Going political

I really hate to disagree with Kevin Drum. He’s thoughtful, moderate, level-headed, smart. He’s the kind of guy who is, on balance, usually right. So, it makes me nervous to read his recent post, Pass the Effin Bill.

I don’t know if the financial universe will blow apart if Asian markets open tomorrow night and there is no bail-out in sight. I do know that the TED spread may not be telling us what we think it is, that the current proposal has almost nothing to do with the stressed out corporate paper market except via the catch-all term “confidence”, and that the timing of bank failures is largely at the discretion of the FDIC. I accept the principle that it is worth bearing significant costs to insure against even uncertain catastrophes, but other than cries of inchoate pain from anything labeled financial, I have yet to hear a compelling tale of why we should be confident that this expensive ounce of prevention will actually work. Hope is not a plan, and neither is discomfort.

Of course the people advocating the Paulson Plan have the capacity to create pain that might be perfectly avoidable. Yes that’s cynical. But that’s honestly where I am. Not only do I not have confidence in the solvency of the banking system, I don’t even have confidence that important players in both the public and private sectors wouldn’t use the tools at their disposal to create a little pain, until they bully the public into giving what they want. I know, I know, give me my tinfoil hat. But, if you believe the advocates of the Paulson Plan, major financial institutions would be insolvent if they marked their assets to current (um, “fire sale”) market bids. That’s not what their balance sheets say. If it’s true, investors and the public at large have been lied to for months by the leaders of the institutions to which we are expected to trust our life’s savings. And they want us to help cover that up. So, I’m cynical.

Anyway, for better or for worse, I was finally moved to do get political and write my representatives in Congress. I hope this was the right thing to do. For whatever it’s worth, here’s what I wrote:

September 27, 2008
To:	Representative Ben Chandler
Senator Jim Bunning
Senator Mitch McConnell
Re:	the “bail-out” (Fax transmission, 3 pages including this page.)

Like many voters, I feel helpless and angry as an astonishing bail-out of our corrupt and obsolete financial industry wends its way through the Congress. I am a new resident of Kentucky, have lived here for just over a year. The three of you are now my voice in Washington.

I am a doctoral student in finance at the University of Kentucky. I am not the world’s foremost expert in anything, but I am making the study of financial markets my vocation.

The legislation submitted by Secretary Paulson last weekend, if passed, would have been an astonishing arrogation of unchecked power. I fear for the United States of America that the proposal was even considered by the Congress, and described as “a good foundation” by Senator Schumer. After his crass attempt to assume near dictatorial power, I have lost my trust in Secretary Paulson. I believe this financial industry insider must be kept on a very tight leash for the few months he has left to help his friends and former colleagues on Wall Street.

I do, however, believe that we face a financial emergency, and that the Congress could play a constructive role in resolving the crisis in a manner that protects taxpayers and the general public and ensures that those responsible for our financial collapse bear most of the costs. I think there are two workable paths, one fully public and one fully private. I am open to both approaches. But I am adamantly opposed to a "public / private hybrid" solution, because frankly, I don’t think even our most well-intentioned public officials can avoid being milked and hoodwinked by the world’s greatest dealmakers. Either the Federal government should take over failing institutions, as it has taken over the insurance giant AIG, or the barrier between the public purse and the private banks should be made impermeable. The first thing that any legislative proposal should do is remove the gun that bankers currently hold to the head of our nation: the threat of disorderly bankruptcies. All systemically important financial firms should be subject to a controlled procedure in the event of insolvency, and should only have access to ordinary Chapter 11 reorganization or Chapter 7 liquidation after regulators have vouchsafed that such a filing would not imperil the nation’s financial system. Similarly, a petition by a creditor for involuntary bankruptcy should trigger the same regulatory review.

