Dean Baker Explains It All to You

UPDATE: Krugman comes to the same conclusions, more concisely. (That’s why he gets paid the big bucks.) And Brad DeLong has modified his original position to the point where it’s got a good chance of working going forward.

I started a “What is an Asset” post yesterday, which got sidetracked by Brad DeLong’s urging that the rewards for bad behavior be maintained while expecting a return to the “good” intertemporal equilibrium to be maintainable in the face of payoff-dominant strategies that, in his scenario, become equally risky and offer higher rewards.*

For those who want to see where the post would have gone, let us pull two comments from AnonCC to the fore:

“There are only a few problems, key of which is the title of this piece. Derivatives may have a value, but are they actually assets? Worse, if the Fed buys an asset, does it also have to buy all of the associated derivative contracts, one side of which may—by that simple—become worthless or become payable?”

This is precisely what really scares me about Paulson’s description of the bailout plan. Hybrid and synthetic CDOs (which cover most CDOs issued from 2006 on) are definitely not assets! These monsters are insurance companies that will be seen to be severely underfunded when insurers like MBIA, Ambac and AIG fail to pay on their reinsurance policies. If Treasury buys these insurance obligations, it will become a financial insurer for subprime.

(I should add that there are cash CDOs that are not insurance companies and can be fairly considered as assets. So all CDOs cannot be grouped in the same category.)

I think we’re talking hundreds of billions paid up front for the privilege of providing this insurance, and trillions out the back door to hedge funds and the remaining investment banks over the next decade.

Dean Baker takes the question of the bailout to an even more elementary level, having remembered that there is a market and therefore a “market value”:

The most obvious question: is how will paying market price for near worthless assets prevent the collapse of zombie institutions like Bear Stearns, Lehman Brothers and AIG? These institutions needed money. They won’t get it from selling mortgage backed securities, that are chock full of bad mortgages, at the market price. We already know this, because they already had the option to do so.

The Bush proposal to throw out hundreds of billions of taxpayer dollars to buy up this debt will do little if anything to prevent another round of collapsing banks. We will again see desperate weekends with Treasury and Fed honchos running around trying to save the next major basket case.

The other big question is: how will we get the banks to honestly describe the assets they throw into the auction?

Unless the Fed is planning to buy assets at above market value—that is, to directly subsidize those same bankers and firms with taxpayer dollars, with concomitantly to make those risky assets “less” risky in the market and still providing no route or incentive to return to the “good” equilibrium—the “bailout” as discussed with have no positive effect on the health of the firm(s).

So what Henry Paulson is proposing has to be a direct subsidy to have any effect.

As an isolated plan, it is a reward for bad behavior. Only if it were combined with those items for which we “don’t have time”—say, the plan suggested by Mark Thoma—could it possibly be an economically viable plan:

First, in return for taking toxic assets off of a firms books at a price that is higher than the market rate, the government would get a share of any future profits the firm makes for some time period, say 10% for ten years, something like that. Administratively, it could come as an increased tax rate on profits and, if it helps politically, it could be earmarked for a particular cause. The government pays the firm a fair value for the assets plus an additional amount to help with recapitalization, and in return gets a claim on future profits for a period of time (I would also tie executive compensation directly to profits to help prevent gaming).

*As a result of this, and some unfelicitous phrasing, I am now in DeLong Coventry. I can live with that.