gilts, her US cash into Treasuries, her stock market holdings out of institutional titles and into her own name. There are plenty of e-mails circulating that advise friends to buy physical gold and silver; oil, gas and copper; notes of banks that cannot be allowed to fail; currency. Dump the US dollars as quick as you can. This kind of detailed advice makes plenty of people feel panicky. Moving assets fast means accepting the status quo and probably realising big losses. "Realise" is a good word. Most of us need to linger in disbelief for a while, or at least mull over what has happened.»

The problem with:

«That system is over unless trust is restored, and nothing substantial has been done to restore foreign trust in citizens/banks/shadow banks for the last year.»

is that it is difficult to achieve without a significant cut in the living standards of Usians, as they look at a drastic change in their implicit discount rate; even, and this is too terrible to consider, a cut in the living standards of the top 1%.

Anyhow, those foreigners that have been lending to the USA treasury for commercial instead of political reasons (bribing voters to elect Republican administrations) will soon learn not to trust it either, as the dollar may be let to fall sharply.

But the flow of funds numbers seem to show that private commercial investors are getting out of USA government debt even as politically motivated ones are stepping up their purchases.

[Blissex]

«wouldn't profit sharing help with his second worry, that inflated prices will cost taxpayers money?»

But the basic problem is that the afflicted institutions are deeply insolvent, that their capital has been wiped out.

Why ever would one want to share profits with ex-shareholders and executives that have no equity left in the business and created the problem in the first place?

Ah but those shareholders and executives have a lot of equity in the campaign funds of many politicians, so they cannot be ignored.

[James Kroeger]

...nationalization of the weakest elements of the commercial and investment banking system, which would become the core of the taxpayers bank. Setting up a new bank from scratch could not be done quickly or efficiently, but an existing organization infused with unlimited capital and clear objectives could hit the ground running within a week.Absolutely. The federal government should get into the banking business by buying the assets of a failed/failing bank and do it quickly...

[James Kroeger]

Whatever the details of the plan, it will have the essential form that our gov de facto borrows money from foreign govs/savers, and loans it out to domestic citizens...Of course, another option would be to collect the money needed for the bailout from the upper class through steeply progressive income taxes. They were, after all, the ones who benefited primarily from the wild casino and who will benefit primarily from the bailout. Besides, they are the only Americans who have any money for this OMG Crisis.

[Blissex]

«I'd also like to see some help directed to people, who are losing houses to foreclosure.»

These people have absolutely no excuses: they chose to buy at inflated prices, when they could have rented (for usually less), and even if they did not intend to speculate on equity appreciation (but that's ridiculous: of course they all wanted to get a huge capital gain), they did buy.

If subsidizing bankers and their shareholders with a bailout gives bad incentives, doing the same to smaller-scale "equity" holders is bad too.

«One simple approach would be to institutionalize the practice of people staying rent-free in a house destined for foreclosure.»

A different approach would be to sell those houses cheap to townships or local housing associations, who would then maintain them and rent them out. Giving people a legal right to rent-free occupation would have many bad consequences, like giving them no incentive to maintain the property and making it much more difficult to sell the house. Who would ever want to give up the right to rent a house for free?

Unfortunately selling the houses to townships and housing associations would mean increasing the number of people who rent and decreasing the number of people who "own", and it is well known that "owners" tend to be reliable Republican voters (or "blue dog" Democrats).

That would be considered a grave attack on the interests that sponsor the Republicans (and many Democrats).

[James Kroeger]

Once more, I see James Kroeger has come on board with the Commonwealth Bank of the United States, only he has a different name for it.I was not aware of your concept, but I'm glad to see we're both hot on the same idea. Hopefully there are some members of Congress who are also contemplating the same sort of thing.

Unfortunately, I get the impression that Mark Thoma fears he would be cast out of the economics profession if he were to even acknowledged that such an option was worthy of consideration...

[Trust]

"..is that it is difficult to achieve without a significant cut in the living standards of Usians, as they look at a drastic change in their implicit discount rate;"

You are right. Interest rates would have to rise to a level that pays for default risk, and down payments would have to rise to the standards of the rest of the world. This is politically unacceptable, so rates/standards stay so low that foreigners won't loan directly to citizens. The only way to keep the low rates/standards is for the gov to borrow the money, and loan it to citizens at politically acceptable rates/standards.

