Brad Setser

Brad Setser: Follow the Money

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Sharing upside and downside risk …

by Brad Setser
September 23, 2008

Sovereign wealth funds have invested about $35b in US financial institutions. Adding in Qatar’s investment in Barclays and Singapore’s investment (through the GIC) in UBS brings the total up sovereign funds have invested in firms with a large US presence to around $55b.*

The US taxpayer is now being asked to invest $700b to help recapitalize the global financial system – a sum that is more than 10 times as much as the world’s sovereign funds put in.

But, at least as I read Paulson’s initial proposal, the US taxpayer would not get any equity in the world’s large financial institutions in exchange for this help.

Now the US isn’t making a pure equity investment, though some – like Doug Elmendorf and Sebastian Mallaby– think it should.

It is buying the banks’ illiquid assets.

But there is at least the possibility that it will “overpay” for those assets, and in the process effectively contribute equity capital to the US and global banking system. Indeed, there is a real probability it will overpay by more than the $55b sovereign funds have put into the global financial system.

There are broadly speaking two ways a government can recapitalize a banking system.

One is to put in a lot of equity. That equity can be put in to allow the banks to write down (and eventually sell) their bad assets – or it can be put after the banks’ have down the write down, providing the funds both to make the banks’ creditors whole and to supply the banks with new equity. It works out to the same thing. Such an equity infusion is good for the holders of the financial systems debts (depositors, money market funds, bond holders) and bad for the holders of the banks’ equity.

The other is to buy the banks bad debt. That clearly generates a bit of liquidity for the banks – they have more cash on hand, and thus more capacity to make new loans. But it also is risks providing a large gift to the banks equity investors – as they get to move an illiquid asset off the banks books at what may well prove to be an above market price.

Most bank recapitalizations have elements of both. The FT – in its usual sensible way – suggests that the US recapitalization should too. I agree.

To give a concrete example, the Chinese recapitalized their state banks earlier this decade both by buying bad assets off the banks books (usually by exchanging bad assets for the bond of an asset management company, with bad assets shifted to various asset management companies at book value) and by injecting new public funds (whether new funds from the Finance Ministry or some of the PBoC’s foreign exchange reserves) in exchange for the banks’ equity. Now the state banks were already owned by the government, so it didn’t matter too much – apart from internal accounting — exactly how the system was recapitalized: Chinese taxpayers stood to gain on their “equity” in the state banks if China’s taxpayers overpaid for the banks bad assets. But the Chinese example still illustrates the range of choices available to the government.

Some banks still seem to have faith in the illiquid assets they hold and worry that the government might be getting too good a deal on their MBS and complex securities; it will buy distressed assets at a discount from illiquid institutions, and could end up with a significant financial gain if it holds those assets to maturity. Maybe. The mysterious knzn at least initially believed that this scenario wasn’t entirely unrealistic. The obvious solution to this concern is to give the banks a bit of the government’s upside: if the taxpayers make a profit, some of it could be “given back” to the banks.

On the other hand, the government might end up overpaying – perhaps significantly – on the banks’ assets. That helps the banks and hurts the government. The fairly obvious solution here is to give the taxpayers some of the banks upside.

Apparently one objection to an “equity” component of a recapitalization is “a gut Congressional reaction against the government taking equity stakes in a broad array of American corporations.

Alas, that cart has already left the barn.

The Fed effectively bought AIG last Wednesday – and the Treasury took over Fannie and Freddie the previous weekend.

And unless foreign governments’ do not count, governments (though not the government) already have an equity stake in a lot of US financial firms. The governments of Singapore, Abu Dhabi, China, Korea, Kuwait and Qatar (through Barclay’s investment in Lehman) all hold equity stakes in the US financial system.

Is it really better to reward the banks’ existing equity investors — remember, they own the financial institutions that made the bad bets that led the financial system to seize up – to avoid a US government equity stake?

* My accounting is as follows:

Morgan Stanley: $5.6b (CIC)
Citi: $17.4b ( $7.5b from ADIA, $6.88b from the GIC, $3 from the KIA)
Merill: $12.5b ($5.9b from Temasek and, per Craig Karmin and Carolyn Cui of the Wall Street Journal, $6.6b from KIA and the KIC)

Total: $35.5b

UBS: $9.54b from the GIC and $1.8 from an unnamed investor in the Gulf widely thought to be a member of one of the region’s royal families.
Barclays: around $9b from a rights issue with substantial participation from both the QIA and Sheik Hamad’s private “Challenger” fund (Sheik Hamad also runs the QIA)

Combined total: $55.84b

This leaves out some pre-crisis investments – like the CDB’s investment in Barclay’s. And I am not totally confident of the accounting for the increased stake various funds took in Merrill when the initial deal was reopened, or for the Barclay’s rights issue. It is an approximation.