The Congress should choose either a private sector or public sector approach to managing the failure of systemically important firms. A private sector approach should follow the principles outlined by University of Chicago Professor Luigi Zingales. [See http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf] All of our financial firms are "asset rich" — they have plenty of money, it’s just that they have too much debt. They can be rendered liquid and solvent by requiring some creditors to accept equity in the firms in exchange for their debt claims. This is a perfectly fair outcome: People who lent these highly leveraged companies money knew or ought to have known they were taking a risk, and capitalism requires that lenders every bit as much as stockholders take responsibility for the soundness of the firms in which they invest. Unless these firms are quite profoundly insolvent, most creditors should take only a small haircut on the value of their debt, and could profit over time if the firms recover. Even the thorny issue of derivatives and other contingent liabilities can be addressed in this fashion: Firms that undergo a “fast-track reorganization” would be given the right to pay these obligations in the form of $1 par value preferred stock (the structure of which would have to be defined by Congress). Counterparties to derivatives transactions would undoubtedly prefer cold cash to company stock, but at least these contracts wouldn’t become fully worthless, as they would have under ordinary bankruptcy. Since counterparties would take only a haircut rather than a total loss, debt-to-equity conversions would help minimize the likelihood of cascading defaults on derivative contracts, the dreaded "CDS meltdown".

A public sector approach the problem would be to let the controlled failure of AIG serve as a model for systemically important financial firms. The banks that are today failing took on huge and foolish risks. (That "everyone was doing it" is a schoolboy’s excuse, not acceptable from people entrusted to manage trillions of other people’s money.) If as a consequence of their poor decisions, they now need money from the Federal government, we should demand that the taxpayer take effective ownership of the firm in exchange for the support. Regulators could then ensure a reorganization that promotes systemic stability while minimizing taxpayer costs, following which firms could be reprivatized in small, conservatively financed pieces that would no longer be "too big to fail".

Both the private sector and the public sector approaches presented here are workable, protect taxpayers’ interests, and avoid rewarding malefactors of great wealth with gargantuan public subsidies. The hybrid approach at the core of the Paulson Plan will result either in a serious cost to the taxpayers, or in future inflation as the Federal balance sheet is stretched to the breaking point and people lose confidence in US Treasury securities. (With a high enough rate of inflation, the Treasury can definitely turn a paper profit on any trash it buys from Wall Street, but that paper won’t be worth much. We could avoid a lot of foreclosures if we devalued the dollar by 50%.)

I am an independent voter. At the Presidential level, the Republican Party has already lost my vote. The last eight years have been catastrophic for the country, and accountability demands a change of party in the White House. At the Congressional level, however, my vote is up for grabs. Frankly, your response to the current financial crisis is my litmus test issue.

If there is any way I can be of service as you work through these difficult issues, I would be very honored to help. I thank you for your time and consideration.

/s Steve Waldman

Real capitalists nationalize

Brad DeLong made my day:

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

  • grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship

  • requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury

  • requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

  • grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

…It’s time for the Democrats to pass a nationalization in the taxpayers’ interest bill and dare Bush to veto it.

There’s a beautiful irony here. The superficially private-sector-friendly Paulson Plan is likely to entail socializing losses and undermining the incentives that give capitalism its efficacy and its legitimacy. Outright nationalization, on the other hand, may look like a Commie statist plot, but strengthens the “invisible hand” in the long run, as long as the nationalization is temporary.

To understand the paradox, go back to Zingales’ excellent essay. Under ordinary circumstances, when firms can’t manage their debt, Chapter 11 reorganization is an excellent means of preserving market discipline while preserving the “going concern” value of the enterprise. Unfortunately, bankruptcy is a slow and uncertain process. In the current crisis, the insolvent enterprises are so large, numerous, and interconnected that financial markets might self-destruct if we “let nature take its course”.

Temporary nationalization could serve as a kind of fast-track bankruptcy. Creditors, counterparties, and customers would have some certainty that firms in conservatorship would continue to function, and most could expect to be made whole (although the state could and should force haircuts or debt-to-equity conversions on the some junior claimants). Stockholders and incumbent management would be unceremoniously booted from nationalized firms, creating a strong incentive for companies to avoid the state’s tender mercies if at all possible.

Besides reassuring counterparties, nationalization provides an opportunity for the government to restructure firms prior to reprivatization with an eye towards reducing systemic risk. “Too big to fail” firms can be sold off in pieces, rather than merged into superbehemoths with a government-arranged subsidy, as is the current fashion.

Of course, nationalization does represent a “taking” by the government of private sector assets. The salutary effect with respect to market discipline has to be weighed against a corrosive effect on property rights. But if the terms under which firms can be nationalized are reasonable and carefully spelled out, especially if nationalizations generally occur where firms otherwise would have fallen into bankruptcy, the harm to property rights would be minimal. Also, procedures and timetables for reprivatizing or liquidating nationalized enterprises would have to be built into the plan.