The old system is gone, and will not come back anytime soon. Loans with rates too low to cover default risk, and down payments out of step with the world standard, must be provided by the gov. Foreign lenders won't do it again anytime soon after being ripped off so egregiously.

[Concerned Citizen]

Please use this weekend to write to your local Congressional representative and Senators letting them know how you feel about this bailout.

[Trust]

"Of course, another option would be to collect the money needed for the bailout from the upper class through steeply progressive income taxes."

That would be nice, but is unfortunately unlikely. Standard procedure is to borrow from overseas, supplemented by regressively extracting forced savings from the lower 90% via uncompensated money expansion driven inflation.

[Blissex]

«Standard procedure is to borrow from overseas, supplemented by regressively extracting forced savings from the lower 90% via uncompensated money expansion driven inflation.»

Expect also a steep increase in sales taxes and other local taxes (as local budgets shrink and federal transfers to states shrink), progressive income tax cuts "to incentivize productivity", and large reductions in the provision of government programmes that mostly benefit the mass of citizens.

[save_the_rustbelt]

From an accounting and from a property management perspective this could be a nightmare.

I suggest the banks be responsible for maintenance and insurance on any empty properties they unload for up to a year.

"Fair value" is really fuzzy when dealing with huge amounts of wasted properties.

Claims on future profits would need to be structured very carefully, not an easy task.

One thought, some urban areas are going to have huge concentrations of bad properties, and probably concentrations of unemployment, we should be able to target something to those areas. Any thoughts?

[Trust]

"Expect also a steep increase in sales taxes and other local taxes..."

Yes, this seems likely.

[Blissex]

«"Fair value" is really fuzzy when dealing with huge amounts of wasted properties.»

It is not a fuzzy concept at all when the people assessing are (or will be nominated by) those who have received from the sellers a stream of generous campaign contributions.

As used by Paulson, "fair value" can only mean only "way above market value", because he mantains that market values have been artificially depressed by lack of liquidity (despite providing several hundred billions dollars of extra liquidity at low, low prices).

«Claims on future profits would need to be structured very carefully, not an easy task.»

Well, what about outright ownership? Doesn't that solve the problem?

If it is instead claims over part of the profits from property owned by someone else, why is that someone else still "owning" that property, if they have zero equity in it?

[jm]

...in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years,...

This is very naive. Accounting firms would be generously rewarded for finding ways to ensure that no profits showed up on the books. Simultaneously, stock prices would be supported by making sure that the market knew the concealed profits were there, and executives would be paid huge bonuses for their contributions in the execution of this fraud. Indeed, huge payouts to executives would help to ensure there were no profits. Compensation consultants would assure anyone objecting that the huge payouts that they were vital to recruiting and retaining those brilliant and talented executives.

[jm]

Blissex wrote, "...they chose to buy at inflated prices, when they could have rented (for usually less)..."

Apparently true in some areas such as California, but not in other parts of the country. During the bubble years in the Chicago suburbs, very few decent single-family homes were available for rent -- flippers rehabbing them for later resale, or spec-builders tearing them down to throw up million-dollar McMansions, created a situation in which the only alternative to buying was to live in a 2-bedroom apartment. The teardowns decreased the amount of affordable housing on the market, both for rent and for sale, by decreasing the physical supply and setting asking prices for the available supply at what the flippers and spec-builders would pay.

When I considered selling my home and renting at bubble peak in 2005, only seven homes were listed for rent on the local MLS, none an attractive place to live. (Now there are 120, many very nice, and I sold last year at a decent but sub-bubble-peak price and am living in one.)

[save_the_rustbelt]

After listening to the morning cable news it sounds like the student loan market is teetering if not collapsing.

This may be the next big emergency, although certainly smaller than this first mess, it could be really critical.

[Whatever]

These proposals are not going to solve anything. Homeowners are saddles with overpriced homes, and nowehere do I see any proposal on alleviating this problem. So what if you recapitalize banks - those loans are still there for the people who matter. They will still have to pay the mortgage, no?

Why not provide this 1T dollar as a loan at low rates for homeowners to refinance out of their toxic loans. If the homeoer is unable tomake the payments, take a equity stake in the home e government.

I predict that wall street will use this recapitalization to finance the next bubble in someting new - not mortgages for sure,not high tech. Maybe solar and wind?

