Paulson bailout

Let me begin with the point on which I am in complete agreement with Treasury Secretary Henry Paulson and Federal Reserve Chair Ben Bernanke– it is hard to overstate just how scary this week’s developments in financial markets could be.

Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as “financial panics.” Rick Mishkin noted that these usually occurred after a recession began and a major financial institution had failed, and were characterized by a sharp increase in the spread between the interest rate paid by higher risk versus lower risk borrowers.The graph below plots the difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years. Aggressive responses from the U.S. Federal Reserve and other central banks last August succeeded in bringing banks’ borrowing costs back down, though we saw subsequent comparable spikes in December 2007 and March 2008.

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But those events would barely be noticed when compared with what happened last week. Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday.Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply can not be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist. Only the safest customers could be expected to obtain loans, and only after paying very high interest rates.To respond to this situation, Treasury Secretary Paulson has proposed a plan whose key feature is the authorization to spend $700 billion to purchase troubled assets from financial institutions.By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in “other loans”, $30 billion from the Bear Stearns deal, and $100 billion in “other Federal Reserve assets”. That $455 billion total does not include this week’s $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.

My primary criticism of these previous unconventional actions by the Fed is that they are better characterized as fiscal policy rather than monetary policy. They unquestionably represent an implicit potential commitment of Treasury dollars. If the latest $700 billion Treasury proposal were to take these assets off the books of the Federal Reserve and put them onto the Treasury’s balance sheet, and have Paulson rather than Bernanke be the guy who makes these calls of when and where to put the taxpayers at risk, I would be all for it.

But I gather that instead the $700 billion is construed to be in addition to the comparable sum that’s already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.

And do you think that this week’s $700 billion is going to be the last such request?

Granted, these numbers I’ve been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.

Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.

But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place? My answer would be that the core problem was financial arrangements in which the gains went to one group but the downside risk was borne by somebody else. The loan originators offered unsound loans, but still made big profits because they sold those bad loans off to the loan aggregators. Fannie and Freddie earned themselves nice income while the loans were performing, but the taxpayers absorbed the loss when the loans went bad. CEOs and fund managers earned huge bonuses while the boom went on, leaving stockholders and investors holding the bag when things went sour.

And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else’s.

How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment. We can’t just impose tougher requirements and expect everybody to extricate themselves from the mess they’re in without some federal contributions. But I do not see that a clear vision of exactly what is expected and required, in the way of modified capital standards and risk management procedures, for any institution that receives federal assistance is a key part of any of the proposals. And it should be.

Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there’s a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we’ve been fighting. But I think the uncertainty itself may be even more destabilizing.

Before the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again.

There’s lots of other good analysis out there in the ‘sphere. Brad DeLong has a nice exposition of the conditions in which a government intervention could be successful and desirable, and when it could fail. Calculated Risk offers details of how he would run the bailout. Yves Smith and Paul Krugman [1], [2] express their reservations about the Paulson plan. Representative Barney Frank (D-MA) wants to see a cap on executive compensation be part of any bailout. For some comic relief (and heaven knows we could use some at the moment), see the Washington Post (hat tip: Greg Mankiw).

And your thoughts, dear readers?


Originally published at Econbrowser and reproduced here with the author’s permission.

7 Responses to "Paulson bailout"

  1. London Banker   September 22, 2008 at 7:39 am

    I’ve been puzzling why Paulson would propose legislation which is so obviously dictatorial, extra-legal and dangerous, even with the careful orchestration of the Lehman Brothers/Reichstag Fire.I think I’ve just figured out why they are doing it.All the Fed’s alphabet soup of emergency liquidity facilities innovated over the past year were structured around repurchase agreements. Toxic waste securities were used as collateral for US Treasuries and dollar credit at 85 percent of face value. But as each facility expires, it has to be rolled over and increased to keep pace with the implosion of credit in the interbank markets. Well over half the balance sheet assets of the Fed have been loaned out in this way, perhaps a critical amount in excess of this estimate. Without recapitalisation, the Fed is at risk of failure in the midst of this crisis. It’s Enron-style accounting for the toxic waste collateral makes it very vulnerable to a default by any of the repo counterparties it oversees as it would be forced to realise a loss and limits its ability to enforce any constraints as well.The Paulson plan will provide a one off opportunity for banks to take their toxic collateral back and sell it at a Paulson-determined price for cash. He issues Treasuries to finance the plan which increases the supply available. He selectively decides winners and losers, of course in making the scheme available and pricing assets, creating arbitrage opportunities and survivor bias in the process.In the meanwhile, the removal of the toxic waste from the Fed balance sheet and redeposit of sound Treasuries and cash as the repos unwind gets the Fed off the hook for having hypothecated most of its assets against impaired collateral at Enron-style false valuations.If I’m right, the Paulson Plan recapitalises the Fed without ever publicly admitting that it was dangerously overextended. This could be why Dems are lining up tamely behind it despite its obvious flaws if this is the gun being held to their head.BTW, the clearing house for OTC derivatives and central counterparty margin is already being developed and planned for launch in Q4 for credit default swaps. There is a broader ISDA target architecture that will extend it to almost all OTC derivatives dealing in due course. It is Geithner’s pet project at the NYFed, but strikes me as More CCCP Than CCP.

