Why Paulson is (maybe) right

First of all, let me state clearly my position. Banks have made huge mistakes.

Even though many serious economists (the likes of Robert Shiller and Nouriel Roubini) had warned for years – not months – that the credit boom and the housing price bubble would end up in tears, bankers superbly closed their ears and soldiered on, driven by greed and short-term analyses. When the mix of reckless lending and securitisation exploded in their faces, more than one year ago, they stonewalled and drove the economy down in the hope of being bailed out. It would be criminal to bail them out. It would guarantee even worse crises in the future. Conclusion, there must be blood.

This being said, spilling blood for the sake of it is a bit silly. Banks are not oil companies. When an oil company goes bust, by definition, it is because its liabilities exceed its assets. After bankruptcy, its assets remain as valuable as before. Oil is safely tucked away under ground, refineries and gas stations stay put above ground.

A bank goes bust when its assets have collapsed. Bankruptcy means that its liabilities collapse too and these are assets of other banks and of millions of hapless citizens. This is why contagion and bank runs occur more frequently than oil runs. Sure, with patience, both assets and liabilities can regain value, but in the meantime the financial system is impaired and the resulting credit crunch provokes an economic crisis that spares no one. This is why large, systemic financial institutions cannot be summarily dispatched to receivership. Avoiding a credit crunch ought to be every one’s priority.

Bleeding the culprits cannot be done with a truncheon, it requires a surgical intervention.

Secretary Paulson has obviously been testing many scalpels:

  • He half bailed out Bears Stearns.
  • As he butchered Lehman Brothers, he so frightened Merrill Lynch that this last problem was not solved at taxpayer’s cost.
  • On the next day, though, the Fed and many other central banks were lending huge amounts of money – presumably to Lehman’s creditors and to horrified financial institutions that realised that bailouts are not part of the plan anymore.
  • The following day, he effectively nationalised AIG. This is not a bailout. AIG shares have been so diluted that shareholders lost most of their money. The Treasury will keep this too-big-to-fail company functioning but over time it will dispose of its assets. For all practical purposes the old AIG is gone.
  • Then, on the final day of the creation of the new financial order, Paulson did a mega-AIG – he offered to buy all the toxic assets that financial institutions will care to sell.

The details of the plan are not known yet, so it is too early to determine whether it is a bailout or more blood. All will depend on two things. The price at which the assets will be acquired by the yet unnamed RTC, and the price at which the RTC will dispose of these assets.

Indications are that these assets will be bought at auctions. These will have to be reverse auctions, probably of the Dutch variety. If the sellers are confident in their financial health, or just smart enough to collectively bluff Paulson, the price will be close to the purchase price and it will be a bailout. If the sellers are scared and unable to organise themselves, the price will be a deep discount. Willem Buiter argues that the auctions are likely to force the sellers to reveal their true reservation price and I tend to agree.

Let us assume that, indeed, the toxic assets will be acquired at a deep discount. What happens next?

  • First, the selling financial institutions will have to acknowledge their losses, a step that they did their utmost to resist for more than a year. They argued all along that there was no market for these assets – indeed they refused to sell them – so no price to mark them and therefore no objective way of entering the losses in their books. The auctions will provide a market price, at long last. Whether they sell or not, being forced to mark their assets to market, all financial institutions will have no choice but to formally acknowledge their losses. Either they recapitalise quickly, which dilute existing shares, or they will file for bankruptcy, which is even worse for the shareholders.

That does not look like a bailout, but it still could be one. Before we reach any conclusion, we must consider the second stage of the story.

  • Second, the RTC will hold a huge portfolio of toxic assets, but it will be in no rush to sell them.

Like the previous RTC, thanks to taxpayers’ money, it can take years to do so. If the toxic assets gain some value, the RTC and the taxpayers will make a profit and the financial institutions that sold them will definitely not have been bailed out. We will be able to call the operation a bailout only if toxic-asset prices go on falling, since it will then be established that the financial institutions managed to sell these assets above market price and at taxpayer’s expense.

It is therefore much too early to call the operation a bailout or a shrewd cleansing operation. Judgment will have to wait until the yet-to-be-created RTC is folded, several years from now. Meanwhile, for the first time since mid-2007, we can foresee the beginning of the end of the crisis since the financial institutions will have either to promptly recapitalise or fold. This, in my view, justifies Paulson’s bet, probably history’s biggest ever.


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

8 Responses to "Why Paulson is (maybe) right"

  1. Anonymous   September 22, 2008 at 2:54 pm

    If the Treasury acquires the toxic assets at a deep discount (to what? it will still be above market price) it will probably put the banks under. So they discount (to face value I guess) will not be so steep, and the entire difference will be paid by the generous taxpayers.This scalpel is directed at the taxpayers, or maybe it’s a bludgeon.It’s not to early to say this whole thing needs to go in the bin, don’t re-engineer it or tack on amendments, just say no and start over with something that has the taxpayers’ welfare first in mind. Why don’t we just nationalize those financial institutions? I’m not kidding. We nationalized AIG which cost much more. It would probably be cheaper to nationalize these banks, for example the Treasury could buy them out of Chapter 11. What about their counterparties that are thereby destabilized? Buy them too!These banks have great trading systems and great human talent with nowhere else to go at the moment. It’s a great opportunity for the Treasury if it would just act on behalf of the taxpayers rather than the banks.