[Blissex]

«Why not provide this 1T dollar as a loan at low rates for homeowners to refinance out of their toxic loans.»

This sounds like that you are talking your book :-).

The problem for most homeowners is not that the rates are too high -- they are not. It is that they borrowed too much to pay a price that was too high.

The problem is not that they are being strangled by a usurious interest rate on a 150k house that they bought for 150k; it is that they are enjoying pretty low rates on a $150k house that they bought for $500k, and they cannot afford even the low rates on $500k, which they paid only because they hoped to resell for $700k.

The other problem is that there is an overstock of around 3 million empty homes; 3 million homes that have been built but are not currently needed. Many of these are still on the books of developers, who got a lot of loans from banks too, not just mortgagees. Also that overstock of 3 million homes is going to depress house prices for a long time.

So there are very good reasons not to bail out mortgagees:

* Have mortgagees given to Congress more generous campaign donations than Wall Street or big corporates? No, and that should be enough of a reason; Usian politics is rather overtly pay-per-play, and nobody likes scroungers and freeriders.

* New buyers would have to be given the same treatment; why subsidize the mortages only of people who have already bought $150k houses for $500k? One would have also to subsidize the mortgages of people who would buy those houses from the current owners for at least $500k.

As to the latter point, that has what has been going on for the past 13 years: ever increasing asset prices due to ever decreasing mortgage costs.

At least if the USA bought outright those mortgages and houses and then leased them to townships and housing associations the whole chain of mad credit and mad prices would stop.

Anyhow, there is no way that people who would buy on credit $150k houses for $500k will escape unscathed, and if there were, it would be very bad, either a colossal depression or colossal inflation.

[bakho]

Insurance Payments

What we are looking at is buying insurance against a recession by "clearing the freeway of hurricane debris". Insurance comes with premiums. Who pays the premiums is a political question. Maybe the insurance premiums should be funded by higher capital gains taxes? or a financial transactions tax?

There is a huge opportunity cost from 8 years of Bush. First there is all the money totally wasted on the military and the Iraq War, Now there are billions going to financial bailout that should be spent on energy efficiency and alternatives.

Worst president ever.

[save_the_rustbelt]

Being an old timer, I seem to remember that down payment requirements for anything but the primary residence were higher than the typical 20% for a primary residence.

Could this stop the flippers? Or would it just wreck our ability to rehab and move properties into the rental market?

Damn, no easy answers.

[ddt]

Rescue Plan Seeks $700 Billion to Buy Bad Mortgages

By THE ASSOCIATED PRESS
Published: September 20, 2008
Filed at 10:30 a.m. ET

WASHINGTON (AP) -- The Bush administration is asking Congress to let the government buy $700 billion in toxic mortgages in the largest financial bailout since the Great Depression, according to a draft of the plan obtained Saturday by The Associated Press.

The plan would give the government broad power to buy the bad debt of any U.S. financial institution for the next two years. It would raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion to make room for the massive rescue. The proposal does not specify what the government would get in return from financial companies for the federal assistance.

''We're going to work with Congress to get a bill done quickly,'' President Bush said at the White House. Without discussing details of the plan, he said, ''This is a big package because it was a big problem.''

The White House and congressional leaders hoped the developing legislation could pass as early as next week.

Administration officials and members of Congress were to negotiate throughout the weekend. The plan is designed to let faltering financial institutions unload their bad debt on the government, and in turn the taxpayer, in a bid to avoid dire economic consequences.

Bush said he worried the financial troubles ''could ripple throughout'' the economy and affect average citizens. ''The risk of doing nothing far outweighs the risk of the package, and over time we're going to get a lot of the money back.''

He added, ''People are beginning to doubt our system, people were losing confidence and I understand it's important to have confidence in our financial system.''

''In my judgment, based upon the advice of a lot of people who know how markets work, this problem wasn't going to be contained to just the financial community,'' the president said. He said he was concerned about ''Main Street'' and that what happens on ''Wall Street'' affects ''Main Street.''

Democrats are insisting the rescue include mortgage help to let struggling homeowners avoid foreclosures. They also are also considering attaching additional middle-class assistance to the legislation despite a request from Bush to avoid adding controversial items that could delay action. An expansion of jobless benefits was one possibility.

