The Original Bailout Bill, or Ms. Smith Goes to Washington*

by Ken Houghton

Prefatory Note: I wrote this several hours ago, but we had enough great posts this morning from Robert, Spencer, cactus, and rdan that I scheduled it instead of posting directly. In the interim, the House approved the second bailout bill, which I am already on record as opposing, for reasons similar to those of YouNotSneaky!:

So after voting “no” before, enough lawmakers might now vote “yes” on the new bailout plan because:

1. Mental health provisions in insurance plans.
2. State and local sales tax deductions.
3. Subsidies to rural counties
4. Relief for victims of natural disasters
5. Business tax breaks
6. Energy subsidies

…[W]hat 1-6 above have in common is that


So, just for the record, I’m not posting this now out of “sour grapes.” Just so that we have a record of why the bailout was a bad idea to begin with.

I was wrong.

There are conditionals I could put around that, but, really, why bother? I read the press releases, and quick-skimmed through the bailout bill itself on Monday, trusted Paul Krugman’s “hold your nose and support it” analysis, and hoped for the best.

I forgot Daniel Davies’s Three Laws. (Well, actually, I didn’t, but I hoped Chris Dodd’s efforts weren’t in vain.) I forgot that the only exception to the “left the Bush Administration with a positive reputation intact” rule was Douglas Holtz-Eakin, (who just waited until he joined the presumptive Next Administration to go into the tank).

But I forgot the fundamental rule of economics: mechanism design has to be done well, or the idea will just be economic theory that “depend[s] on assumptions which no one claims are approximately valid.”**

Let’s review the assumptions under which the bill made at least some form of sense:

  1. There was only going to be $250B taken in the first round, which would (by Paulson’s own description) provide financial until the next Congress was in place and could readdress the issue.
  2. There would be oversight so that the Secretary of the Treasury (Paulson [GS], Gramm [UBS], etc.) couldn’t just reward his friends and punish his enemies.
  3. The bill required equity compensation for overpriced securities. (Not a great deal, but a gain from a poke in the eye with a sharp stick.)
  4. The bill included changes to the compensation model that (let’s be nice) encouraged risk-taking where the bill came due on the next watch.
  5. The compensation changes were also supposed to ensure that the current leadership—the people who drove these companies to the point of insolvency, that is—would not receive the monies and just pay themselves bonuses all out of proportion to performance.
  6. There was never going to be a direct $700B economic gain from the stimulus package. That the proposal came out of Treasury told us that. Some of the monies were going to go to “shoring up” firms that didn’t need it.
  7. Even with that, monies that did get allocated optimally would have a multiplier effect, so you should get more than $700B in stimulus from them alone. (Brad DeLong estimated $500B, but that was based on E(loss) around $100B. Even his worst case—$400B loss—would imply an $875B economic gain even in the event of a $700B government loss. It’s not good budgeting, but it is a stimulus)

That was the bill as presented.

Yves Smith discovered the reality, and, while I’m late to the party, I’ll join the piling-on:

1. The tranching is a mere formality, and the Treasury boys as much as said so. They could take the $700 billion max as soon as the bill has passed,

2. However, they do not plan any action immediately, will wait a couple of weeks. They want to focus their efforts on stronger companies but also made noise about protecting the financial system. This, by the way, is the Japanese convoy system all over.

3. There seemed to be a lot of tap dancing about what price they will pay for assets and no straight answer about their policy on warrants. They did say that if the amount sold was greater than $100 million, they would take warrants. FYI, the current draft allows them to pay up to the price at which the assets were initially booked (yikes) . I wonder if this is obfuscation, if they have an idea of what the plan to do but will not admit it in any public forum.

4. As the person who listened to the call stressed, DealBreaker wasn’t clear on the bifurcated process. If you come to the Treasury and you are in trouble, you get reamed. Bear/AIG style treatment, execs probably fired. But if you participate on a voluntary basis, the intent is to make it very user friendly. That is consistent with Paulson’s position during the negotiations.

5. The exec comp provisions sound like a joke, They DO NOT affect existing contracts, they affect only contracts entered into during the two years of the authority of this program and then affect only golden parachutes. More detail on that point, but I don’t need more detail to get the drift of the gist.

and that reform to executive compensation only exists for the official time of the program:

Market mechanism: if sell over $300M into fund, some exec comp limits
come with it. For 2 years, the firm could not enter into NEW contracts
including golden parachute, for involuntary departure. And lose some

Well, that undermines completely assumptions 1-5 above, leaving us with a poorly-targeted bill that does nothing to address the credit crunch (in a positive way, that is; negative implications discussed below the fold).

Ms. Smith later noted that her readers argue, probably correctly, it will make things worse [numbering added to emphasize sequential nature of events]:

  1. Fed as only lender, in an attempt to keep the financial system from imploding;
  2. TARP needed to keep Fed balance sheet intact so that it can continue as only lender;
  3. Treasury will need to significantly increase the amount of Ts (public money) auctioned to fund TARP;
  4. Panic serves to encourage T. buyers, especially for bills;
  5. This represents a liquidity trap: TARP recipients of Ts will hoard cash to buy Ts: rinse and repeat.
  6. This results in drying up of lending to corporations/crowding out private capital – no new credit lines.

And that has become the groundswell opinion, with which the market appears to agree.

So, even initially, we were left with a stimulus package that won’t save any firms, will support those who don’t need it, may well remove liquidity from the market at a time when it is desperately needed, and where none of the reforms that would ensure that this wouldn’t happen again.

There’s nothing left. Follow the DeLong/Phelps recommendation and nationalize the lot.

*Its not, by the way, that I’m not still sick. It’s that when you can’t tell whether the character on the page is a dot, a carat (^), or a tilde (~), it’s time to take a break. Which has mean reading some blogs that didn’t fit the bandwidth a few days ago, with Firefox set to an increased text size.
**I could pick nits here and note that many of the theories can be considered valid if they are trivial, but is that really an argument for theory?