Let’s not get distracted. A meltdown is not imminent, chicken-little anecdotes to the contrary. Dodd’s proposal is a tremendous improvement over Paulson’s original proposal. But there are still critical improvements that are vital parts of the overall final package. Below the fold are the components of a comprehensive plan.
In part 1 http://www.dailykos.com/... I discussed the principles underlying the problem and the reasons why Paulson’s plan made no sense. In part 2
http://www.dailykos.com/... I discussed - at excruciating length - the underlying problem and the basic principles that any solution must address. Here, the goal is simple: describe what can be done in the context of a plan like Paulson’s or Dodd’s to overcome their current limitations.
First, a bit of background. Paulson has done his best to give the impression that if his plan isn’t adopted virtually immediately then a financial crisis and likely a depression are inevitable. Borrowing Colbert’s terminology, THE WORD is HUMBUG!
My work primarily concerns statistical issues so I think in terms of probabilities - and the probability of a financial crisis or depression does not equal one. It is far removed from one. For over twenty years teaching macroeconomics I’ve told my students as we study the Depression that the probability of another depression was virtually zero. In retrospect, I was wrong. It was greater than zero - but still not by much. My estimate is that we have perhaps a 50% probability of a recession within the next year. My probability of a true depression is in the range of perhaps 5%. That 5% probability is still excruciatingly scary, however, since the financial and economic dislocation would be much greater than virtually any of us can truly appreciate. However, a 5% probability - or even 10% or 20% - is a far cry from Paulson’s implicit "inevitable financial meltdown."
If you want to argue with my numbers above, I would recommend that you go to Intrade http://www.intrade.com/ and look at the betting line on a recession in the U.S. As I write this, the probability is 13% of a recession - which makes my probabilities look relatively pessimistic. (Their probabilities presumably take into account the probability of passing a bailout plan which is now priced at 75% but that market is very thin, i.e. lacking liquidity - pardon the pun.)
These probabilities are critical to the discussion. If Paulson is correct, then immediate action is required. If I am correct - or if the general market view is correct - then we have time to "do it right." We are far from crisis mode despite all the scare talk. Credit crunches are nothing new even in the U.S.; e.g. google "credit crunch".
(1) Doing it right means first and foremost obtaining information on the relevant markets. The Fed knows the amount of bank deposits, loans, reserves, nonperforming loans, etc. Neither I nor the Fed nor Paulson know the amount of Credit Default Swaps (CDSs). Estimates of its size run from $45T to $65+T. If you don’t even know the size of the market, how can you possibly know that there is a problem in that market let alone know the magnitude of any problem? Step one means that a regulatory agency needs monitoring capability of CDSs. Without such monitoring - and public reporting - any reform or bailout effort is doomed. Monitoring, however, does mean regulation, if only the regulation that firms writing or issuing CDSs must report to the monitoring agency. (CBOs need similar treatment.) Dodd’s plan, at least in my reading, does not appear to adequately address this issue.
(2) Having information is only the start. The CDS market in particular is the Wild West of finance. That its magnitude dramatically exceeds any other economic aggregate - e.g. GDP, the sum of all stock values, the total housing stock, ... - suggests that something is going on with CDSs that is independent of any real economic activity. That "something" is gambling. Now I’m not opposed to gambling, but I doubt any Republican who so feverishly opposes regulation would at the same time say "Let’s legalize gambling and let’s not regulate it." (Libertarians may be an exception.) However, unregulated gambling makes up a huge fraction of this market. I’m not suggesting prohibiting CDSs; some have a legitimate economic function. However, if you’re looking for speculative excess, they’re Exhibit A. Regulating CDSs is also critical. I won’t go into the specifics of the regulations. However, if you want to gamble - or give others the opportunity to gamble - then you need to be regulated. The parallel between gambling and CDSs must be emphasized. While Mortgage Backed Securities (MBOs) and many Collateralized Debt Obligations (CDOs) have very useful applications, some CDOs and perhaps the majority of CDSs are just legal forms of wagering, without any appreciable contribution to economic activity.