  2. Anonymous   September 22, 2008 at 9:27 am

    One of the root causes is the existence of firms that are “too big to fail”. One of the fixes should be that any financial institution is broken up once they get to certain size. By ensuring that no banks are too big to fail we improve the odds of not having to bail them out in the future.The consolidation that has gone on in many industries is not good. Major industries like computers and software are rapidly becoming dominated by a few hyper-large firms. While this is good for execs it’s bad for everyone else: employees, consumers, shareholders and communities.Banking is the poster child for gigantic firms being a net liability to our society.

  3. low-tech cyclist   September 23, 2008 at 5:11 am

    “By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in “other loans”, $30 billion from the Bear Stearns deal, and $100 billion in “other Federal Reserve assets”. That $455 billion total does not include this week’s $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.”If a relatively high-info voter like me only knows about Bear Stearns and AIG, what do you think the reaction of the American citizenry would be to finding out they’re already on the hook for $700B?They’ll think that the titans of Wall Street, plus the Paulsons and Bernankes of the world, plus the economic press and the press in general, has been colluding to hide all this from them.And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility.Ditto the $3.1 trillion in agency MBS, whatever the heck that is. NOBODY knows about this, except a handful of experts.Seriously, do a telephone poll. Or ask random people on the streets of Los Angeles or Philadelphia or Atlanta if they know what agency MBS is/are, or that the taxpayer’s potentially on the hook for $3 trillion of it.You know, someone – or, rather, a lot of someones – have been doing an absolutely sucky job of explaining what’s going on, even to the handful of Americans who’ve been trying to pay attention for the past few years.And as a result, Americans are apparently on the hook for enormous liabilities that they’ve never meaningfully consented to.So much for the illusion of living in a democracy.

  4. Guest   September 24, 2008 at 9:41 am

    TO BAIL OR NOT TO BAIL(Adapted from William Shakespeare’s Hamlet)(WilliamBanzai7)To Bail, or not to Bail, that is the question:Whether ’tis nobler in the mind to sufferThe slings and arrows of outrageous loss of fortune,Or to take arms against a sea of financial troublesAnd by opposing end them. To die—to sleep,No more; and by a sleep to say we endThe heart-ache and the billion market shocksThat investor hubris is heir to: ’tis a consummationDevoutly to be wish’d. To die, to sleep;To sleep, perchance to dream—ay, there’s the rub:For in that sleep of death what dreams may come,When we have shuffled off this market coil,Must give us pause—there’s the respectThat makes calamity of so long life.For who would bear the whips and scorns of time,The CEO banker’s wrong, the proud man’s contumely,The pangs of write offs, the law’s delay,The insolence of office, and the spurnsThat patient merit of th’unworthy takes,When he himself might his quietus makeWith a bare quill? Who would Federal oversight bear,To grunt and sweat under an ordinary life,But that the dread of something after death,The undiscovere’d country, from whose bournNo traveller returns, puzzles the will,And makes us rather bear those ills we haveThan fly to others that we know not of?Thus conscience does make cowards of us all,And thus the familiar hue of resolution trustIs sicklied o’er with the pale cast of thought,And enterprises of great pitch and momentWith this regard their currents turn awryAnd lose the name of action.

  5. Anonymous   September 25, 2008 at 9:16 pm

    In The Lord of the Rings OnlineTM: Shadows of AngmarTM (LOTRO), players can customize certain elements of the game’s user interface (UI), also known as “skinning.” While we don’t allow you to do a full-scale UI replacement, we do give you the ability to replace selected visual elements of the UI. (A full list of these elements and their sizes is provided at the end of this overview.)This is an updated (and prettied up) version of the information that had originally been posted in their Beta forums which we had copied to our Developer Discussions – Tutorials & Other Helpful Information forum. It is a combination of the Skinning the LOTRO UI and Art Assets posts.http://www.lotro-shop.comhttp://www.aocgolds.net/http://www.allgametrade.com