  2. Guest   September 22, 2008 at 2:56 pm

    A blogger wroteHere is the Cliff Notes version of the economic disaster.1. The banks and investment houses made up a bunch of products and sank their investors’ money into them.2. The banks and investment houses couldn’t convince you or anybody else to keep buying those products.3. The banks and investment houses got the government to FORCE you to buy those products.Any questions?did these companies and their employees make obscene profits and salaries on these products?Are they the ones that broke the system that Paulsen admits is broken?Are we to give an open line of credit of 7oo billion dollars to Paulsen who said in June of 06 – “This is far and away the strongest global economy I’ve seen in my business lifetime” !!!! so he can fix a problem he couldn’t see coming?He also wants the authority to designate any financial operation he deems fit to act with his authority. In this case Paulsen comes from Goldman Sachs who in my opinion i sone of the foxes.Where are the proposals for new regulations – an updated Glass-Steagall act to keep this from happening again? did the repal of Glass Steagall Act have anything to do with this present crisisIf a financial institution is to big to fail why not make a law so that no such finanacial institution can get that big?

  3. villager   September 22, 2008 at 2:56 pm

    The article provides two reasons not to support the Paulson plan. These are:(i) “The details of the plan are not known yet …”; and,(ii) “Judgment will have to wait until the yet-to-be-created RTC is folded, several years from now.”Those 2 reasons comprise an enormous gamble both of faith and of money for the taxpayer. Unfortunately, the authorities have demonstrated their ineffectiveness and their lack of credibilty. As much as the Paulson plan could avert serious consequences, it could if misapplied result in serious consequences. With such a dilemna, credibilty becomes the paramount factor.

  4. artichoke   September 22, 2008 at 2:58 pm

    We taxpayers need an advocate proposing something just as bold on our behalf, as Paulson’s proposal was on behalf of the shadow banking system.When the Congressmen come home to their districts for the election, we’ll see which proposal they voted for. Throw them out of office for a mistake here, this is the moment of truth. They lied about getting us out of Iraq, now they have a chance to redeem themselves.

  5. Steve   September 22, 2008 at 5:53 pm

    “This is not a bailout.”This remains to be seen, the honest answer is that this “may not” be a bailout.History points to we the taxpayer getting the short end of the stick in these arrangements.”AIG shares have been so diluted that shareholders lost most of their money”Rightly so, shareholders are a part of the governance structure.They rubber stamped AIG’s policies and ought to lose everything.Sadly, I see no sense of personal responsibility on Wall Street.Hell they can’t even “acknowledge their losses”Without Wall Street as a whole accepting personal responsibility – the problems will just continue.With personal responsibility taken, Wall Street (Not Government!) can take steps to fix the deeper market problems that allowed this to happen.Meanwhile – not a dime more.

  6. Guest   September 22, 2008 at 6:00 pm

    If socialization is necessary, and it may be warranted in this situation, it must be done so with a very real cost to the parties involved in this disaster. The creditors need to be punished for their foolishness, just as any other foolish investor or creditor is in a capitalistic society. The debtors must be punished for lying about their income and assets and their speculation on housing values using other peoples money. The mortgage brokers who pushed these subprime products and facillitated the inflation of apprasials, income and assets, deserve greater regulation as they have proven that they are incapble of self-regulation. The investment banks, with their financial engineers, MBA’s etc, need to be penalized for the sham derivatives and risk transfer products and other shades of “lipstick” that they put on this pig.If the Fed determines that they need to be the buyer of last resort, then they should bid on this toxic waste accordingly. Given that the ex-ceo of Goldman is the person that wants to put in the bid, I am not confident that creditors and middlemen are going to recieve the meaningful penalty that they deserve, and still maintain order to our markets. If the Fed purchases these at prices that there is not, at least, a 50% chance of profiting from, then they are paying too much and it needs to be viewed as simply a bailout for middlemen.

  7. Guest   September 23, 2008 at 7:14 am

    They have to do whatever to get people spending again even thoughit seems a hopeless cause. Just annull all debts and there will be no eco depression.If depression comes World War 3 won’t be far behind.God Bless us All

  8. DR Fish   September 25, 2008 at 2:11 pm

    Quick question. I seen great debates on CSPAN and other networks when Bush was asking for more money for the war effort and our troops and the amount was like 50 billion. And there was so much bitching by the democrats not wanting to fund our troops, saying we are over spending by doing this, but man when the finanacial markets need 700 billion lets open the checkbook and in BIPARTISANSHIP bail out these markets. Can you say CORRUPTION? Stand up and speak people.