(3) Who or what should be eligible to participate in any bailout? If the goal is to prevent a potential financial crisis from spilling from Wall Street to Main Street, then we need some parameters on what the Treasury can purchase. The current language focuses on mortgages and derivative products. Why? (A rhetorical question only! I have some ugly thoughts on the true motives.) The funds most likely to be recycled into the real economy - as opposed to simply bailing out speculators - are those that have gone to purchase mortgages, MBOs or commercial and industrial (C&I) loans. The funds underlying those loans are the funds that need to be recycled, not funds that were borrowed to buy CDSs. Paulson’s plan fails miserably on this point. His proposal would make mortgage-based CDSs eligible but C&I-based loans ineligible. The third step then is to rewrite the legislation to exclude virtually all CDSs from the bailout and include only initial mortgage and C&I loans, MBOs, and a limited set of CDOs. Unfortunately, the Dodd plan does not appear to address this issue.
(4) What price should the Treasury pay for these assets? If the program is optional, financial institutions will participate if and only if they receive a price that at least equals their perception of the market price. However, institutions have at least partially avoided marking-to-market some of these assets because there is no functioning market. Thus, they will be reluctant to accept the market price, assuming it can be determined, because in many cases that would mean recognizing the losses they have incurred. Paulson has talked about a liquidity crisis. However, looking at Bear, Lehman, and A.I.G., it’s reasonable to conclude that he’s really worried about a solvency crisis facing additional financial institutions. Paying market price for toxic waste doesn’t solve an institution’s solvency crisis; it only makes it worse in their eyes by drawing attention to their insolvency. Thus, it should be clear that the prices at which firms will offer their toxic waste will be less - perhaps dramatically less - than market. The implication is that taxpayers are going to take a bath on the loans purchased. Any thought about "making money" on the waste sold under Paulson’s proposal is Alice-in-Wonderland talk. And that’s why right from the start this plan was called - correctly - a bailout rather than a loan. Dodd’s proposal (might have been Mallaby’s idea initially) to avoid this scenario is good. The Treasury buys loans at the offered prices with the clause that any shortfall on the loan’s future sale will be made good by the selling institution. I would allow the selling institution the option at that point of either making good in stock or in cash. The former has the potential advantage of injecting additional liquidity into the firm. However, if market conditions improve for the institution, they should have the option of paying cash and not diluting equity.
(5) Much discussion has focused on limiting executive compensation for institutions that participate in this plan. Frankly, I’m not in favor of limiting executive compensation just because it appears politically popular. I say that as someone who thinks that many Wall Street salaries and bonuses - including Paulson’s - were grossly out of line. However, the point of salaries should be to reward good performance, to align incentives - in this case management and shareholders and taxpayers since we are potential owners - and to preclude moral hazard. The populist in me says "first make the CEOs return the past three years’ bonuses before participating." However, if the regulations and pricing are structured appropriately, regulations on executive pay are unnecesary. I say this assuming that the financial institutions are not guilty of fraud. To the extent that loans were created fraudulently or that securities were marketed fraudulently, I would encourage the most stringent and aggressive prosecution possible. Under those conditions, frankly I want more than a claw-back of bonuses; I want those guilty to see some hard prison time.
(6) Finally, it has been my contention from the outset that the fundamental problem is a decline in housing values and thus a rise in mortgage delinquencies and an increase in foreclosures. Thus the first five points, like much of the bailout discussion, does not address the underlying problem. Ignoring that problem would mean the problem will quickly recur. The key to making everything else work is stimulating the housing market. We can debate the best means of doing this, e.g. further tax breaks for mortgages under say $150,000 or foreclosure leniency. I would favor a tax break, gradually phased out over say five years as the oversupply of housing is hopefully eliminated. Such a proposal would appear better geared to solving the immediate problem than any solution based on future profits from asset sales.
I have said nothing about the amount of money that needs to be on the table. $700B strikes me as excessive if the problem is truly a liquidity crisis. With the restrictions above, the amount that the government would have at risk would be dramatically smaller so the magnitude of funds is not critical. Without those restrictions, basically we would be collectively giving - not loaning - the financial services industry the entire sum. Personally, I would first determine the amount of tax relief to be provided and then subtract that amount from the $700B to determine the amount potentially loaned.