The Paulson Plan, a political bridge to nowhere
Posted in Uncategorized by demandside on September 26th, 2008 George Soros’ piece from the Financial Times, observations on regulation
09.26.08
Hello and welcome to demand side economics
I am Alan Harvey and this is the demand side podcast for Friday, September 26, 2008.
Today,
In a moment, we’ll recite some George Soros,
and yes, observations on inflation generated by a weakening dollar,
But of course we must weigh in on the Paulson Plan for the bailout of Wall Street financial firms. That plan has been reworked by Congress into something somewhat more palatable, but as you heard in yesterday’s press briefings, is now hostage to the political theater produced for the benefit of John McCain.
Henry Paulson and Ben Bernanke are negotiating on behalf of Wall Street, for Wall Street, not for the American people. They staged a remarkable emergency and forced action on their own terms. Now they are watching as the man who would benefit most from the absence of a general collapse hijacks the negotiations for a photo op.
On the other hand, the mega-bank model, and the banks are getting bigger every day, is not the answer.
The so-called insurance alternative is nothing more than a banner for the McCain-inspired House revolt. We notice it is not serious when we hear suggestions for cuts in capital gains and further deregulation.
From George Soros writing in the Financial Times Wednesday:
By George Soros
Mr Paulson’s record does not inspire the confidence necessary to give him discretion over $700bn. His actions last week brought on the crisis that makes rescue necessary. On Monday he allowed Lehman Brothers to fail and refused to make government funds available to save AIG. By Tuesday he had to reverse himself and provide an $85bn loan to AIG on punitive terms. The demise of Lehman disrupted the commercial paper market. A large money market fund “broke the buck” and investment banks that relied on the commercial paper market had difficulty financing their operations. By Thursday a run on money market funds was in full swing and we came as close to a meltdown as at any time since the 1930s. Mr Paulson reversed again and proposed a systemic rescue.
Mr Paulson had got a blank cheque from Congress once before. That was to deal with Fannie Mae and Freddie Mac. His solution landed the housing market in the worst of all worlds: their managements knew that if the blank cheques were filled out they would lose their jobs, so they retrenched and made mortgages more expensive and less available. Within a few weeks the market forced Mr Paulson’s hand and he had to take them over.
Mr Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value but the sellers know more about them than the buyer: in any auction process the Treasury would end up with the dregs. The proposal is also rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?
Barack Obama has outlined four conditions that ought to be imposed: an upside for the taxpayers as well as a downside; a bipartisan board to oversee the process; help for the homeowners as well as the holders of the mortgages; and some limits on the compensation of those who benefit from taxpayers’ money. These are the right principles. They could be applied more effectively by capitalising the institutions that are burdened by distressed securities directly rather than by relieving them of the distressed securities.
The injection of government funds would be much less problematic if it were applied to the equity rather than the balance sheet. $700bn in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble. By contrast, the addition of $700bn on the demand side of an $11,000bn market may not be sufficient to arrest the decline of housing prices.
Something also needs to be done on the supply side. To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay.
The rescue package leaves this task undone. Making the necessary modifications is a delicate task rendered more difficult by the fact that many mortgages have been sliced up and repackaged in the form of collateralised debt obligations. The holders of the various slices have conflicting interests. It would take too long to work out the conflicts to include a mortgage modification scheme in the rescue package. The package can, however, prepare the ground by modifying bankruptcy law as it relates to principal residences.
Now that the crisis has been unleashed a large-scale rescue package is probably indispensable to bring it under control. Rebuilding the depleted balance sheets of the banking system is the right way to go. Not every bank deserves to be saved, but the experts at the Federal Reserve, with proper supervision, can be counted on to make the right judgments. Managements that are reluctant to accept the consequences of past mistakes could be penalised by depriving them of the Fed’s credit facilities. Making government funds available should also encourage the private sector to participate in recapitalising the banking sector and bringing the financial crisis to a close.
The writer is chairman of Soros Fund Management
One of my good friends is a Russian expatriate. She inquired about the derivation of the term “bail out.” Or more precisely, “What this bailout?”
First I said it referred to bailing out of a plane before it crashes. That didn’t seem quite right. Then I thought about bailing out the water so the boat doesn’t sink.
But no, that’s not it. It is running to the jailhouse with cash so your miscreant friend or relative doesn’t have to stay in the pokey. You bail him out. It doesn’t get him off the hook for his misdeeds. It just gets him away from the tight quarters.
Likewise we are bailing out JP Morgan, Citibank, Bank of America, Goldman Sachs, Morgan Stanley and the lesser of this ilk. But if they don’t show up in court and do their restitution, we’re going to be out a bunch of money. More than we can afford. And they need to pay the price for their crimes.
