by Ken Houghton
I don’t believe David Leonhardt is an idiot, but that’s not based on the evidence at hand:
There are really only two [questions]: What steps are most likely to solve the immediate crisis? And how can the long-term cost to taxpayers be minimized?
Everything else — reducing executive pay on Wall Street, changing the bankruptcy laws, somehow slowing the descent of home prices — is either a detail or a distraction.
Let me say this slowly, so even a NYT reporter can understand it: If you are taking an equity stake in a firm, one factor is how much cash the firm will have on hand. Cash paid to executives is not cash on hand, nor can it be used to produce future capital, investments, and free cashflow, or even “the miracle of compound interest.” So executive pay is very much a factor in equity calculations.
Changing the bankruptcy laws is more tangential, but let’s again explain this slowly. Mortgage-backed securities are, well, backed by mortgages. Their value depends directly on those payments. If it becomes easier to workout a mortgage in bankruptcy court, the holders of those MBSes are liable to (1) receive a higher value and (2) know sooner how severely their securities are impaired. So changing the bankruptcy law will, again, make the value of the assets clearer sooner. Which is especially important if we’re all going to pretend that this thing is going away after two years.*
Slowing the descent of home prices—well, that’s a second-order effect, so I’ll agree with him there. Or at least let it ride.**
His next paragraph, however, is incomprehensible:
Usually, it would be easy enough to dismiss these sideshows as the inevitable gear-grinding of democracy. This is an extraordinary time, though. The credit markets are nearly dysfunctional, leaving the economy at risk of falling into a downturn unlike any most of us have lived through, and the government is about to commit billions of dollars after only a week of political debate. There’s no time to waste. [emphasis mine]
Let’s be clear: the government (meaning here the Executive Branch and the Federal Reserve, controlled and run by Republicans) has already committed billions of dollars over the past six months. Maybe $900,000,000,000. During the entire time of which, Mr. Paulson was (1) certain the crisis was over and (2) working on the
idiocy plan that he presented.
Leonhardt’s very next sentence undermines his previous paragraph.
The first thing to understand is that a bailout plan doesn’t have to cost anywhere close to $700 billion, so long as it’s designed well. [italics mine]
This is the plan that included absolute authority for the Secretary of the Treasury, and of which the Secretary of the Treasury said, “No, I’m not asking for absolute authority,” right? I would again invoke Daniel Davies’s Three Laws, but Leonhardt wants us to believe that this time will be different, if the plan is well-designed.***
Figuring out how much to pay for the assets is the first problem. The drop in house prices and rise in foreclosures have made it clear that these securities are worth considerably less than banks expected. But there is enormous uncertainty about how much less.
That’s why we have a market, no? (Clearly, the answer will be “no.”)
Based on the underlying fundamentals (like the current foreclosure rate and the one forecast for the future), many of the securities appear to be worth something on the order of 75 percent of their original value. But thanks to the fear now gripping the market — not necessarily an irrational fear, given that most forecasts have proven far too sunny over the last year — very, very few of those securities are trading hands. Among those that have, the sales price has been roughly 25 percent of the value. [I italicized, but he blocked it off in the first place; the bold is mine]
So the market has a price, but Mr. Leonhardt wants us to believe that these securities could be worth three times as much.
Assume I do. What should I be willing to pay for those securities? And what would I offer for them?
Now assume several of us believe that. What will be we do? Well, I’ll offer the current market price, Tom will offer 25.5, Robert will go 26, and pretty soon we’ll own all we want somewhere around 65.****
So where are the hedge funds and investment managers and new Vulture Funds? Who believes these securities are worth 75? Surely, they are willing to bid 25, 26, even 30. Mr. Leonhardt doesn’t tell us. In fact, the people who know the market best—Barack Obama’s classmate, Tom Marano, for instance—are retrenching, even after the first $900,000,000,000 in liquidity has been added.
Which price is the government going to pay?…[I]t probably can’t pay 25 cents. That might fail to fix the credit markets, because it would do relatively little to improve financial firms’ balance sheets. Firms might then remain unwilling to lend money to businesses and households, which is the whole problem the bailout is meant to solve.
Oh, wait. I thought that list of side considerations above were unimportant; now it turns out they’re “the whole problem the bailout is meant to solve.”
The most obvious solution is to pay more than 25 cents on the dollar and then demand something in return for the premium — namely, a stake in any firm that participates in the bailout. Congressional Democrats have been pushing for such a provision this week, and it’s one of the most important things they have done.
Well, that’s nice to know. Too bad it wasn’t in the original “well-designed” plan. I guess David Leonhardt believed Dick Fuld when he said he, er, gave at the office, too.
