We are at the edge of a financial abyss. For the first time since the 1930s we face a potential meltdown of the majority of the financial system that underlies our economy. While I don’t think it’s most likely that the system implodes, it is likely enough to scare me. Why? Well, because I know more than a little about the problem as a professor in finance at a major research institution with a specialty in valuation. And because I also know that the currently proposed plan has major flaws, which Paulson and Bernanke should know as well. And because there is so much misinformation floating about how we got in this mess and how we should get out.
First, the financial system could well have a complete meltdown. The worst-case scenario is extremely bad. How bad? Very scary bad and bad enough to scare me. Perhaps worse than the depression given the increased importance of the U.S. financial system. If financial institutions won’t trade with one another due to liquidity concerns or concerns about the value of assets being traded, then the ability to get loans for anything quickly evaporates. That hurts Main Street as much as Wall Street. Want to buy or sell a house, borrow on a credit card or for home improvements, a business wants to finance inventory or an expansion, a farmer want to finance seeds and fertilizer for next year’s crop, ...? You would be out of luck. And it’s pretty easy to construct a doomsday type scenario. I don’t think that’s the most likely scenario, but the fact that respected financial analysts are talking about it indicates that it’s not a remote and esoteric possibility.
What are the parameters of the problem?
First, Paulson & Bernanke are correct that the immediate problem is a liquidity crisis. Short-term treasury rates are close to zero while many financial institutions have trouble borrowing at all, hence A.I.G.'s willingness to pay an effective 12% to the Fed for their ability to borrow and short term Treasury rates this past week declining effectively to zero - 0.03% or 3 basis points - while some financial institutions could not borrow at any rate.
Second, the problem - at least at the moment - is not with banks. Let me repeat that. The current crisis is not with banks. Only IndyMac has failed or required a buyout, and only Washington Mutual is on the short list for possible closing or buyout in the near term. The problems have occurred largely in the financial sector other than banks. That's a key point because banks - and thrifts - are regulated while the institutions that have got into difficulty - and have caused difficulties - are unregulated. That is a point that cannot be over-emphasized.
Third, there's a ton of financial instruments out there going under the general heading of derivatives that most people even in finance simply do not understand. I value a particular type of financial instrument and do it very well, but I don’t have a clue about the valuation of some of the instruments floating around the financial universe. That I don’t know their value isn’t a problem. That unregulated financial institutions have been playing in these markets often with little understanding of the risks involved or understanding how the derivatives were related to the underlying assets - that’s a major problem. This point is key to understanding the general lack of liquidity. Suddenly there has been a recognition that some of these financial instruments don't have quite the properties - in particular the risks - that people thought. Thus, they have become illiquid, and thus we have a liquidity crisis.
However, there are a couple of key points that make me extremely concerned that the fundamental underlying issue has not been addressed. Since it has not been addressed, we could easily see the situation dramatically worsen even if Paulson's plan goes through without changes.
To understand the extent of the problem, let me go back to the start of the broad recognition of the problem in the summer of 2007. (I believe the problem itself started much earlier with (1) financial deregulation, (2) the emphasis on meeting quarterly targets for growth and profits, and (3) the rapid expansion of areas like the subprime mortgage market. But that’s another story.) By August 2007, pretty much everyone financially clued in knew that there was a liquidity crisis, in particular relating to mortgages and deriving at that time primarily from so-called Alt-A and sub-prime mortgages. Institutions like IndyMac and Countrywide were in serious trouble. And at least part of the "solution" was to encourage Fannie Mae and Freddie Mac to aggressively enter the sub-prime mortgage market. Up to that point, while they had accounting issues and may have been undercapitalized, they had also generally stuck to conventional mortgages. Nevertheless, they entered the sub-prime market, perhaps much too enthusiastically. They did provide additional liquidity to mortgage markets. Now they're effectively gone, sucked dry of their liquidity. Bottom line? There is an incredibly large pool of illiquid assets and Fannie and Freddie couldn't provide sufficient liquidity. Unfortunately, it's not clear that the Fed and the Treasury - with the current proposal - can provide sufficient liquidity. That is a concern that, quite frankly, scares me. You're talking $700B in a market of over $40T. (The two key indicators: (1) nonborrowed reserves, historically a key indicator for monetary policy, has fallen through the floor,
http://research.stlouisfed.org/...
and the Fed now has a line of credit at the Treasury because actions that the Fed has already taken have had a considerable impact on its balance sheet.)
The point here is simple. How much "toxic waste" is out there? I don’t know and I don’t have confidence that Paulson and Bernanke know.
Even if you knew how much toxic waste was out there, you would still have the questions of how to value it and what to buy. Goldman, WaMu, Merrill Lynch, ... will likely offer billions in different packages, including some that contain the stinkiest stuff in their portfolios, and that they might offer it for pennies on the dollar. They may also offer higher quality assets, albeit with lower offered discounts. Does the Treasury secretary really believe that he has the ability to sort through what constitutes the best deal? I could probably put together alternate portfolios at different discounts where the lower discounts would be better deals but where the instruments would be so complex that virtually no one would be able to decipher what's really in each. Given current market conditions, valuation of those assets is probably the toughest financial game in town. This is the point that Krugman emphasizes.
http://krugman.blogs.nytimes.com/...