All of which is a lengthy way of introducing the point: Absent a restructuring of the banking system, there will be no improvement to its stability or soundness. We will lurch on into the next crisis. The Paulson proposal is only the largest ad hoc measure, only the latest in a series of supply side solutions that don’t reform the market or put a floor under the price of housing.
Regulation, regulation, regulation. What does that mean?
Regulation and regulatory bodies currently in place could have stopped this long ago. But the Bush anti-government regulators were not interested in enforcing the regulations. And those in the House who now claim to have a solution cheered them on. The invisible hand will do it, they claim. The invisible hand is invisible because it does not exist in this type of market.
But what improvements could be made? One important improvement is an office of consumer protection for financial products. Non-industry, non-administration people would review the Alt-A’s and the credit default swaps and the rest for their propensity to fall apart and cause injury. This notion has been seconded by Joseph Stiglitz and others.
The best solution and absolutely essential for stability is the reversion of the financial sector to its pre-sexy, pre-business school graduate thesis innovation form. (I note now that an apt abbreviation for Business School is BS. Wharton BS. University of Chicago BS. I like it.)
Glass-Steagall was regulation which structured the market. After Glass-Steagall was dismantled the market lost its structure, or rather was formed by participants in a free-fire zone. Disaggregating these megabanks into their commercial and investment and insurance components, and prohibiting these instutitions from getting so big they again shape and control the market — and their regulators — returns to a market structure that is stable.
One of the reasons an economics education is a waste of time is the assumptions. You assume a fantasy and then spend years studying what an alternative universe in which this assumption were true would look like. Market efficiency assumes first that there are many players none of which is large enough to affect the price or distort the market itself.
How many times do market-first apologists point to the efficiency of markets when they are pointing to oligopolies in which a few large firms, or even one, control every aspect of price, supply and demand? Even in the rubble created by collapsing economies the free marketeers hold out for more free market solutions which could work only in their alternative universe.
The second assumption of market efficiency is perfect information. Buyers and sellers know exactly what they are buying and selling. There are so many examples of the tragic end of those who accepted this assumption. Right now we have financial players who do not understand what they themselves own, no matter the information available to their potential buyers. And be sorry for all the foreign buyers of mortgage-backed paper who did not realize that the American mortgage comes with an implicit put option on the house. Since it is a non-recourse loan, she can walk away with impunity and give you the asset.
Now in Congress with the collapse of the Financial mega-opoly, the free-market Republicans who have bawled this line like calves in the springtime cannot change their tune. Even when the last of the behemoths is about to go down, they cry that this must be done for the free market to be efficient. I’m sorry, but it was a long time ago and on your watch, that the free market failed. You have been used like … You have been stooges for their expansion and have spent your careers fronting for something that was anti-free market.
Now it seems that the financial cowboys who used free market as a synonym for free rein cannot corral their stooges quickly enough to keep the barn from burning down with them inside.
You may say that this is similar to my comment Wednesday that the bailout is a trillion dollar brace against a collapsing building and conclude that I, too, prefer the collapse of the building and so am somehow in their camp.
No. No. I only recognize that the building is collapsing and suggest we admit that fact and go on to the next step. The Free Marketeers suggest dispensing with a demolition and reconstruction plan in order to teach the building and its occupants to do better next time. Those who support some sort of reinforcement say it is a solution and now the building and the activities it houses may go on as before. What is more dangerous? Both are dangerous.
Ideally we would shore up the building while we get the occupants to safety and use the materials to build lower, more stable structures.
Now
Inflation
One of the regrettable consequences of the Paulson-Bernanke bridge to nowhere is that the rest of the world is seeing the huge hypocrisy that has been foisted on it over the past several decades. The United States through its wholly owned subsidiary the IMF has imposed the most draconian conditions on Third World countries in exactly this situation. We don’t need to go into that here.
Just realize that the Fed and Treasury and Wall Street have had more than a year to deal with this crisis. Many have predicted exactly this pass — See Nouriel Roubini and Joseph Stiglitz — and they have come up with a sequence of ever more hysterical solutions. Asians and others are going to start trading in their Treasuries because it is obvious that those in charge are out of control, or at least things are out of their control.
A trickle of redemptions could well turn into a flood, since the last holder will be the poorest. Aside from what it does to the triple A rating of the U.S. government, it means a weakening dollar. A weakening dollar means inflation, because imports are more expensive and domestic goods with export markets are bid up in price by foreign demanders.
Inflation itself is not so problematic, since it is a vague phenomenon the specifics of which reflect a necessary adjustment to relative prices. It is the reaction to inflation that could be the problem. A healthy response could help. The likely Fed response could be catastrophic.
Let’s approach the subject from the idea of deflation. Worries of deflation were what Alan Greenspan cited for his obscenely obtuse one percent interest rate policy in the early part of the decade.
I agree, deflation is the problem. Deflation that began with income. The deflation of the price of labor.
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