  6. Guest   September 26, 2008 at 11:32 am

    Ground Control to John McCain(David Bowie, Ground Control to Major Tom)Adapted by WilliamBanzai7Ground control to Captain John, Ground control to Captain John:Take your liver pills and put your bailout helmet onGround control to Captain John: Commencing countdown engine’s onCheck ig-nition and may the GOP right be with youThis is Commander Bush to Captain John, a huge mess you’ve really made!And the papers want to know which party’s shorts you wear,Now it’s time to leave and go debate if you dareThis is John McCain to ground control, I’m sitting on the floorAnd I’m thinking in the most peculiar wayAnd the campaign stars look very different todayFor here am I sitting in a hotel room, far above the worldThe TARP bailout is through and there’s nothing I can doBRIDGEThough I’m passed one hundred thousand campaign miles, I’m feeling very stillAnd I think my handlers don’t know which way to go,Ground control to Captain John:Your campaigns dead, there’s something wrong.Can you hear me Captain John?Can you hear me Captain John?Can you hear me Captain John? Can you …Here am I sitting in my hotel room, far above the worldThe TARP bailout is through and there’s nothing I can do….

  7. Guest   October 19, 2008 at 7:15 am

    THE George “W” BUSH FINANCIAL LEXICONFor use at the World Financial Crisis SummitBy WilliamBanzai7Absquatulate- To disappear or get out of Dodge CityAlamos- The fall of LehmanAce-high ~ Highest rating agency score.According to Hoyle ~ Regulatory requirements. Hoyle is the card playing dictionary.A hog-killin’ time ~A market bubbleAmbush- What “W” says to himself constantly “I am Bush”A lick and a promise ~Over the counter tradeBad medicine-Bad market newsBig hat no cattle- Paul Volker and Alan GreenspanAt sea ~ at a loss, not comprehending. “When it comes to finance, I am at sea.”Bail out-Bail outBandito- A sort sellerBang-up ~ first rate. Similar to “heck of a” “The SEC sure did a bang-up job.”Bartenders- Rating agenciesBank heist- Robbed by your bankerBear sign ~ cowboy term for financial trouble.Beat the devil around the stump ~ to evade responsibility or a difficult task. “Quit beatin’ the devil around the stump and bail that sucker out.”Bend an elbow ~Forcing a bank to accept bailout moneyBender ~ drunk. “Wall Street’s off on another bender.”Best bib and tucker ~ your best pinstripes.Big gun ~ A Central Banker “He’s one of the Feds big buns.”Bilk ~ Fraudulent behaviorBone orchard ~ Cratered deals.Boot Hill- The United States Bankruptcy Court Southern District New YorkBunko artist ~ Quantitative engineerBushwack- Selling repos or getting votesBuzzard food- Level 3 assetBy hook or crook ~ to do any way possible.Calaboose ~ jail.Catawamptiously-Thoroughly, utterly. Catawamptiously insolvent!Cattle Baron-Wall street CEOCattle Kate-Female investment bankerChucklehead-An AIG executiveChinaman- One who is loaded with capitalChisel, chiseler ~ to cheat or swindle, a cheater.Clean his/your plow ~ A good or bad tradeCoffee boiler ~ Jr AnalystCopper a bet ~ Hedging or being prepared against loss. “I’m just coppering my position.”Come a cropper ~ come to ruin, fail, or fall heavily. “He had big plans to get rich, but it all come a cropper, when the bank failed.”Croaker ~ pessimist, doomsayer. “Nouriel Roubini is just an old croaker.”Crowbait ~ derogatory term for a poor-quality asset class.Custer- Dick FuldDifficulty ~ euphimism for trouble, often the shootin’ or otherwise violent kind. “He had to leave Wall Street on account of a difficulty with the SEC.”Deadbeat ~ Unemployed banker.Dinero ~ from the Spanish, a word for money.Don’t care a continental ~ Don’t give a damn about the EURO.Down on ~ opposed to. “He is really down on cheap leverage.”Dragged out ~ fatigued, worn out.Dreadful ~ very. “Oh, these CDOs are dreadfully lucrative.”Dry gulch ~ Short seller ambush.Dude ~ an Easterner, or anyone in up-scale town clothes, rather than plain range-riding or work clothes.Dude ranch- Bond conferenceEucher, euchred ~ to out-smart someone, to be outwitted or suckered into something. “We sure euchered that pension manager”Fandango ~ from the Spanish, a big deal closing party with lots of dancing and excitement.F Troop- The United States Securities Exchange CommissionFederales-Washington regulatorsFetch ~ bring, give. “Fetch me my blackberry.”Flannel mouth ~ an overly smooth or fancy talker, especially politicians or derivative salesmen. “I swear that banker is a flannel-mouthed liar.”Flush ~ prosperous, rich.Fork over ~ pay out.Four-flusher ~ a cheat, swindler, liar.Fools gold- Synthetic