Toxic Sludge Inc

There are three reasons that the give Paulson $700,000,000,000 to play with plan might save world finance

1) the value of a pool of all the mortgage based assets is easier to determine than the value of particular assets — making a huge pool of all the toxic sludge will cause it to melt, that is be liquid (check the metaphor is not mixed).

2) If all claims on a mortgage belong to one legal entity, that legal entity can renegotiate the terms of the mortgage and avoid foreclosing. This is often good for creditors as a group, but when they are many, each one benefits if the others renegotiate and he she or it demands full payment. Thus reassembling sliced and diced mortgages will reduce the number of foreclosures with associated legal costs, delays and distress sales of foreclosed properties.

3) by paying more for mortgage based assets than they are worth, Paulson will re-capitalize banks and insurance companies.

Paulson obviously doesn’t stress the third aspect, and, to the extent that he admits it might happen, would like to present it as an inevitable side effect of the first two.

It is not at all. All the gain in liquidity and ability to renegotiate which can be achieved with toxic sludge pool belonging to the treasury can be achieved with a new private entity toxic sludge inc whose shares belong to the banks that contributed the sludge.

If we want to give Paulson a huge amount of authority, we can let him negotiate the price in shares of toxic sludge inc for particular assets. That would be crazy of course, but not as crazy as letting him spend our money as he pleases.

I think a reasonable plan is to require all banks and insurance companies to pool all their claims on mortgages in exchange for shares proportional to the most recent market price. The revenue from the mortgages pays them dividends, people can buy and sell shares of toxic sludge inc which is easy to price as it is a claim on a huge pool of mortgages some of which were reasonable business propositions to begin with.

Now a problem with this approach is that with an accurate valuation of shares of toxic sludge inc. many banks will be obviously insolvent (they are already but it isn’t obvious).

That is a separate problem — recapitalizing banks. That can be done by having the treasury buy an equity stake (as proposed by Doug Elmendorf) so that the treasury shares the upside as well as the downside.

More arguments after the jump.

One problem is that mortgage based assets are currently illiquid, because no one knows what they are worth, and, especially, because their current owners have a better idea than possible buyers. They are hard to price in large part, because the underlying mortgages are varied. To own a claim on the proceeds of liars loans is not the same as owning a claim on mortgages whose borrowers documented their income. Current owners don’t know as much as they should, but they know more than non-bank investors. Thus there is a market for lemons/adverse selection problem. The solution to adverse selection problems is a mandate. All mortgage based assets must be sold to participate (or x% of such assets on the books of participating firms). This was obvious to my dad and Mark Kleiman , who are real smart but not economists. I’d say that participation in the scheme can be voluntary, provided that participating means selling all or a multiple of the portfolio of mortgage based assets with no picking and chosing. Non participating financial institutions are not likely to survive long.

Paulson proposes solving the problem by having the treasury, which has poor information perverse incentives and no accountability, buy the assets for inflated prices. That is a huge transfer from the public to shareholders and officers of banks.

A huge pool would be easier to price as the nationwide mix of securitized mortgages, bad as it is, produces a revenue stream which is relatively predictable.

Now recapitalization is all well and good, but normally the people who put up the money get an equity stake in exchange. Recapitalizing by having people deliberately make bad deals on behalf of the public is first a transfer and second a way to guarantee corruption (even if you don’t count it as corruption in the first place).

There is no logical link between pooling mortgage based assets and nationalizing them. The only point of creating that link is to privatize public money.