Nationalization is a hard sell politically. Small government, free-market types naturally have a problem with the Feds coming in and taking over stuff. But counterintuitive though it may be, overt nationalization is more consistent with the principles of a free market than covert government subsidy. Real capitalists nationalize.

Update History:
  • 27-Sept-2008, 2:oo p.m. EDT: Changed “let nature taking its course” to “let nature take its course”. Fixed spelling of “mericies”.

Why did Friday come early this week?

Okay. So now I reveal myself for what I am. A conspiracy theorist, a nutcase, a crank.

But tell me, why did Friday come early this week?

Isn’t it a tradition for bank reorganizations to be announced after market close on Friday nights? Isn’t part of the reason for that to give markets time to chill out, think a bit, notice that the ATMs still work and the branches have not been demolished, to let the sun rise and shine for a whole two days, in order to diminish the possibility of people freaking out?

So, here is today’s news cycle. Red State Republicans react to a unprecedented popular outrage among their constituents and refuse to get with the program. It is leaked that President Bush solemnly opined, “If money isn’t loosened up, this sucker could go down.”

Was he standing at the teller window with a note about a bomb when he said that?

And, for good measure, the government announces “by far the largest bank failure in American history” with less than 16 hours to market open.

That loud noise, was that the sound of a single gunshot? Have the robbers killed a hostage, to show that they mean business?

Yes, the irony is delicious that Paulson’s plan has for the moment been scuttled by the ideologues that his party has cynically nurtured, by the base that the business wing of the party always thought they could play. And yes, the House Republicans’ alternatives, as reported by Justin Fox, are laughable.

But that doesn’t explain the sequence of events this evening. Nor does it excuse the fact, that if a legislative response to the crisis was so critical, a single deeply flawed proposal was thrown at the Congress a week before adjournment, under terms that basically said “pass this, or else”. It is surely coincidental that the plan was the most generous and least disruptive policy possible to industry from which Secretary Paulson hails.

No, I am a nutcase. These are all public servants doing their very best for the American people in a difficult situation. We need to pull together, rise above politics. Our leaders would never manipulate markets to frighten and punish the public so that we fall into line. That could never happen in the United States of America.

I am dark. Secretary Paulson could have offered any number of proposals to help ensure that this collapsing house of cards is a controlled demolition. He and Dr. Bernanke had months to put together policy options, long months between the fall of Bear and the fall of Lehman to create orderly processes for disorderly events they knew could come. At the last moment, they offered one option, a particularly unpersuasive plan imperiously presented as a fait accompli. When Congress balked, they relented and offered a few crumbs so that the people we elected could nibble at the edges without altering the core. And today, when it looks like those crumbs might not have been enough, we have the largest bank failure in American history, announced, oddly, on a Thursday night.

JPM, BOA, and Citi: The new big three

Manhattan, 2008 = Detroit, 1979?

How many of readers believe these behemoths, our new saviors, could survive the present crisis without unprecedented Fed liquidity support and the pending Treasury solvency infusion? What would have come of Citi and its famous SIVs had it been without a too big to fail option?

Now, after a series of deals, several of which involved the government stripping liabilities of and privatizing assets, these commercial bank holding companies are the new kings of Wall Street, the white knights of our financial crisis. What lessons have been learned? Is it better to be canny and prudent in business, or to have Robert Rubin on your board and Timothy Geithner in your rolodex?

Detroit’s big three had a near death experience, and learned that by working the government, they could survive and sometimes even prosper. Working the government meant especially throwing their very bigness around the political system to get subtle little perqs, twists and loopholes in, say, well-intentioned environmental regulations, to keep them going and give them an edge over far superior competitors elsewhere in the world. GM has got to be the most insolvent going public concern in the history of the world, with -$57B in shareholder equity, but the beat goes on, with $25B in new government loans to the big three currently in the pipeline (and $25B more demanded). Imagine an alternative history in which these firms had painfully reorganized in 1980, their plants and assets taken over by lean new competitors with the fear of death in ’em, desperate to learn from and best their rivals everywhere.

Barry Ritholtz is exactly right.

We now have a new big three, each intimately connected to the government monetary and regulatory establishment, and each profoundly too big to fail. They won’t abuse the that position, say, to strangle or absorb innovative competitors, would they? Cherish the thought. Thank goodness for the Borg. Who else could have eaten WaMu-Bear-CW-Merill? J.P. Morgan / Washington Mutual / Chase Manhattan/ Chemical Bank / Bear Stearns / Bank One / Manny Hanny, you’re my hero!