CDOFriendlies- Gullible investorsFull as a tick ~ Irrationally exuberant.Fuss ~ disturbance. “They had a little fuss at the FED.”Get it in the neck ~ get cheated, misled, bamboozled. Goldman gave it to AIG in the neck.Get the mitten ~ to be rejected by a potential investor. “Looks like the Koreans gave poor Fuld the mitten.”Ghost Rider- Bull market investorGo through the mill ~ gain trading experience. (Often the hard way.)Gold Country- The Gulf StatesThe Good, the Bad and the Ugly- Goldman, Lehman, Bear StearnsHalleluja Trail- AMTRAK train to Washington DCHired Gun- Wall Street lawyerHole in the Wall Gang-Private equity fund managersHoosegow ~ jail.Hot as a whorehouse on nickel night ~ volatile marketIs that a bluff, or do you mean it for real play? ~ Are you serious?The Heckowy Tribe-AIG “Where the heck ah we?”Hostile Indians-Mumbai short sellersJig is up ~ scheme/game is over, exposed. Loss of all market confidenceThe “Judge”- Alan GreenspanLet slide/ let drive/ let fly ~ go ahead, let go. “If you think you want trouble, then let fly.”Light (or lighting) a shuck ~ to get the hell out of here in a hurry. “I’m lightin’ a shuck for Bermuda.”Loot- Cash bonusesLynch Mob- Angry shareholders.Mudsill ~ low-life, thoroughly disreputable banker.Nailed to the counter ~ proven a lie. That road show presentation is nailed to the counter.Necktie social- Hanging someone with rumorsNucular weapons-CDSsOK Coral- NY Federal Reserve BankOdd stick ~ eccentric person. “Judge Greenspan sure is an odd stick.”Of the first water ~ first class. “It’s a security of the first water.”Outlaw- Errant bankerPardon my French- ____________Pass the buck ~ What Wall Street CEOs do.Pay through the nose ~ Settle of a credit default swap.Peter out ~ Cheap market rallies peter out.Pilgrim- Naive investorPistolero- Hedge fund guru.Play to the gallery ~ to show off. “That’s just how he is, always has to play to the gallery.”Plunder ~ personal belongings. “Pack your plunder, Joe, we’re headin’ for Dubai.”Posse- An underwriting sydicatePowerful ~ very. “He’s a powerful rich man.”Pull in your horns ~ back off a trading strategy.Quick silver- Toxic equity tranche of synthetic CDORake and scrape- Asset recovery in Chapter 11Road agent- Distressed debt investorRodeo- A world market summitRodeo Clown- WRound up- Looking for white knight investorsRich ~ amusing, funny, improbable. “Oh, that’s a rich pitch!”Ride shank’s mare ~ to be laid off.Riding shotgun-What Bernanke does for PaulsonRob the bank- Borrow from the FedRoostered ~ drunk. “Looks like those Wall Street boys are all in there gettin’ all roostered up.”Russling- Making a marketRussler- market makerScatter Gun- The TARP legislationSeeing the elephant ~ Going to Wall Street or the City of London, where all the action is.Sell your saddle- Resign from officeScalping- Marking to marketScoop in ~ trick, entice, inveigle. “He got scooped into a credit swap and lost his shirt.”Scuttlebutt ~ market rumors.Shave tail ~ a green, inexperienced hedge fund trader.Shoddy ~ poor quality paper.Shoot, Luke, or give up the gun ~ poop or get off the pot, do it or quit talking about it. Come on Hank, shoot luke or give up the gun!Shoot one’s mouth off ~ talk nonsense, untruth. “Wilumstead was shootin’ his mouth off and Paulson gave him a black eye.”Shove the queer ~ to pass securitized assets (CDOs).Simon pure ~ the real thing, a genuine fact. “This market bust is Simon pure.”Skedaddle ~ run like hell.Smoke the Pipe- Listen to a lecture on self regulation and free marketsSnake oil salesman- Seasoned investment bankerStage Coach- Limo serviceStampede-A market runStand the gaff ~ take punishment in good spirit. “Wall Street bankers can’t really stand the gaff.”Stumped ~ confused. I’m stumped!Sun up-Market openSun down-Market closeSuperintend ~ oversee, supervise. “He just likes to superintend everything.”Take French leave ~ to desert, sneak off without permission.Take the rag off ~ surpass, beat all. “Well, good old Warren knows how to take the rag off the bush.”The Old States ~ back East.The whole kit and caboodle ~ the entire company.The Unforgiven- EnronThrow up the sponge ~ File Chapter 11 petitionTombstone-An announcementThe Undertaker- Harvey Miller- Undisputed dean of the bankruptcy bar, currently represents LehmanUp the spout ~ gone to waste/ruin. The bank’s capital went up the spout.Wake up/Woke up the wrong passenger ~ to trouble or anger an activist investor.Wampum- MoneyThe Wild Bunch-Hedge fund managersWind up ~ settle. “Let’s wind up this business and go home.”Wild West- Wall StreetWyatt Erp- Andrew CuomoYammerin- Talking to investors and taxpayers