Asked about the chances of adding such items, Bush sidestepped the question, saying only that now was not the time for political posturing. ''The cleaner the better,'' he said about legislation he hopes Congress sends back to him at the White House.

If passed by Congress, the plan would give the treasury secretary broad power to buy and sell the toxic mortgage-related assets without any additional involvement by lawmakers. The proposal, however, would require that the congressional committees with oversight on budget, tax and financial services issues be briefed within three months of the government's first use of the rescue power, and every six months after that.

In a briefing to lawmakers Friday, Paulson and Federal Reserve Chairman Ben Bernanke painted a grave picture of an economy on the edge of a major recession and telling them that action was urgent and imperative.

In a session with House Democrats, they described a plan where the government would in essence set up reverse auctions, putting up money for a class of distressed assets -- such as loans that are delinquent but not in default -- and financial institutions would compete for how little they would accept for the investments, said Rep. Brad Sherman, D-Calif., who participated in the conference call.

''You give them good cash; they give you the worst of the worst,'' Sherman said. A critic of the plan, he complained that Bush and his economic advisers were trying to panic lawmakers into rubber-stamping it.

Paulson said the new troubled-asset relief program must be large enough to have the necessary impact while protecting taxpayers as much as possible.

''I am convinced that this bold approach will cost American families far less than the alternative -- a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion,'' Paulson said. ''The financial security of all Americans ... depends on our ability to restore our financial institutions to a sound footing.''

Administration officials hoped the rescue plan could be finalized this weekend, to lend calm to Monday morning's market openings, said Keith Hennessey, the director of the president's economic council. The goal is to have something passed by Congress by the end of next week, when lawmakers recess for the elections.

[Blissex]

«Asked about the chances of adding such items, Bush sidestepped the question, saying only that now was not the time for political posturing. ''The cleaner the better,'' he said about legislation he hopes Congress sends back to him at the White House.»

Not only the can is being kicked down the road to after the November election, now the Democratic Congress is going to be blamed for any further problems if they don't write a blank cheque to the Republican campaign donor base, and blamed later for tax rises because of the blank cheque they wrote if they do.

I have to admire the effrontery and skill of the Republican machine and their strategy advisors.

[James Kroeger]

...uncompensated money expansion driven inflation.I'm not sure if you're aware of just how irrational this statement actually is.

The idea that money expansion driven inflation would be, or could be, uncompensated is simply not true. Many people make the mistake of assuming that wages can remain relatively stagnant during a period of robust inflation. Precisely the opposite is true. The only way it is possible for higher prices to hold over a period of time is if disposable incomes have also increased, enough to cover the additional cost. If at any time wages/compensation starts to fail to keep up with prices, then sellers will not be able to sell all they have and they will start to reduce prices. When that happens across the economy, you no longer have inflation.

In actual fact, moderate to robust inflation is relatively harmless to most consumers, since they are earning enough nominal income to purchase the nation's product. They do not lose that purchasing power. What the economy is able to produce is being purchased and consumed. That means that output, consumption, and investment are all optimized. Moderate to robust inflation just ain't the nightmare it's made out to be. The only people who have anything to worry about re: inflation are the masters of the financial sector, who have managed to ruin our capitalist economy with their laissez-faire philosophy and now they want us to bless them socialism for rich people.

[James Kroeger]

Uhh..."...bless them with socialism for rich people"

[roger]

Kroeger is right. Tragically right - tragically, because there isn't an element in the establishment at the moment who will stand up against the elite notion that the economy is for and by the upper class.

When people say it is a solvency problem, what they really mean is that the effect of amplifying income inequality over the past thirty years and using all the resources of the government to stamp out "wage inflation", ie the just distribution of productivity gains to the producers, is that households are not increasing their incomes as they did in the pre-70s days. But policy makers are pretending like they are. The bailout plan still pretends that the bottom 80 percent of the population will buy and sell houses at prices that are greater than they can afford. Are the politicians still that stupid? The government can buy a 300 thousand dollar house in Phoenix and hold it all it wants to, the number of buyers who can really afford a 300 thousand dollar house simply aren't enough to make up a healthy market. It is that simple. If the government spent its 700 billion dollars giving every household in America a 20,000 a year raise, well, then they could afford those houses. Otherwise, no.

