Saturday, September 27, 2008

A Bad Bank Rescue

In the 1980s, the government did not need a strategy to decide which bad loans to take over; it dealt with anything that fell into its lap as a result of a thrift bankruptcy. But under the current proposal, the government would go out and shop for bad loans. These come in all shapes and sizes, so the government would have to judge what type of loans it wants. They are illiquid, so it's hard to know how to value them. Bad loans are weighing down the financial system precisely because private-sector experts can't determine their worth. The government would have no better handle on the problem.

In practice this means the government would make subjective choices about which bad loans to buy, and it would pay more than fair value. Billions in taxpayer money would be transferred to the shareholders and creditors of banks, and the banks from which the government bought most loans would be subsidized more than their rivals. If the government bought the most from the sickest institutions, it would be slowing the healthy process in which strong players buy up the weak, delaying an eventual recovery. The haggling over which banks got to unload the most would drag on for months. So the hope that this "systematic" plan can be a near-term substitute for ad hoc AIG-style bailouts is illusory.

~Sebastian Mallaby
in the Washington Post


At 9/27/2008 11:25 AM, Anonymous Anonymous said...

The good thing about the proposed bailout is that it has started the discussion about what steps should be taken to address the problems with credit crisis that has resulted from a housing slump/sub-prime problem.

With a possible bailout looming, economists have to start proposing workable alternatives rather than just sitting on the sidelines criticizing the FED & Treasury.

It would appear that buying securitized mortgages that few buyers will touch which are difficult to price/evaluate is riskier than allowing the excess leveraging to play out in the private sector and instead, seeking to increase capital.

At 9/27/2008 11:46 AM, Anonymous Anonymous said...

Letter to Greg Mankiw about the bailout is very interesting reading.

At 9/27/2008 7:08 PM, Blogger the buggy professor said...

1) No point in beating around the bush (no pun intended). The fact is, most economists except those who specialize in finance and financial institutions --- a small minority, I suppose --- aren't the best guides in coming up with an alternative plan to the Treasury one. And even those specialists in financial institutions need to have a good historical background, it seems, in how financial markets went haywire in previous eras . . . especially the Great Depression period of the 1930s.


2) Are business school specialists, with a good research background in finance and possibly a Ph.D. in economics better situated on the whole?

Probably, it all depends. Interestingly, the most stimulating alternatives or discussions are those put out by a few specialists from business schools like Chicago's or Columbia's or by financial experts themselves in the private sector or --- like those of Mallaby's to which Mark links today --- economic or financial specialists with a good grounding in both disciplines.


3) I myself --- with a Ph.D. in both economics and political science --- am hardly one of those specialists. About all I can do is note that the problems of recapitalizing the financial institutions --- especially banks --- do seem serious, with credit loans drying up as even solid commercial banks are upping voluntarily their reserves rather than lend even, it appears, to good businesses, big or small.

So on that basis, buying toxic loans on the books of fragile banks as the Treasury plan proposes looks inescapable . . . the problem being as Mallaby notes how to evaluate those tumbling assets.


4) Auctions with market participations might seem to help, but the problem is . . . well, investors and traders in the market don't have the kind of long-term horizon that governments do. In the upshot --- as pointed out in a very good WSJ article by four Chicago business school professors noted today --- the true hypothetical price couldn't be discovered by auctions either. Paste this into your address bar for the link to the WSJ article:

If so, some stab in the dark at pricing is unavoidable by the Treasury . . . though doing what Senator Dodd insists on, endorsed by the Chicago-four, would help protect taxpayers. Namely? Taxpayers would get, say, "contingent equity from any financial sellers that is equal to 125% of any losses the government bears on the assets it purchases from a given bank."


5) An added advantage of the Dodd proposal is that the banks and other institutions that sell their shaky assets are likely to be the ones with the most toxic --- virtually all of them, ultimately, in the falling housing market (though linked forward to various others in the form of repackaged financial derivatives) --- and hence Treasury purchases of them pose the biggest threat of losses.

In that case, too, the government could in buying these assets offset the losses in large part by getting the contingent equity that Senator Dodd proposes and the Treasury and White House have accepted as part of the deal.


6) Remember here.

These assets look toxic now and in the near future --- which is what financial institutions are largely concerned with in such exigent circumstances --- but they are, at bottom, houses or other residences whose prices are falling. Over the mid- or long-term, that fall will stop and in most instances the prices will rise and hence compensate the taxpayers for the losses. Wait long enough, and taxpayers may even have had a good bargain as long as they have the equity guarantees in selling the houses once the prices bounce back.


7) My main problem in all this still remains. To understand it, we need to consider the two core sides of the financial crisis that has emerged.