To those of us who do believe that, despite this decade’s toxic experiments, good financial innovation is not only possible, but desperately needed, this looks like the beginning of a new dark age. All the wrong lessons are being learned, as we muddle through an acute crisis by ratifying past idiocies, reinforcing ill-gotten inequalities, and consolidating where we ought to be cutting up.

All is not lost though! There is a scrappy new upstart to really shake up the Wall Street establishment! What was its name again? Oh, right. Goldman Sachs.

What was wrong with the AIG model?

I’m feeling unhelpful, because I’ve complained bitterly about the Paulson Plan and been cool towards the Dodd Plan, but my own suggestion was an obvious nonstarter. We mustn’t offend the delicate sensibilities of creditors, or God forbid give them a haircut. So, really, what would I suggest?

I wonder, what was wrong with the AIG / GSE model? The government has already published a pretty exhaustive list that includes the systemically important and potentially vulnerable financials along with many other firms — the “no short” list. Suppose Congress passed a law providing for fast-track reorganizations modeled on AIG. Firms on the “no short” list would be required to consult with the Treasury prior to any bankruptcy filing, and listed firms would be presumptively eligible for an AIG-style bailout. During an insolvency, the government would take warrants on 79.9% of firm stock, in exchange for a loan or preferred equity infusion sufficient to cover obligations to creditors during an orderly wind-down or reorganization. Existing management would be replaced, and government auditors would examine firm accounts to ensure that there were no “fraudulent transfers” precipitating the bail-out. Any such transfers discovered between the listing of the firm and the reorganization would be criminalized, and prosecuted vigorously. Listed firms would have a fiduciary obligation to the government as well as shareholders, such that “gambling for redemption” near insolvency would also place firm managers in criminal jeopardy.

Temporary routinization of AIG-style bailouts would put skittish creditors at ease. Although Treasury would retain the right to opt out and permit a traditional bankruptcy, the default course of action would make creditors whole. Equityholders and management of listed firms would have a strong incentive not to take the government up on the bail-out if they have any prudent means of avoiding it, since they would lose nearly everything. Taxpayers would own the firms they rescue, and would enjoy the upside of successful reorganizations or divestitures.

Like all the bailouts, this scheme rewards the moral hazard of creditors, and I hate that. There is the danger that it would not be temporary, and that promised regulation to restrain leverage would never materialize, leaving only a subsidy to future blackmailers. Still, I think it’s a lot better than silently and opaquely recapitalizing firms without replacing management or forcing at least shareholders to take a hit.

AIG-style bailouts would stigmatize firms that take advantage of them, as any form of bankruptcy does, but many firms do successfully reorganize from bankruptcy, and the stigma would be well deserved. The process would be transparent.

That many firms would not survive their brush with insolvency in anything like their original forms is an positive. I strongly agree with Barry Ritholtz, quoted in a piece by David Leonhardt:

If Chrysler had collapsed, [Ritholtz] argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.”

If we do end up with a gentle, behind-closed-door bailout of financials, I’m afraid that in twenty years, we may view lower Manhattan the same way we see Detroit today. What Wall Street needs is what it has delivered to so many other industries, a dose of Schumpterian creative destruction, to make room so that better things may rise up from the ashes.

p.s. I do hope to rise to Dani Rodrik’s challenge and be concrete about what “better things” might look like, but, alas, my bitter obsession with the looming bail-out takes priority.

p.p.s. Since the government has stormed the commanding heights anyway, does anybody else think it’d be a good idea for some bureaucrat to declare a ban on dividend payments for all firms on the “no short” list? This would have the effect of helping troubled firms preserve cash, while softening the hit individual firms would take if they announce dividends cuts. Firms on the list would have no choice, and only a small minority of “no short” firms are in crisis, so there should be no stigma.

Paulson’s vacuum cleaner?

Commenter “geee” asks a very good question:

[W]ould banks and other financial institutions be allowed to act as conduits to hedge funds selling these securities?