The housing bubble, the easy credit bubble, and stagnant wages form the bermuda triangle of this economy, into which a trillion dollars is going to disappear. The United States of Denial strikes again.

[Organic George]

Disgorging

If a financial institution wants to sell their toxic financial instruments to the Fed the present and past senior executives and board members must give up their personal wealth
They looted the companies now they have to give it back to the taxpayers.

[Whatever]

My comments were semi-serious. semi because what the hell, if we are subisidizing one set of morons, do it for the others as well. But you are right, homeowners do not lobby, and they do not finance pols campaigns.

I also mentioned that just like AIG, the govt takes a financial stake in the homes. It can be arranged in such a way that most profits would go to the state rather than the homeowner - though the homeowner now escapes a default, gets to live in an oversize house and can get whatever he has put in back. That way new homeowners are not burdened, or responsible homeowners.

The current plan is treating the symptom. The housing markets will still drag us down. Unless homeowners are helped in a significant way, we are not excaping a recession or a depression.

[Julio]

James Kroger & gordon,

Glad to see you back plugging your excellent suggestion.

Blissex,
I remember a discussion with you several weeks or months ago where we agreed that nationalization was (unfortunately) out of the public discussion.
Maybe its time is coming...

[PghMIke]

James Kroeger points out something I've been wondering about. If the economy is threatened by the loss of loans to businesses, why not fund new purely commercial banks, instead of bailing out organizations that bought into bad investments. For that matter, there must be *some* solvent commercial banks that can fund normal businesses.

What, specifically, is the function provided only by those organizations made insolvent by their mortgage-based CDOs?

And why the rush? Japan ran for a decade in this mode -- while that's not advisable, neither is coming up with a new banking architecture in 4 days.

[Julio]

James Kroger, gordon,

Good to see you back plugging your excellent idea for a national bank.

Blissex,
Some time ago we had an exchange lamenting the fact that nationaliation was out of the political discourse. Maybe its time is coming?

[Julio]

James Kroger,

I'm with you on inflation.

I think there's an extraordinary confluence of events where inflation transfers money from the mortgage holders to the homeowners, but also puts money in the pockets of the mortgage holders by increasing the market value of their "toxic waste".

Who is left holding the bag? I'm not sure. Probably, a lot of it is foreign owners.

But, without a compensating program for e.g. retirees on fixed incomes, it will be a cruel transition.
So, a massive TIPS program for US residents and citizens? Or what? I'm totally over my head making proposals here, but something must be done.

[Blissex]

«I'm totally over my head making proposals here, but something must be done.»

I'll repeat my Modest Proposal for a MASSIVE TAX CUT on incomes above $100k, to be extended for example to a tax exemption on bonuses paid out by financial companies (retroactive of course), and a tax credit for incomes above $1m, to stimulate the most productive citizens to create more wealth. These measures will result in so much trickle down that it will fertilize America's economy out of this recession.

:-).

[donna]

I think they need to buy up some pizza chains with this money so we can all at least order free pizzas for our tax dollars.

Oh, and I want a pony, too.

[PghMIke]

One other question -- why buy *all* of a particular type of security -- why not only buy from those organizations (whatever they are) critical to the functioning of the economy, and require as a condition of sale that shares in the organization are turned over to the US government as well.

[Apprentice to Darth Holden]

No no no.

We bail these guys out, they are OURS. In perpetuity. None of this sharing profits crap. The profits are OURS. The taxpayers OWN these guys. Oh, and a GS4 has VETO power over any executive compensation packages. Golden Parachutes are a thing of the past, like buggy whips. Personal responiblity will no longer just be a thing for the serfs.

If they don't like these terms, tough. The Masters of the Universe had their shot.

[Trust]

"Many people make the mistake of assuming that wages can remain relatively stagnant during a period of robust inflation. Precisely the opposite is true. The only way it is possible for higher prices to hold over a period of time is if disposable incomes have also increased, enough to cover the additional cost."

While it is true that someone necessarily has to have the purchasing power to buy the goods, it is not true that the general worker has to inevitably wind up with this purchasing power. Real wages can remain stagnant, as long as the purchasing power is transferred to some other group. Under our system, those first in line to receive newly expanded money are the chosen group. The first in line gain the purchasing power that the general consumer loses.

[ken]

In the 1970 the federal government gave Urban Renewal block grants to cities to be used to buy up houses, renovate them, and sell them hoping to either recoup the cost or suffer at most a minor loss.

