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Thursday, October 16, 2008

Would the Paulson Plan Have Worked Six Months Ago?

Is this wrong? It's an email I sent awhile back:

...On the original Paulson plan, if it had been implemented last March (that's when I first proposed it, and similar proposals were floating around before that), then it effectively does recapitalize relative to today’s prices (and probably sets a floor higher than where we are now). So part of the problem is just waiting too long to put the plan in place. Many more banks were solvent at that time, and simple toxic asset removal might have been all that was needed in most cases. Maybe the government takes bigger losses since it would pay more for the assets - depends upon where the floor is in the alternative scenario so don’t know for sure - but doing the trade for toxic assets back then might have stopped much, much larger private sector problems later on and avoided the kinds of instability we are seeing lately. So it might have worked then, but not now.

The idea is that if the price of a distressed asset originally valued at 100 is 50 today, and the price was 75 back in March, then purchasing the asset back then with a haircut to, say, 60 would still have provided a capital injection of 10 relative to today's' price. Thus, implicitly, it is a capital infusion relative to where the price is today. In addition, removing the assets back then might have stopped prices from falling to 50, or even further, before stabilizing or turning around. And if the long-run price stabilizes at 60 or above, the taxpayers will get two benefits. One is to avoid a more severe downturn by stepping in early and removing the risky assets, and that benefit could be large, and the other is to potentially make money on the bailout. But even if there is a cost from the bailout, it has to be balanced against the benefit of having a smaller downturn in the real economy.

It seems, though, that within the window of time when the Paulson plan might work the problems in the financial sector and the real economy are not yet evident enough or severe enough to provide the political will for its implementation. By the time things get that far, simple asset removal is no longer enough because the domino effect associated with a fall in prices brings about more and more insolvency, and recapitalization is also required.

Update: Free Exchange comments on this post:

...I believe he is correct about this (and about the subsequent point that it would have been politically difficult to accomplish this before the fallout from Lehman's failure). But another point is that general solvency fears six months ago were significantly different than they are now, when virtually every financial stock has been beaten to within an inch of its life. Had the Treasury begun buying assets back then, presumably establishing something like a market price for various securities, then in all probability some institutions would very quickly have been exposed as insolvent...

    Posted by on Thursday, October 16, 2008 at 12:15 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (25)

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