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
Steve Randy Waldman — Sunday September 28, 2008 at 12:22am permalink
Lasse Enersen (mail):
Great letter. That's all I have to say.
9.28.2008 12:54am
Very good letter.

"the threat of disorderly bankruptcies" should be categorized and prioritized as a systemic risk. Whatever the outcome of the Paulson plan, lawmakers should next be working around the clock to deal with this one. They aren't do so right now, but they should be as the next step. Their work won't be finished after passing this weekend's legislation.

The problem from a pragmatic perspective is that the perception of this threat, which remains as a risk, will be diluted by the resolution of the current Paulson plan this weekend.
9.28.2008 8:35am
It is a great letter. When it comes to doing practical politics though, it is often about simple encapsulations.

The sentence that stands out most from Zinglaes might be: "As corporate finance experts have been saying for the last thirty years, there are real costs from having
too much debt and too little equity in the capital structure,"

So, in an encapsulation... Most wrong with the Paulson/Congress approach... We are still piling debt on debt (including gov't borrowing to pay for "loans" to Wall St. .etc) rather than working with real equity.

A few repetitions of the concept -- and maybe somebody would get (a part) of the idea.
9.28.2008 8:40am
In summary, I feel strongly that the proposal ideally should have been two-pronged:

a) A reworking of the Paulson plan, as is being done now, with immediate implementation
b) Dealing with the structural issue of solvency as per your letter, probably via targeted debt-equity swaps, with implementation ASAP

Among other things, this might have co-ordinated the mechanism for taxpayer equity participation through either or both.

The implementation could have been dual track, with dual oversight, and dual consideration of the weight accorded to either part of the program at any point in time.
9.28.2008 8:49am
Final point – the two components I defined as a) and b) above are positively correlated in the following sense: progress on liquidity induces progress on solvency, and vice versa. Work the problem from both sides.
9.28.2008 9:05am

Perhaps another idea might be to draft a letter in support of a Swedish approach to this problem, and circulate it to collect signatures from supportive economists. I know that Krugman, DeLong and Baker are already on board. There have also been a few articles in the NYT in support of a Swedish approach.

I wouldn't underestimate the reception that a Swedish plan would get if presented to the public by credible economists. It is obviously the best way to handle this. With Wall Street begging for $700 billion, the accusations of socialism would fall flat. I think you would be surprised at how good "nationalization" sounds these days, as opposed to "bailout".

Even as a statement-for-the-record, or a guideline for future bailouts, it would be good to have a joint statement issued stating that Swedish nationalization is the best option available.
9.28.2008 11:11am
Nemo (mail):
I read your opening paragraph and your closing paragraph and I cannot tell how you want them to vote.

Therefore, it is not a well-written letter.
9.28.2008 12:45pm
I would have to agree that this is poorly written. There is only bitternest and vindictiveness coming through, with a veiled threat.

I for one do not respond to threat.

That aside, all of what you want should be in the first and last sentence. Just what do you want the congress to do, why do you want it, and when do you want it?

Good luck. All economics is politics. Or did I get that backward?

9.28.2008 3:00pm
Benign Brodwicz (mail):
RGE Monitor has a summary of the plan, and at least equity participation and limits on executive comp are in there.

Gingrich is calling for Paulson to resign! I second!

Your letter is too long. They can handle about three sentences, things like "Lend the banks the money, and make them pay it back," and "If you pass Paulson's plan all you bums will be thrown out of office."

Congratulations on doing something. I use congress.org and the phone. I gave staff at my Senators' offices a piece of my mind this week, when I could get through.

There will be incredible blow-back from this that our probable President Obama will have to transmute into a new social contract. See also Ben Stein's column today.
9.28.2008 4:16pm
RueTheDay (mail):
Fed to get ability to pay interest on bank reserves as part of resue bill:


I was wondering when this one would come back to life.

This will start Oct 1. Just in time so that the Fed won't have to cut rates at the October meeting. They will be able to flood the market with reserves while maintaining their Fed Funds target.
9.28.2008 4:28pm
Peter Schaeffer (mail):
Kudos. By the way, letters like this have considerable impact. Far more than you might think. Considering who you are (doctoral student in finance), you will be amazed how interested your Representative is in your views. By contrast, Senators are further up the food chain. Your name had better be Krugman (or the like) to get their attention.

Get the schedule of where your Representative is meeting the public. Show up. He will be glad to speak with you in person. Once he finds out your background, your views will be of great interest.

Rememeber. One person acting out of conviction has the weight of one thousand following their interests. I think this is a quote from a 19th century anti-slavery activist.

Still true.
9.28.2008 11:43pm
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