What happened instead was that the houses sat empty and derilict even under city ownership until the cities started to tear them all down leaving empy lots pocking our urban landscape.

Forget about the government buying up surplus houses now and trying to rent them out. Just tear them all down now.

Either that or open up immigration to anyone who buys a house for cash with deed restrictions that 1)that no loan can be taken out for five years, 2) house be owner occupied for five years and 3) owner provide insurance, pay taxes, upkeep etc and 4) if owner 'defaults' on any deed restriction the home can be 'foreclosed' and the property ownership transferred to the INS.

[Trust]

"The other problem is that there is an overstock of around 3 million empty homes; 3 million homes that have been built but are not currently needed."

There is an overstock of expensive McMansions. There is a serious shortage of inexpensive small homes.

[Blissex]

«We bail these guys out, they are OURS. In perpetuity. None of this sharing profits crap. The profits are OURS. The taxpayers OWN these guys.»

Brief introduction to power politics: if group A manages to extract a lot of money out of group B, that is evidence that group A has the political power to take that money from group B; group A *owns* group B.

In this case group A is a small group that has immense wealth, safely stored abroad, with foreign homes, who has sponsored/leases the lot of the Republicans and many Democrats, and group B is a lot of people who have voted for all of the above, out of fear or greed, and who have likely made no campaign donations (only 5% of voters do, the richest 5%). Guess who owns whom.

[JeffF]

It seems to me that any deal with banks, etc, should guarantee the government a profit eventually if the saved institution survives. So the 10% of profits a year for ten years can be a minimum, but the term and potentially the rate should be extendable for as long as it takes the government to come out some percentage ahead on the deal.

[Stuart Eugene Thiel]

Here's a proposal. First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

Don't peg anything to profits. Profits are a shell game. Eventually, of course, a corporation must account for its long-term profit, but in any given quarter or year, or if the corporation has significant assets shared by different lines of business, or if it owns subsidiaries in other nations, profits will evaporate in precisely the year that the government comes to collect. In most years, one of the top three issues in U.S. Tax Court litigation is the profitability of corporations, mostly pissant little closely-held entities, that like to pay their owner-operator in salary or dividends according not to accounting principles, but according to the overall tax consequences. (BTW, this is illegal.) And that's at the bottom; imagine what creative accounting they can do in the Fortune 500.

If true (I don't know), here's a story that will cure you of ever, ever, bargaining for a cut of the profits: James Garner, star of The Rockford Files, had negotiated a deal by which he was to receive a cut of the profits of the show. Lo, when the bookkeeping was done it turned out that Rockford, one of the most popular shows ever, made zero profit.

[Bruce Wilder]

Crises are destructive, and policy wisdom consists in focusing that destruction, not in preventing it altogether.

Some thing about the status quo ante did not work. Restoring the status quo ante without judicious strategic alteration will just invite a larger crisis next time.

The distinction between "liquidity crisis" and "solvency crisis" is really a statement about the observor's strategic discretion regarding the scope and urgency of fundamental reform, an indicator of what the observor thinks the evident defect in the status quo ante is. "Not serious at all" is a "liquidity" problem; and restoring the "status quo ante" with only minor alterations is perfectly sensible. Ex: The financial world would work just fine without LTCM, so let it -- move on.

The scale of the present crisis, and the long anticipation of an unhappy ending to many unsustainable trends of recent years, makes it so obviously "a solvency crisis" that it may be hard to imagine that others think otherwise. But, if we were to have an open discussion of just what the fundamental defects of the status quo ante might be, I expect we would hear some pretty bizarre accounts. (Yes, Alex Tabbarok, I am looking to you, to amuse and alarm me.)

Ben Bernanke wrote a scholarly account of monetary policy before the Great Depression, which argued, in effect, that that was a "liquidity problem". If anyone could look at the financial and economic structures of the 1920's, and the scale and scope of their collapse, and think that that system could go on, as it was, with just some timely, albeit possibly massive, liquidity injections, well . . .

Right now, the crisis is being managed by Bernanke and Paulson, two reactionary conservatives, who are really invested in the idea that the status quo ante worked really well. (As Blissex and others have argued in comments, it did work really well, for some people, notably including Paulson.)

