Paul Krugman: Gone Baby Gone

Paul Krugman is unimpressed with Treasury Secretary Paulson’s rescue plan for financial markets:

Gone Baby Gone, by Paul Krugman, Commentary, NY Times: It pains me to say this, but this time Alan Greenspan is right about housing. ...[H]is latest pronouncement — that the market rescue plan being pushed by Henry Paulson, the Treasury secretary, is likely to make things worse rather than better — looks all too accurate.

To understand why, we need to talk about the nature of the mess. ... Today, when a bank makes a home loan, it ... quickly sells the mortgage off to financial engineers, who chop up, repackage and resell home loans pretty much the way supermarkets chop up, repackage and resell meat.

It’s a business model that depends on trust. You don’t know anything about the cows that contributed ... to your ... ground beef, so you have to trust the supermarket when it assures you that the beef is U.S.D.A. prime. You don’t know anything about the subprime mortgage loans that were sliced, diced and pureed to produce that mortgage-backed security, so you have to trust the seller — and the rating agency — when they assure you that it’s a AAA investment.

But in the case of housing-related investments, investors’ trust was betrayed. Supposedly safe investments suddenly turned into junk bonds when the housing bubble burst. ...

Thus, when two hedge funds run by Ralph Cioffi of Bear Stearns imploded last summer, it came as a huge shock to many investors, and helped trigger a market panic. ...

The funds borrowed huge amounts, and invested the proceeds in questionable mortgage-backed securities. Even worse, “more than 60 percent of their net worth was tied up in exotic securities whose reported value was estimated by Cioffi’s own team.” We’re profitable because we say we are — just trust us. That hasn’t ever caused problems, has it?

Stories like this have led to a crisis of confidence..., and ... people are parking their money in government debt because they don’t trust private borrowers. And the result is a shortage of liquidity — the ability to raise cash — that is greatly damaging the economy.

Which brings us to the rescue plan proposed by a group of large banks, with Mr. Paulson’s backing.

Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles” — basically hedge funds that borrow from the public and invest the proceeds in mortgage-backed securities. The new plan would create a “super-fund” ... which would seek to restore confidence by, um, borrowing from the public and investing the proceeds in mortgage-backed securities.

The plan, in other words, looks like an attempt to solve the problem with smoke and mirrors. ...

[T]he bursting of the housing bubble means that someone, somewhere, has to accept several trillion dollars in losses. A significant part of these losses will fall on mortgage-backed securities. And given this reality, the “conduit” looks like a really bad idea.

I’d put it like this: Investors aren’t putting their money to work because they don’t know where the bad debts are. And when investors need clarity, the last thing you want to be doing is pumping out more smoke.

Mr. Greenspan’s take ... seems broadly similar. “If you believe some form of artificial non-market force is propping up the market,” he said, “you don’t believe the market price has exhausted itself.”

Translated: this rescue scheme could be seen as an attempt to hide the bad debts everyone knows are out there, and as a result could delay any return of trust to the markets.

Alan Greenspan is making sense.