•On one side: Falling housing prices, which aren't just hurting the balance sheets of banks and other financial institutions, but homeowners . . . most of whom aren't even at risk, though enough are to cause lots of problems for refinancing mortgages and the construction and repair industry and consumer spending and the like.

•On the other side Deregulated financial institutions that went haywire --- as the head of the SEC admitted today, Christopher Cox, who was appointed by President Bush in 2005 because Cox's predecessor, William Donaldson actually thought it was the job of the SEC to regulate excesses in securities and related financial areas. That penchant of Donaldson earned the ire of Republican Congressmen. They wanted Donaldson's head. They got it. And we got our current financial crisis, though other deregulatory changes were aggravating causes too.

(For Cox’s mea-culpa and his new faith in the need for effective regulations, go here by pasting it in your browser address bar:,%20SEC&st=cse


The result: a morass of derivatives in which sound accounting principles were ignored by every sort of financial institution --- housing and other loans given not on the base of credit-worthiness and risk-analysis but on asset-based hopes that housing (to stay with it) would continue to rise in price until the last galoot gets rowed to the other side --- and further ignored, even turned topsy-turvy, by slicing, dicing, and repackaging these now toxic assets


Enter the problem that still remains in my mind. The Treasury scheme, reinforced by Senator Dodds’ proposal about contingent assets for the taxpayer --- plus the other Democratic scheme to limit the compensation given to the top executives of unsound banks, insurance companies, brokerage firms, and hedge funds --- will help pour recapitalize the financial institutions. But what about the home-owners whose prices are still falling or who can’t pay their mortgages and consequently are causing further havoc to our economic prospects?

What specifically will be done to help them directly --- many of them our neighbors?


9) And so here are two alternative schemes that were set out in the New York Times today that offer either alternatives to the Treasury Scheme or as supplements.

* One is by Chris Mayer at Columbia business school

* The other article is by Frank Partnoy, a law professor at the University of San Diego:


10) The trouble is, neither of these very tantalizing schemes fully addresses the problems of what to do with recapitalizing a tremendously over-leveraged financial system. As Japan’s troubles the last 17 years show, only effective government action to recapitalize the system --- rather than let the banks and other financial institutions do it --- could easily set off a deflationary spiral and torpedo solid economic growth for years and longer. And I won’t pretend to do what far too many other professors do --- to have the knowledge and background to say anything more, let alone arbitrate between these two competing problems:

1)Recapitalize our shaky financial system, allowed to go haywire because of both deregulation and poor regulation of the statutes and rules that did remain on the books.

2)And deal with the direct blows to our economic prospects because of the housing market itself.

Maybe some other readers of Mark's web site have enough knowledge of finance, real estate, and past problems of tottering financial institutions to enlighten me and others on how to link these two problems within the scope of one scheme.

Or, alternatively, to show that the second isn't needed or could be, say, addressed separately as a second follow-up package.

That seems possible, but would probably bog down in political arm-wrestling in Congress, no?

Michael Gordon, AKA, the buggy professor:

At 9/28/2008 12:00 PM, Blogger Arman said...

>And even those specialists in financial institutions need to have a good historical background, it seems, in how financial markets went haywire in previous eras . . . especially the Great Depression period of the 1930s.<
I do not think that there are any such people. Economists as a whole seem incapable of getting a handle on the 20s and 30s. Every article that I have ever seen explains things in very superficial terms. Most blame the fed, without really seeming to understand what the Fed does, or even what money is. Many blame Roosevelt, who came into power when the depression was at its worst, taking the worst economy ever seen and turning it into the greatest economy ever before seen, pretty much overnight.
Economists as a whole seem to be indoctrinated with a denial of history, rather than any understanding of historical reality or current reality. It seems that Economics is geared more towards explaining why economists make goofs, and why predictions are almost never seen in fruition.
I find it appalling that I never see a good explanation of the base nature of money from any economist, and I have seen so many professors and students wanting to talk about the gold standard. This just illustrates to me that they have absolutely no understanding of where money comes from, and what real value there is behind it. This ignorance that our universities seem to instill is quite bizarre.

At 9/29/2008 12:45 PM, Blogger Arman said...

>"1)Recapitalize our shaky financial system, allowed to go haywire because of both deregulation and poor regulation of the statutes and rules that did remain on the books."<
Specifically, why is the financial system so shaky? It has been SHAKEN by the adjustment of interest rates by the Fed!!! The cut to the interest rates cuts local bank profits and so impedes in the local bank's lending, cash distributing, and cash creation activities. And so they keep cutting it some more!! Why are economists in general, and specifically the economists at the Fed helm so bloody THICK!!!
The markets went into turmoil almost immediately after the Fed cut the rate last September! The turmoil keeps getting worse as the Fed keeps cutting rates. What is the definition of insanity??


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