For people not deeply invested in specific ideas and institutions, it is pretty easy to imagine that great crises might shake the faith. But, that's not a realistic appraisal of human psychology. Whatever the logical structure of shared ideas, the secret, psychological structure of private beliefs tends to favor the interpretation of all new data as confirming prior beliefs.

It may be a trifle unfair and unsporting to observe that Hank Paulson is a Christian Scientist. Some of my relatives, and my boss for many years -- a fine individual -- have been Christian Scientists, and I mean no disrespect, but it is a religious identity that relies on a psychology that is both open to persuasion and resistant to it. It believes very much in the power of persuasion, and the virtues of being persuaded, but, also, commits itself against admitting to consciousness a very common, mechanistic view of how the world works.

I wonder if either Paulson or Bernanke will be an Obama voter. If I knew that either was, as one should expect, a committed McCain voter, how would that darken my view of them as well-informed, responsible adults? I don't mean to completely trivialize the issues of the financial crisis, but, really, how sensible and responsible am I really justified in believing these two humans are? I want to trust them. And, I know that this is a common sentiment in crisis. The New York Times, I note, is supplying propaganda this morning to the effect that there are no ideologues in foxholes (quoting Bernanke, himself), in a profile of Bernanke and Paulson, which is full of reassuring praise for both. (That's where I got the tidbit that Paulson is a teetotalling Christian Scientist; no hint that Christian Science involves something other than being abstemious.)

In blog comments, but not so much in our mainstream media, I see the recognition that the financial services industry must be reformed and must shrink substantially. Mindlessly, trying to prevent large-scale destruction, is not going to be productive in the long-run. And, although the task of detailed regulatory policy reform might, logically, be put off, there's no merit in the idea that the destruction of corporate businesses can be put off.

It is not good policy to rescue WaMu, if WaMu has to go out of business as the banking and financial services sector shrinks from 20% of the economy to 10%. They will just have to fail and go out of business a second time.

This is where I am puzzled. If this is a "solvency crisis" then destruction is the order of the day. The sector has to shrink, give up resources; businesses have to dissolve. I can accept that comprehensive policy reform has to be put off, but I don't see how the shrinkage of the sector and the destruction of businesses can be usefully put off. A "solvency crisis" cannot be resolved without liquidation, in some form. One wants it to be as orderly as possible, with as little collateral damage as possible. But, putting it off, or attempting to restore a dysfunctional status quo ante without alteration is just asking to go thru all of this a second time.

Is that we are doing?

[Julio]

Blissex,

You underestimate your own proposal.

The Unearned Income Tax Credit would also add transparency to the system. Just think, all those fat cats saying "I made 400 million in bonuses last year, but I only earned $100,000, the rest was unearned".

[Blissex]

«But, putting it off, or attempting to restore a dysfunctional status quo ante without alteration is just asking to go thru all of this a second time.
Is that we are doing?»

Depends on the who is «we»... The administration is doing whatever it takes to win the election or cause trouble to Obama if he is elected instead.

The precedents are that a system that has worked so well for 15 years has been repeatedly bailed out with ever large injections of liquidity. So this looks like a tempting option now. Problem is, Bernanke and Paulson probably realize this time the problem is so big that it cannot be solved that way. Or perhaps they hope that the "laissez fairy", which is actually the Chinese Communist Party, will continue to bail them out as long as they continue to export American jobs to China.

Many Democrats are on board too of course.

Watch and see -- I doubt that one can predict what's going to happen, it all depends on politics and miscalculations.

[Anonymous]

I second the proposal for implementing a steeply progressive income tax. I want an aggressively progressive income tax PLUS even more aggressive taxes on financial sector bonuses (retroactive five years), an increase in the capital gains tax rate, federal property taxes on homes worth more than $2 million....

A girl can dream.

[Imelda Blahnik]

Some thoughts regarding these excellent points:

If this is a "solvency crisis" then destruction is the order of the day. The sector has to shrink, give up resources; businesses have to dissolve....A "solvency crisis" cannot be resolved without liquidation, in some form.

and

simply create a Taxpayer's Bank that is fully capitalized and ready to provide the loans that are needed to keep the economy functioning

This bailout, that is, this shift of wealth from taxpayers to Wall Street is being justified as necessary to keep the economy functioning. Credit markets have seized, no business wants to lend other businesses money, without credit businesses can't survive, etc., and for these reasons we must bail out Titans of Wall Street. But if the "real" economy is what we're trying to preserve, why bail out the financial services sector? Letting insolvent banks fail and setting up a Taxpayers' Bank seem more direct steps towards restoring faith in markets, which is inseparable from faith that assets are properly valued, and making sure the rest of the economy has access to the credit it needs to function.

