Why the GOP Plan Won't Work
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Why the GOP Plan Won't Work
House Republicans would create a new batch of AIG-type debt.
Posted Friday, September 26, 2008 - 11:00am
The Republican points are to be expected. They emphasize free-market principles, smaller government regulation, and less of a burden on the taxpayer. But creating new AIGs could lead to something just as ugly with the original AIG. And that means it could lead to more bailouts-the government-funded kind.
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Where does John McCain stand on all this? Amazingly, we still don't know, and McCain still won't say. Two days after he suspended his campaign, three days after he admitted to not having read Paulson's three-page bailout plan, and four days after Harry Reid said John McCain was going to come out for the bailout, we still do not know what plan McCain favors, what plan(s) he'll vote for, or his reasoning behind supporting one plan or another.
(Photo of House Minority Leader John Boehner (R-OH) by Max Whittaker/Getty Image}
(Photo of Capitol by Mark Wilson/Getty Images)
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(Photo of House Minority Leader John Boehner (R-OH) by Max Whittaker/Getty Images)
Comments
Paulson's bailout won't work either
The core issue is price discovery. In principle, we're trying to find a way to show the financial industry what these assets are actually worth.
The problems with this are many, but the major obstacle is that the actual value of the MBS depend on the future: they depend on how many people lose their jobs, how fast house prices decline, etc...
Dealing with the future is relatively simple in finance - you use models to evaluate different scenarios and you come up with a range of values, depending on your input assumptions. When banks use similar assumptions in a stable environment, these prices are close together and trades happen freely. The problem is that there are no models that deal with extreme conditions, such as those that prevail now, and existing models lead to wildly varying values. That is why these securities are not tradeable.
Holding an auction, any kind of auction, is extremely unlikely to bring the banks' assumptions together. Especially not if it's a fast process, with no time to second-guess, recalculate and triple-check. What it will discover is how much pain each company is willing to go through in order to be rid of its MBS (and anything else the Treasury is willing to buy). This will depend more on their balance sheets that on the perceived value of these assets.
Ideally the financial sector wants to get rid of all MBS - about 5 trillion dollar of it. Unfortunately, that stingy Treasury only wants to spend 700 billion on this. Unless the Treasury ends up buying MBS at 14 cents to the dollar, it can't buy up all this debt, and if it did, the financial sector would have to write down a whopping 4.3 trillion dollars. At once. That would be financial Armageddon.
So we have to hope that the assets get sold to the Treasury at close to nominal value. That would not cause huge writedowns in the industry. But it is unlikely to happen in an auction. Too many institutes will be happy to take the maximum losses they can stomach in order to get rid of these assets. It will be a race to the bottom, not a price discovery. And it will leave taxpayer with assets that are likely to be severely overvalued. If this scenario happens, the auction was likely rigged and the result will not be a reliable price.
What we will end up is something in between. Perhaps the Treasury gets the bonds at 50 cents to the dollar. That means that the financial sector has to write down 700 billion dollar too. Pronto. That's gonna hurt, but it will still leave 3.6 trillion dollar of MBS in the financial sector. If that is marked to market (some in the financial sector resist this, but then what is the point of the price discovery exercise), another 1.8 trillion dollar will have to be written down. Painful, but will the financial companies believe that this is a correct price for these assets, and therefor start trading them again? Un-blooming-likely. Those institutions left standing will still want to be rid of these assets until the broader economy stabilizes.
A few comments
Personally, I think the author overstates his case on a few points.
First, if the House Rep list of principles is "more primordial soup, rather than legislation," what can we conclude about Paulson's three page long bill? In terms of substance, I'm not quite sure that there is a lot of daylight there.
Second, the author implies that since the assets which would be insured have already failed, we might as well proceed directly to acquiring the securities. However, a rather significant chunk of the 700 Billion actually involves securities packaging mortgages which remain solvent. So, it isn't clear that the government would necessarily end up paying out on the insurance - and the cap would be somewhere at or below the 700 Billion. The question is "What kind of guarantees are sufficient to restore the liquidity of the credit markets?"
Third, while the Paulson plan does propose a reverse auction of the assets as a means of "valuing" them, my understanding is that such an auction would take place after the government had already acquired them (could there be any other way of inducing such an auction?) So, the Paulson plan doesn't solve the valuation problem, it simply forces the Government to bear the risk.
Fourth, the initial efforts to save AIG discussed above failed because there was no government guarantee. So, the comparison with what happened with AIG is just specious.
Fifth, House Republicans do, in fact, make some provisions for disclosure of what's hiding in each box of mortgaged-backed securities, so that the valuation process can move forward, and the liquidity of the credit markets restored. And, their approach probably would be as effective and efficient as anything in the Paulson plan.
Solving the "pricing" problem which has arisen because the credit markets have become a "market for lemons" is at the core of any solution to this problem. Focusing on solutions which are expeditious, efficient, and effective are the key to getting through this crisis - and it is simply incorrect to argue that there is that the Paulson plan and the House Republican proposal differ that much in their possibility for succeeding at a reasonable cost.
While the Paulson Plan may have a greater likelihood of succeeding, the cost will be at great, and the potential downside, if it fails, will be much more significant - so significant that there probably would not be a second chance. There is some possibility that the House Republican approach would not completely solve the problem, but we would probably still have options if it didn't.
It's obvious
The Rs in marginal seats are desperately trying to save their bacon, and John McCain didn't do anybody any good (especially himself) by having Bush manage a photo op for the bailout package. McCain's presence inspired a Republican revolt, and McCain is the little man on the wedding cake in the whole mess.
If the Congress is going to pass the bailout package before Monday night (and they will) it will be necessary for the panicky Rs to get some fig leaves into the package that can assuage them enough to allow for a majority of Republicans to sign off on the legislation. Not only will the whole world end if there isn't enough Republican support, but more importantly to the balky Rs, this will maximize their chances for reelection if they claim they held tough against the "special interests" to get their little pieces of the pie.
The only wrangling going on right now in the smoke filled rooms of Congress is which pieces of Republican fig leaves will be included as earmarks on the bill.
Speaking of Political Theater
First, even if the actions by McCain and the House Republicans are a "stunt," the duplicity involved would pale in comparison with "offshore drilling bill that didn't allow any offshore drilling," proposed by the Democrats two weeks ago. Even their decision to let the current ban expire isn't really what it seems because I imagine they'll take the issue up again after the election occurs.
Second, given that whoever gets elected President a few weeks from now is going to be on the hook for whatever passes, I guess I would like that person in the room when the decision is made - just so they'll understand what the Country has committed itself to. And, I hope they would want to be in that room, even if their expertise does not lie in this area. After all, given the track record the Democrats' expert, Barney Frank, has built on this issue, could either one of the nominees do any worse than the Honorable Member from Massachusetts?