Missed Opportunity

It does look like the core idea of the Paulson Plan will be enacted and the Treasury empowered to buy impaired paper in large quantity. It has been clarified that this will be bought at some discount, and probably priced in some reverse auction. Candidate McCain's "campaign suspension" will force the Congressional Republicans to agree to something, and the Democrats will be only too glad to enact the basis of a regulatory expansion while complaining it was the Administration's idea.

Chairman Bernanke's stated motivation is price discovery. I think he believes that if the government can set market prices for the paper, banks will be able to value holdings and understand their counterparties' solvency, and will be able to lend with greater confidence. He has argued against "punitive" steps like warrants and compensation limits because they will constrict the pool of sellers and reduce the value of the price discovery from the reverse auctions. (He further argues that there is no policy basis for punishing someone for selling something at a market price, as there would be if they were bailed out.)

But I'm skeptical of the government's ability to discover market prices, even in an auction. These are complicated instruments, with exposures to interest rates, housing prices, and consumer credit. Their value will vary among buyers according to each buyer's risk appetite, outlook, investment horizon and capital cost.

Up until recently, they have bought by hold-to-maturity investors like pension funds and insurance companies, and by hedge funds as speculators and funding arbitrage players. I suppose the borrow short, lend long buyers (the funding "arbitrageurs") have driven prices to date, but these are the players driven from the market by the liquidity squeeze. It's the long-term holders that will set the ultimate bid. They may be reluctant to bid because they are uncertain of the securities' performance, or concerned what borrower relief would look like, or simply lacking the institutional capacity to evaluate this stuff. Or they may be afraid of touching anything with such a bad reputation,
or unsure what assumptions would be viewed as "reasonable". Or, they may be fully invested and lack liquidity. In any case, we won't know their pricing expectations until they actually do step forward to buy this stuff. So how can the government now set a proper price?

A reverse auction risks underpricing assets (if driven by the most desperate sellers) or overpricing (if driven by collusion). I fear that Treasury is likely to set a minimum price at the point where most institutions can sell without becoming insolvent. Otherwise, the auctions could fail, or institutions pushed under when marking to the prices set. Treasury has already had several failed "solutions", and would be deeply embarrassed by another, so they have every incentive to set rules that "work" regardless of their soundness.

So I'm afraid that we're headed into a very flawed approach, that will be staunchly defended by a variety of political and financial players with stakes in its success. Those defenses are going to badly muddle the principles we ought to apply to economic policy, because they won't make much sense. It will be very hard to argue against progressive interventions that don't make sense when many expert voices are arguing for this intervention that doesn't make sense. Both types will have reasons to avoid closely inspecting arguments and facts in a fashion that would actually illuminate events.

What we're seeing here isn't a complete failure of market principles. The crisis is founded in part in political pressure to extend credit to low income homeowners through the banks and GSEs. (Among other causes, among them a degree of overoptimism about the judgments of market players.) And the proposed resolution doesn't strike me as a particularly intelligent application of those principles. But many will read it that way, and will notice that a lot of Establishment players were willing to abandon those principles to serve their particular interests. We're seeing a major step away from a more intelligent political and economic structure, and it's founded in part by the prior departures from principle by the Congressional Republicans and the lapses of judgment by the Administration.

I suspect the current situation could be managed without financial collapse through a collateral lending approach. I imagine other, less drastic solutions are possible. I agree that if something isn't done we will have a serious financial crisis that will lead to years of recession. And I agree that the manner of any rescue has implications for the pace and extent of any credit unwind. (For example, a collateral approach might halt credit growth if institutions built reserves against losses in their collateral and to get out from the equity payment constraints.) I wonder if these differences would be so great in the long run, as we're looking at a credit contraction in any case.

But I think slower growth, and even the risk of financial crisis, might be better than the damage we're doing to the principles applied to these problems. The bailout as proposed further ratifies the notion that the government should be the ultimate absorber of all risk. That assumption has already driven bad policy on health insurance, storm damage, trade policy and a host of other areas. It won't help as we confront problems of retiree income and health care, and further adjustments to international trade patterns and health policy. We might manage through this crisis, but our politics are taking a real turn for the worse.