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.

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Steve Randy Waldman — Wednesday September 24, 2008 at 6:56pm permalink
Todd_NYC (mail):
"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...the shrouded-in-shadows aspect more than anything else has me wondering whether this is still America.

Oh come on, where've you been the last seven years? "Shut Up and Trust Us" has been the motto for the Bush Administration since day one.
9.24.2008 8:42pm
From listening to the testimony, it sounds to me that under the Paulson plan, the government IS the market maker. They think that 1) price-setting for MBS is broken due to lack of information, and that as a result 2) MBS prices are unreasonably low. To the extent that the government can provide more information with which to value MBS, by holding reverse auctions and opening up the books to look at them, they think they can 1) bring buyers back to the market, and by doing so 2) raise the book value of MBS, which helps out everyone who holds them. No need for the government to pay the full "hold-to-maturity" price, just something above the current "fire sale price." Ironically, the fact that the government is giving cash to banks, which helps with their liquidity, is almost a side-effect; the real goal is to reboot the market. So if a private sector market maker emerges, all the better.
9.24.2008 9:14pm
Given that 700,000,000 is 5% of the market, then they are trying a "slap in the face" as Krugman has suggested and pointed out that: 1 that hasn't worked any other time they've tried it and 2 why does Paulson think he can value these securities better than the market.

A much cheaper design would be a three pronged approach.
1) liquidity - they already are doing that and could continue programs.
2) solvency - fund a FDIC like entity with 300,000,000 that does exactly what the FDIC does - shuts down under-capitalized financial institutions and finds a buyer at a price.
3) foreclosures - allow anyone in foreclosure of a primary residence to choose a government program that will attempt to write down and fix payments into something affordable. Gov't pays mortgage holder 50%.

Better results, much less taxpayer money, more transparent, etc.

UNLESS, hedge funds are part of the problem. Perhaps hedge funds are also now too important to be allowed to fail so Paulson has come up with this scheme. Admitting that Joe Taxpayer is going to be paying $2,000+ to bail out millionaire hedge fund investors (and many of them foreign) is a tough sell.

So, Treasury won't buy from hedge funds directly but there is nothing (in their proposal) preventing them from selling to a bank who sells it to Treasury.

If this is true, I would expect them to oppose an equity stake and probably oppose limits on executive compensation as that would break the plan.

If this fear is reality and we need to bail out significant portions of the international financial system, I don't think we can do it. Collapse may be unavoidable.

I hope I'm wrong and we may know by Friday. Most hedge funds meet redemption requests at the end of the quarter. The one hedge fund I'm familiar with has a cutoff of 1 pm on Thursday to make the request. They will be liquidating positions to meet their requests on Friday and Monday.
9.24.2008 10:42pm
Blissex (mail) (www):
«Given that 700,000,000 is 5% of the market, then they are trying a "slap in the face" as Krugman has suggested»

Ah but Paulson can put into operation a lot more than $700 billion, as that is the limit on the *losses* he makes; so he can use leverage in effect, and some people think that could be worth an intervention of around $2 trillion.

Also, that $700 billion is essentially money; injected in banks at the usual gearing ration of 15x of commercial banks (still a bit too high, not as ridiculous as investment bank 35x and GSE 100x), it means it can create around $10 trillion of new credit.

it is a pretty significant mule kick. Problem is that the capital destroyed in asset deflation is probably rather large than $700 billion and that's not sufficient at recapitalizing banks. Perhaps the best commercial banks.
9.25.2008 10:36am
Does anybody else think that Paulson's whole plan is structured for the purpose of not triggering credit default swaps? If the weaknesses do indeed arise from the gun to the head effect of credit default swaps, shouldn't this be publicly acknowledged at the same time that the plan is passed?
9.25.2008 12:42pm
Hey Steve,

Here's somebody who takes the opposite view to yours: kotlikoff.
9.25.2008 3:02pm
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