Given that Ben Bernanke has conceded that it is the government’s intention to purchases assets at a “hold-to-maturity” price rather than at a price near market bids, banks favored by Paulson could earn a nice living serving as a market-maker to any entity in the world holding bad paper. Bank buys “toxic” asset from hedge fund, individual, foreign government, whomever, for something above the market bid and then resells to Treasury for the “hold-to-maturity” price, earning a nice spread. All those “blockages” in the financial system might start flowing real fast, into as well as out of our poor sclerotic banks.

This adds to concerns expressed by others that banks would acquire bad mortgages and structure new assets eligible for “hold-to-maturity” sale. (The plans do have language specifying “originated on or before”, but it is ambiguous whether that refers to the mortgages or the securities that wrap them, and there is a big loophole, see below).

A related concern is that the Treasury would purchase assets that are simply inappropriate. Both the Paulson and Dodd plans now permit the purchase “any other financial instrument, as [the Treasury Secretary] determines necessary to promote financial market stability.” The term “financial instrument” covers a lot of ground. In particular, I am uncomfortable with the prospect that the Treasury might take over third parties’ contingent liabilities, as the Fed did when it acquired a book of derivatives from Bear Stearns. (The Fed is at least somewhat shielded from liability by its holding company, Maiden Lane LLC. As far as I know, the Treasury would not be.)

With all the world nervous about counterparty risk, having the US government become a “risk-free counterparty” would undoubtedly soothe nerves, but it could put tax-payers on the hook for indeterminate payouts in a bad scenario. Suppose a hedge fund or non-US insurer that has written a lot of CDS protection goes down, and the dreaded counterparty cascade does occur? I don’t think the Treasury should be in the business of trying to insure the 60+ trillion dollar CDS market. (Yes, that’s notional, but blown counterparties mean questionable netting, so liabilities in a bad scenario could become a significant fraction of notional even on a hedged book.) Nothing in either of the major proposals forbids the Treasury from going down that road, and there are all kinds of reasons, some public-spirited and some corrupt, why it might. There needs to be hard and fast language forbidding positions in financial instruments on which losses are not limited to the upfront cost of purchase.

I don’t mean these to be very constructive suggestions. I still don’t like either plan, though I’d much prefer Dodd to Paulson. But in any plan, there have to be controls on what sort of positions can be taken, including when the asset was last restructured, when ownership was most recently transferred, and that the Treasury’s liability must be strictly limited.

While I’m on this, I want offer a shout out to Calculated Risk for continuing to push on transparency. I cannot believe that the government may trade nearly a trillion dollars of assets on my behalf, and I may never learn exactly what it did. I would never invest in a “rocket science” hedge fund whose manager refused to disclose what he was up to. It looks like I may end up paying taxes to one. There is a lot about this plan that really has me angry, but the shrouded-in-shadows aspect more than anything else has me wondering whether this is still America. A Congressional oversight committee is not enough. Investors with 700 billion dollars under management at the very least deserve the frequent statements that any retail brokerage would issue, enumerating and detailing the performance of all assets transacted.

Eichengreen’s May Day Conjecture

This bit from Barry Eichengreen (ht Mark Thoma) is getting a lot of attention. (See, for example, Dani Rodrik.) Describing the “roots” of the current financial mess, he writes

In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers… In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

I want to push back on this a bit. I find it hard to believe that on Wall Street, there were these lucrative side businesses just waiting to be exploited, but investment bankers would have been content to ignore them if they had retained their thick commissions on stock trades. As a historical matter, I’m sure Eichengreen is right that May Day was a spur. But it’s a huge stretch to say that derivatives and originate-to-distribute wouldn’t have been discovered, grown, and grown massively, if only there hadn’t been a competitive squeeze on stockbroker profits.

Eichengreen’s story, taken naively, might lead to the suggestion that we give financial intermediaries cushy sinecures, because, if we don’t, we will have forced the poor dears to get creative and deploy financial weapons of mass destruction that destroy the world!

Financiers will destroy the world however much money you give them (it is never enough), if they have a profitable scheme for doing so and if they are not held back by regulation.

Financiers may also improve the world, in large and important ways, when they find profitable schemes for doing so. We want the financial community to innovate, we just don’t want them to innovate crappily. That means that, yes, we want regulators to have some veto power over their innovations. But a bad response to this crisis would be to suggest that today’s big names be given monopolistic cash cows so they can make lots of money running a museum of Wall Street, circa 1970.