[Blissex]

«In many past bailout the government has ended up making money. If they make money I don’t see a good reason for raising taxes to pay for something that’s already been paid for from internally generated funds gained through the sale of appreciated assets.»

That's a wonderful idea: let's have a huge series of bubbles over a business cycle of 10-15 years, where all the corporate interests make a lot of money, then they obligingly and helpfully bankrupt the system, and then the government makes money fixing it too.

Isn't that awesome? Better than the Goldilocks economy! You can make make both ways!

[sam]

i think professor roubini has it right!! please take a look. "So of the five possible uses of fiscal policy – income relief to households (the 2008 tax rebate), rescue/bailout of financial institutions (Bears Stearns, Fannie and Freddie, AIG), purchase of assets of failed institutions (an RTC-like institution), recapitalization of undercapitalized financial institutions (an RFC-like institution), government purchase of distressed mortgages to provide debt relief to households (an HOLC-like institution) – the last option is the most important and effective to resolve this severe financial and economic crisis. During the Great Depression the Home Owners’ Loan Corporation was create to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure. The HOLC bought mortgages for two year and managed such assets for 18 year at a relatively low fiscal cost (as the assets were bought at a discount and reducing the face value of the mortgages allowed home owners to avoid defaulting on the refinanced mortgages). A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced; thus it will be the macro equivalent of the “bad bank” that Lehman tried to create for its bad assets.

Creating a new HOLC mechanism is likely to be more effective than creating a new RTC (whose purpose was to buy and dispose over a number of years of the assets of already failed S&Ls): we need to provide debt reduction to households well before hundreds of banks failed as working out the bad assets only after banks have failed is costly. Certainly many insolvent banks will fail regardless of in this financial crisis; and once they do their bad assets can be transferred to the new HOLC to be rapidly worked out. But we don’t need an RTC that picks up the bad assets of failed banks and works them out after such banks have failed; the priority is to take off the balance sheet of distressed and/or potentially insolvent banks the bad assets and reduce their face value so as to avoid a tsunami of defaults, foreclosures and/or households walking away from their homes. Similarly having an HOLC is more important than creating an RFC (the institution that during the Great Depression injected public capital – in the form of preferred shares – into 4000 undercapitalized banks).

An RFC mechanism may be necessary once an HOLC is created "http://www.rgemonitor.com/roubini-monitor/253653/we_need_a_new_holc_-_more_than_a_new_rtc_or_rfc-_to_provide_massive_debt_relief_to_the_household_sector_we_need_to_create_the_home_home_owners_mortgage_enterprise

[SocraticGadfly]

I said this was potential trouble for a number of other reasons, more on the regulatory side than the financial side.

Bottom line: Congressional Dems are silent as lambs to the slaughter about new regulatory statutes, and new regulatory mandates.

Passive Pelosi™ and Land-Swap Harry Reid, I’ll give no more than 5 percent odds of them standing up to Paulson-Bermanke.

Bottom line is that this is a good reason to do three things:
1. Vote Green instead of continuing to support the duopoly;
2. Push for public financing of Congressional campaigns, including with third-party provisions;
3. Work on amending the body of the constitution to make us into a parliamentary government, as part of improving accountability.

Call me an idealist.

[Daniil]

Profits, if sharing has some % going to the government, will be zero.
You can't make big taxes for some firms, no taxes for others and expect the first ones to survive to pay smth back. So it should be a tax on the whole industry (and possibly a public takeover of the few most screwed up ones).

Ownership? Ok, they will just sell the good assets at 'fire sale' prices when times good are near to some newly setup entities and liquidate the firm.

Only ownership with control avoids that, aka nationalization.

Next best thing is to tax the whole industry with tax rates setup to depend on by how much housing prices do end up dropping.

[gordon]

Hey, with James Kroeger, Julio, roger, Imelda Blahnik and me all in agreement about a new bank for the real economy, I think we have the beginnings of a movement here!