But the problem may well be worse than even Krugman’s short discussion suggests. And that problem is hubris. All discretion is given to the Treasury secretary both to hire staff as necessary and to buy what he chooses. There is virtually no one that is well qualified to evaluate much of this toxic waste. If it were simple and straightforward to evaluate, then we wouldn’t have nearly the problem we currently have. In fact, it is likely that the staff Paulson would need to hire would include some who were responsible for creating the problem in the first place - and then paying them seven figure salaries - not likely a popular position.
There is one more ugly feature complicating the analysis and that is moral hazard. If I’m Goldman Sachs, for example, I may have assets that are completely toxic, 98% loss rates and perhaps completely written off. I may have other stuff that looks not unreasonable, maybe 5% loss rate. But if I’ve already written off the worst junk, I want to keep it because it can’t do any worse and if things improve then I’ll get a big gain. Alternately, I might have concerns that the 5% stuff is likely to worsen based on inside information. (Financial institutions work based on gathering information on clients - who is credit-worthy and who is not, e.g. what’s your credit score.) The stuff that Goldman is going to offer the apparently best deal on is the stuff that they most want to dump, and there will be good reasons for that. If that’s what the Treasury buys, then it will be the stuff that’s least likely to be profitable in the future.
There is, however, an even more fundamental problem with the plan. It calls for buying and thus valuing financial assets but says nothing about the value of the assets underlying any of these financial instruments. As long as the housing sector is heading south, property values declining, foreclosures increasing, ... then any derivative based on mortgages is going to be "problematic" - and that’s exactly what the Treasury is requesting authorization to buy! I don't think that there's any precise accounting for what part of the $40+T derivatives market is based on housing, but I would be very surprised if it were less than $20T. (Yes, that's a multiple of all the mortgages in the U.S. but we’re talking about packaging and repackaging.) There clearly are some very sound mortgage-related financial instruments still out there. However, my point is simply that there's also likely a huge amount of stuff that's problematic, and all the money injected doesn’t address the underlying problem that the value of the underlying assets - real estate - has dropped.
And just one additional "kicker" here: it could be cheaper to prop up the housing market in the short-term than it is to prop up the financial sector!
Finally, a point of some solace for many, again relating to the moral hazard problem. Suppose you're a bank - again, regulated and relatively safe - and you've a healthy stream of people looking for mortgages. You may have more than you can fund from internal sources, e.g. deposits, and you may choose to sell some. What are you going to sell? Subject to some constraints, you'll keep the best and sell that which is most likely to pose future problems. Suppose you've a portfolio of people borrowing, say some at 80% and some at 60% of the price. You'll sell off the 80% crew and keep the 60% crew. The 80% crew may still meet all the standard packaging criteria, but if there's trouble, it will likely occur to the 80%’s before hitting the 60% crew. Moral hazard is another reason why the problems are more severe at particular types of financial institutions. Most banks and thrifts limited their exposure to subprimes mortgages and are not nearly as exposed as many might think. Nevertheless, the stuff that is trading - or that financial institutions are trying to trade - has a potential moral hazard problem that now implies a discount for those derivatives.
I must admit that I'm absolutely and totally opposed to the present statement of the plan.
First, the lack of oversight should scare the ?#@?*&! out of everyone. The Treasury Secretary answers to no one on any and all decisions. Paulson, I believe, has done a reasonable job as Treasury secretary, and I have to give him credit for accepting the job from a lame-duck President. Nevertheless, Paulson’s role in creating the problem as the CEO of Goldman Sachs cannot be ignored. In addition, even if you’re willing to cede the authority to Paulson, do you want to cede the same authority to a McCain Treasury secretary, e.g. Phil Gramm?
Second, the fiscal implications of this are absolutely incredible. There are limits to what we can do as a nation and those limits largely stem from the health of our economy. Not doing anything could be absolutely disastrous. However, there’s no mention of where the $700B will come from. Taxes? Additional debt? I suspect the latter with the plan being to replace private sector bonds with government bonds. But a $700B increase in supply is likely going to mean a hefty drop in price, higher rates, possibly a drop in the value of the dollar. In addition, one needs to ask about the opportunity cost, that is, what will we NOT be able to do because we’ve committed so much money to this bailout? Will we not have comprehensive health care? Not have a middle class tax cut? This plan at one level is a total perversion of Grover Norquist’s desire to shrink government so that it doesn’t do anything, it grows government and saps government so that it is powerless to do anything.
Third and perhaps most importantly, the plan doesn't address what would appear to be a drop in the value of the assets underlying the derivatives. Why is there a bailout for the financiers and not for the underlying assets, e.g. houses & homeowners? One can argue - as Poulson and Bernanke have done - that the cost of having a financial system collapse is just too great to bear. I wouldn’t disagree, at least strongly. However, they haven't addressed the question of whether it's less expensive to bail out the financiers than to bail out the underlying assets.
And fourth, what happens if it doesn't work? Then what?
I wish at the end of this that I could say that I have the solution. I don’t. What’s proposed might work, but at an incredible cost and not particularly efficiently. For people that allegedly believe in markets, it’s a remarkably non-market based proposal: let the Treasury secretary decide what to buy from whom - and thus who to assist in recovery. Who survives and who does not will depend on the decisions of the Treasury secretary - with no appeal! And all this done based on financial instruments for which there is no functioning market. A better proposal has been floated that focuses on buying stock in financial institutions and avoids the problems with asset valuation since stocks are publicly traded. However, even that fails to address the more fundamental problem that the value of the financial instruments has shrunk because the value of the underlying assets has shrunk. The ultimate solution is to take steps to increase property values, but that appears to be a "non-starter" for Bush, Paulson, and the financial services lobbyists.