Today’s big names deserve to be ripped apart. They should not be granted plush monopolies. Tomorrow’s big names deserve competition just as much as the next business. More so, actually. Finance should be rife with creative destruction to keep that market discipline vibe going… the “masters of the universe” must always be kept meek and terrified.

Finally, not all “financial innovation” is created alike. Collateralized, cleared, exchange-traded derivatives were a marvelous innovation. Letting poorly collateralized, opaque, nonstandard, eclectically-offset swaps grow into a large-scale financial instrument was idiotic, and was recognizably idiotic (which is why ISDA has had to work so hard and diligently to patch all the idiocies as they showed through the cracks). We desperately need good innovation, tools for intermediation that increase investor discrimination and decrease aggregate credit and counterparty risk. Sure, that’s precisely the opposite of what this decade’s signal innovations were all about. But developing a poison and developing the antidote are both innovation.


The following expands on ideas from a previous post, but is similar in spirit to a wonderful essay by Luigi Zingales (ht Tyler Cowen, Arnold Kling). If you have not read that, please do. I think it is the most important document to have arisen from this debate this far.

Rather than a bail-out, Congress should pass an “ARISE act”. ARISE would stand for Automatic Reorganization of Insolvent Systemically-important Enterprises. It could be very simple.

The Secretary of the Treasury, in consultation with the Chairman of the Federal Reserve and subject to judicial review, would declare certain firms systemically important according to criteria specified by the act. Those firms would be subject to a streamlined form of bankruptcy rather than ordinary Chapter 11 reorganization or Chapter 7 liquidation. The Treasury would compile a list of all systemically important firms, not just those considered to be imperiled, so inclusion would not signal any sort of distress. Should a systematically important firm find itself unable to meet its obligations, it would be subject to a very simple reorganization procedure: common and preferred equityholders would be wiped out (but would be given deep out-of-the-money warrants on stock of the restructured firm), a new class of $1 par value common equity would be established, which would replace existing debt claims dollar for dollar, until the resulting firm would be no more than 4x leveraged and can be certified as conservatively solvent and liquid by independent auditors. Junior debt would be swapped for equity before senior debt, and secured debt would become unsecured. All creditors would have the option of exchanging their debt for equity in the new firm. Further, reorganized firms would have the right to pay off unsecured contingent liabilities (including, for example, liabilities under derivative contracts) in stock at par value rather than in cash.

An intended “unanticipated consequence” of this proposal is that it would make the debt of firms that are potentially “systemically important” much more equity-like, long before any hint of financial distress or reorganization (and even before an explicit listing by the Treasury). That would raise the cost of capital for such firms, serving as a kind of a tax on scale and criticality. Leveraged firms that are “too big or interconnected to fail” create negative externalities for markets, taxpayers, and the public at large. Under the ARISE act, lenders would absorb some costs that the general public would otherwise bear, and would charge appropriately for the insurance. Firms that prefer inexpensive debt financing to the strategic options associated with scale can spin-off independently controlled entities as they grow.

Those who claim this would be a radical abrogation of contract should note that it would only be a change in the bankruptcy code, basically a new form of reorganization. Individuals have been subject to many retrospectively applicable changes in bankruptcy law over the years, and property rights have survived. This change would affect a very small fraction of firms (although a much larger fraction of debt, since it would predominantly affect very large firms).

See also: Mark Thoma, Willem Buiter


Okay. Let’s leave no room for ambiguity here. The Treasury’s draft plan for saving the world is breathtakingly awful. It would give the Secretary of the Treasury entirely unchecked discretion over up to 700B dollars. Even that “limit” has a loophole big enough that you could drive a truck through it, so the Secretary could in effect spend up to 1.8T dollars, right up to the newly raised Federal debt ceiling, without further Congressional action. This act would be such a wholesale delegation of the power of the purse that I wonder whether it is even constitutional. Of course, the act explicitly puts the Secretary’s actions beyond any judicial review, so perhaps questions of legality or constitutionality are merely academic. (Paul Campos shares these concerns.)

As Paul Krugman has pointed out, for the plan to help insolvent institutions, the Treasury would have to overpay for these assets. Yves Smith unearths an account that Secretary Paulson has acknowledged this fact in private, although he won’t cop to it on the Sunday talk shows. It is almost old-fashioned to raise questions about whether or not the former Wall Street banker will offer sweetheart deals to his industry (an industry that has harmed the American economy more deeply than most people realize). Just as big lies boldly asserted can trump plausible untruths nervously defended, overt corruption on a massive scale (but “in the public interest”) might leave a lot of naysayers dumbstruck. It becomes the way we do business. Of course, none of Dean Baker’s progressive conditions, none of Brad DeLong’s dealbreakers, not even my plea for a little transparency are incorporated into the proposal.

