Fed Watch: The Beginning of Another Wild Ride

Tim Duy is "less than enthusiastic" about the Paulson plan:

The Beginning of Another Wild Ride, by Tim Duy: The sheer amount of commentary over the weekend regarding US Treasury Secretary Hank Paulson’s first pass at an ultimate solution to the credit crisis is simply overwhelming. The response is, justifiably, less than enthusiastic. I can be counted among that group.

No one should expect that taxpayers will come away unharmed by a comprehensive solution. That said, the Paulson plan is a virtual giveaway to the financial industry. As commentators noted early on, the objective of any rescue effort needed to be the recapitalization of the financial community. This could not be done by acquiring weak assets at what was initially claimed to be “steep discounts.” The weakness was publicly revealed over the weekend, via an amazing transcript delivered by Yves Smith:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

Paulson is trying to swap $700 billion of US Treasury assets in return for $700 billion of assets valued what I suspect effectively amounts to their original value when the asset was created. Presumably, once this swap was complete and the questionable assets were purged from the system, financial institutions could raise any additional new capital needed via private sources. Such a swap would make sense if the assets the Treasury was purchasing could be sold back into the market at some future date at their purchase price. But no one actually believes this is possible; those assets will undoubtedly fetch less than their $700 billion purchase price, and the taxpayer will eat the difference.

Now, as I said earlier, the taxpayer should not expect to remain unharmed, but should expect to be compensated as much as possible (Mark Thoma notes that even if taxpayers were expected to break even, they still need to be compensated for the risk of harm). And it is on this point that the plan is woefully insufficient. See Steve Waldman at Interfluidity for a very nice, concise reaction to the deficiencies of the plan, with a variety of links. I don’t see how any plan can commence that does not include substantial equity dilution for existing shareholders of firms that transfer their bad assets to the government.

Perhaps, in the name of expediency, you are willing to accept the taxpayer burden implicit in the Paulson Plan. A rational justification can be made for quick action when faced with a complete collapse of the US financial sector. Indeed, the consequences for the taxpayer from inaction may greatly exceed that of even a poorly structured rescue effort that nonetheless begins the important task of recapitalizing the financial sector. But what cannot be accepted, under any circumstances, is this clause:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

That Paulson should even propose that he be given authority that supersedes all other should be grounds for demanding his resignation. I am not prepared to anoint Paulson or Federal Reserve Chairman Ben Bernanke or anyone to the position of economic dictator, regardless of the danger to the economy. How ironic would it be if the unbridled push toward free market capitalism brought about the same dictatorship via economic chaos that a worried Frederick Hayek opined would be the end result of socialism in The Road to Serfdom?

Congress is still mulling over the Paulson proposal. We can only hope that less economic dictatorship and more taxpayer upside emerge in the final document. The only sure thing is that the range of assets to be purchased will only increase. From Bloomberg:

Officials now propose buying what they term troubled assets, without specifying the type, according to a document obtained by Bloomberg News and confirmed by a congressional aide.

The change suggests the inclusion of instruments such as car and student loans, credit-card debt and any other troubled asset. That may force an eventual increase in the size of the package as Democrats and Republicans in Congress negotiate the final legislation with the Bush administration, analysts said.

Yes, Virginia, $700 billion is only the beginning. Will markets be willing to finance this debt? That remains the elephant in the room…if our foreign creditors finally balk at the never ending stream of debt they are expected to absorb, the consequences for Treasuries and the Dollar will be devastating as the financial crisis evolves into a balance of payments crisis. If, however, global policymakers maintain the current arrangements of Bretton Woods II, they will absorb the debt via an expansion of foreign central bank balance sheets – raising the specter of inflation at a time when all eyes are on deflation again. What a tangled web…one that I will be taking up later in the week.

The only thing to expect this week is the unexpected. Indeed, the surprises are already starting – tonight the Fed agreed to convert Morgan Stanley and Goldman Sachs to traditional bank holding companies. Wall Street as we knew it for generations is officially gone. I anticipate another rollercoaster week; time to buckle your seat belt and get ready for the ride.