The government would then be accomplishing three things at once. First, it would take possession of the bad assets now causing a panic on Wall Street. Second, it would inject cash into the financial system and help shore up firms’ balance sheets (which some economists think is actually a bigger problem than the bad assets).
There’s a link to Krugman’s column on Monday omitted here. But let’s look at what Leonhardt has just done:
- He has admitted they are “bad assets,” while before they were just underpriced.
- He has declared that it would “inject cash into the financial system,” rather ignoring (again) the previous $900,000,000,000 than the Fed has “injected” in lieu of easing rates further.
- He has invoked “balance sheets,” for discussion of which I refer you to David Altig (h/t Felix)
But the best is yet to come.
And, third, it would go a long way toward minimizing the ultimate cost to taxpayers.
Overpayment is good because we’ll get more back. And I thought only Health Economics had an upward-sloping demand curve.
Why? The more that the government overpays for the assets, the larger the subsidy it’s providing to Wall Street — and the more it is pushing up the share prices of Wall Street firms. As Senator Jack Reed, Democrat of Rhode Island, notes, the equity stakes allow the government to recapture some of the subsidy down the road. It’s a self-correcting mechanism.
It’s a good thing Leonhardt opened his piece by noting that Congresscritters don’t know much about the financial markets, but, really, couldn’t we expect more from Economics writers?******
“Hey, Jack, if you pay me three times what this asset is worth in the market, I’ll give you an extra fifty cents six years from now.”
“Sounds like a great deal to me, Lloyd. And that writer in the Times thinks so too.”
So far, we have established that Paulson presented a plan that, if it had been well-designed, would be great. So who is at fault? Why, Congress, of course:
Instead of a laserlike focus on the big issues, though, Congress has been devoting a good chunk of energy to secondary matters. Some of the proposals, like changing bankruptcy rules to help some homeowners avoid foreclosure, are perfectly reasonable but just won’t do much to cure the credit markets. Others may not even meet that standard.
Let’s try this again. Homeowners who avoid foreclosure can, unlike those who don’t, pay their mortgage. Which monies flow to (wait for it) Mortgage-Backed Securities. Which then gain value and can be sold at a higher price. So, if you really want to reduce the cost of the bailout, keeping people out of foreclosure seems as if it would help. A lot more than seeing a stock price appreciate later, as was suggested
in that well-designed plan by Chris Dodd, Barack Obama, and Congress.
And then Leonhardt just outright jumps the shark:
One of the fashionable ideas of the week, supported by both Democratic leaders in Congress and John McCain, is to limit the pay of top executives at any Wall Street firm that sells assets to the government.
Not even CNN fell for that one completely, despite their idiotic headline:
“Contrary to the lies told by the McCain campaign, it was John McCain who followed Sen. Obama’s lead in laying out principles that call for strict oversight and accountability, protecting taxpayers and cracking down on CEO pay. We only wish he had adopted those same principles over the last 26 years rather than cheerleading for the deregulation agenda that helped produce today’s crisis and repeatedly opposing limitations on the obscene compensation given to failed CEOs.”
And it doesn’t take a long use of The Google (well, I just went to Brad DeLong’s site) to find, from Sunday night:
Rescue requires mutual responsibility. As taxpayers are asked to take extraordinary steps to protect our financial system, it is only appropriate to expect those institutions that benefit to help protect American homeowners and the American economy. We cannot underwrite continued irresponsibility, where CEOs cash in and our regulators look the other way. We cannot abet and reward the unconscionable practices that triggered this crisis. We have to end them. [italic mine]
That’s rather clear, no? Not to Leonhardt, who tries one last time:
And in a frenzied week, any time spent on talking about C.E.O. pay is time not spent on designing the toughest possible bailout package.
Give you a hint, David. Pass a large portion of the firm’s revenues to Dick Fuld or Hank Greenberg or Vikram Pandit and there won’t be any effing stock appreciation for you to claim to have “reduced the cost” in the end. Even the Chamber of Commerce knows this.
*Brought to you by the administration that expected its Iraq Adventure to last six days, maybe six weeks at most.
**In the context, I’m inclined to argue, under that same “two year” timeframe, that they should want to accelerate the decline in prices. As a current seller, I object, though.
***For starters, it was designed to be initiated and run by a man who is unlikely to be in that same position six months from now. That this might be an elementary design flaw seems to have escaped Mr. Leonhardt.
****The extra ten is because we are not so stupid as Mr. Leonhardt, on whom someone pulled “75” out of his backside. No, we bid 65 because we know there is substantial uncertainty in that “75,” and we pulled “65” out of our backside.*****
*****Robert is now trying to figure out a correlation matrix for this.
******Ben Stein and Robert Samuelson always excepted.