The oldest technique for the usurpation of power by the executive from the legislative is the manufacture of a state of emergency. That is not to say the present financial crisis is not actually an emergency. But the how the crisis is understood by legislators and the range of options by which it might be addressed have been set by Messrs Paulson and Bernanke. They have presented a single option, one more radical than seemed reasonable even at the height of the depression. (ht Brad DeLong)

It is worth noting that Paulson and Bernanke have thus far proven themselves to be capable technocrats. (Although, as Dean Baker points out, they’ve been awful prognosticators.) There’s a lot to disagree with in how the dynamic duo have handled the torrent of crises that began last August. But they have acted aggressively and creatively, and in their ad hoc interventions so far, they’ve gone to some lengths to create upside for taxpayers and to squeeze miscreants at least a bit. Until reading the text of the Treasury’s proposal and stewing on it overnight, I was inclined not to fight too hard. I saw things as I’m sure legislators see things: Something must be done, a megabailout is disagreeable and imperfect, but it’s something that we can do quickly, and it’s what our experts, whom we trust, recommend. Let’s fiddle at the margins to get it done as best we can.

But the proposed text flipped a switch in my brain. This is not, as Senator Schumer put it, “a good foundation of a plan that can stabilize markets quickly”. It is a raw arrogation of power. My trust, my willingness to extend the benefit of the doubt, has evaporated.

This is overreach. This is bad.

See also… Glenn Greenwald, John Hempton, Sebastian Mallaby, David Merkel, Robert Reich, among many, many others, I am sure.

For a contrary view, check out the always thoughtful knzn. I disagree pretty strongly, but he’s always worth reading.

FD: I am short broad stock indices, which seem to like the prospect of a bailout, so opposing the plan might seem self-interested. But I am longer precious metals and I’m short long-maturity Treasuries. My guess (and of course it is only a guess) is that those positions would do well under the plan.

Update History:
  • 21-Sept-2008, 9:15 p.m. EDT: Removed some ungrammatical excess words, an “on” and a “be do”, doo-be-doo-wah.

Truth & Reconciliation

I am not, on balance, a fan of the proposed megabailout of the financial system. But if it is going to happen, we should require at the very least this — that taxpayers learn immediately what assets they have purchased, from whom, and for how much.

We should tolerate no more of what the Fed did when it bailed out Bear Stearns’ creditors. Maiden Lane LLC sits opaque on the Fed’s balance sheet, hiding an unknowable book of derivatives and a portfolio of assets valued at about $29B, coincidentally almost exactly what the Fed kicked in to purchase them. If we are going to spend roughly a trillion dollars on assets that self-styled masters of the universe failed to value, we ought at least have the opportunity to take a crack at pricing them ourselves, especially once we’ve bought them. It will be essential to form opinions about whether the assets Secretary Paulson will purchase from his former colleagues are fairly priced. The possibility of chummy dealing, the near impossibility of avoiding it, is obvious.

Further, the word confidence keeps coming up, we must restore confidence in the American financial system. It is not enough that we hand over our money, we must hand over our trust as well. Surely, then, if this is a new era of trust, there should be no problem with requiring sellers to disclose at precisely what value the assets for sale had been booked on their financial statements, with criminal penalties for misstatement. We should be able to evaluate, in the light of day, how forthright financial institutions have been in representing their true condition to potential investors and the public-at-large. We may find that some have played things relatively straight, while others survived by sleight-of-hand and exaggeration. The former group will have earned our confidence. The latter will have earned something else.

This is not “a modest proposal”, presented in irony. If we are going to spend hundreds of billions of dollars, absolute transparency strikes me as a minimal prudential requirement. They say sunshine is the best disinfectant. I’m afraid there is a lot of rot in our financial system. It’s time to open up the windows wide.

Update History:
  • 20-Sept-2008, 5:30 p.m. EDT: Changed “to require” to “with requiring”.
  • 20-Sept-2008, 5:30 p.m. EDT: Changed “hundreds of trillions” to “hundreds of billions”. Many thanks to commenter Alan Brown!