Sovereign funds may have provided additional funds through private equity funds or participation in public rights/ convertible issues. I have no way of tracking those investments.

104 Comments

  • Posted by JKH


    This plan is about government intervening in a required deleveraging process, rather than in a direct recapitalizing process. Either approach would improve capital adequacy for the system. But deleveraging assistance is the right choice at this time. Better to assist the financial system with expunging assets it doesn’t want, than to assist by providing additional capital against assets it doesn’t want. The full capital adequacy effect will result from both the removal of risk from balance sheets and the marginal price at which that risk is removed. The second component is a matter of opportunity cost in terms of the difference between current marks and the potential sale price. But it should not be viewed as a basement window entrance to recapitalization. Removing risky assets relative to the existing capital base is the primary objective. The plan’s focus on deleveraging doesn’t mean that further recapitalization won’t be required, even from government. But deleveraging rather than recapitalizing is the right priority in tackling the immediate systemic problem of seized up credit and mired capital utilization.

  • Posted by Rachel

    Its not US presence but the investment by an investment vehicle of Qatar’s emir in Kaupthing Bank, one of the troubled icelandic banks seems an interesting addition to your argument

    In addition to the Qatari investment in Barclays Temasek upped its stake noticeably in the rights issue – as did the CDB. Collectively they probably added somewhat less than $1b to the sums they had already invested last year

  • Posted by Murph

    Brad,

    Very interesting to view this $700B from the perspective of being a USA – SWF… it does lead one to think we darned-well SHOULD be getting an equity stake (or warrants)…

    On the other hand – Kevin Depew at Minyanville posted this sobering screen-capture on Friday:

    HOLDINGS SEARCH – US GOVERNMENT
    http://image.minyanville.com/assets/FCK_Aug2007/File/Sept082/hds.gif

    It is enough to give anyone who is happy to live in a free society the creeps.

    With equity comes control…

  • Posted by Rahul Deodhar

    Fantastic topic Prof. Setser.

    US tax-payer is financing the “global” liquidity crises. Isn’t this similar to central bank intervening in domestic markets to provide liquidity. So in effect US is acting like central bank of the world. But then does US have the clout/muscle to regulate globally?

    If US attempts so – is a political transgression. Naturally this will lead to diplomatic games that often result in lot of dinner and drink expenses and little else.

    If not, US tax-payer is getting a raw deal. In effect the already burdened tax-payer is bearing the global financial load. At this point, it is overwhelming. Add to it consumption responsibility that developing countries expect US to carry out.

    I think the system is near break. It is MUST that global leaders / central banks sit and hammer out the solution at a global level. Else we will be perilous close to political turmoil.

  • Posted by moldbug

    There’s a third way to recapitalize a bank, of course: be a mensch and bring it onto your balance sheet. Acquire its assets and assume its liabilities. Crisis over.

    Note that despite the fact that Uncle Sam has “nationalized” AIG, etc, a consolidated balance sheet is a long, long way away. It may well never happen. I am a blogger, not an accountant, but I’m under the impression that in the private sector an unnecessarily complicated accounting structure is considered a red flag.

    Ie: does USG intend to treat AIG’s liabilities as its own? As a sovereign, this is certainly its option, and it seems to have chosen that option. So USG’s accounting should reflect that. Jehovah doesn’t like to see liabilities swept under the rug – and Uncle Sam seems to have his attention at the moment.

    Note also that there are two variants of “plan 3:” (a) let your bank expire, and then buy it for $0; (b) nationalize it at the present market price. I can’t see any reason to prefer (3a) over (3b), except misplaced political spite.

  • Posted by Cedric Regula

    Uncle Bruno waza wonder’en ’bouts da timing. Does da feds borrow da $700B from whomever start’en dis week, or do da feds send out a emergency tax bill of $15,000 to every dual income household dis week wid payment terms start’n next week?

  • Posted by FG

    JKH: deleveraging assistance is the right choice at this time.

    Why can’t taxpayers be given equity in exchange for buying assets above the market price?

    The current proposal seems to provide a large gift to the banks equity investors.

  • Posted by Fabius Maximus

    Why not hire Warren Buffet to invest our $700B in banks and brokers? He got a sweet deal with Goldman. Upside plus 10%. Better than anything Paulson will get for us.

    No matter what commission Warren charges, we will be better off. And the banks will have more capital, eventually to be lost in the next business cycle.

  • Posted by Cedric Regula

    Fatimus Maxiumus:

    Warren de Buffet only gots $50 Billion, ana we dont’s gots $700 Billion.

    He’s an’ we’s be come’n a bit short.

  • Posted by Blissex

    «Better to assist the financial system with expunging assets it doesn’t want,»

    This is the classic Republican talking point: “expunging” could be done by simply writing those assets down. What JKH is rather disingenuously omitting is that “expunging” in this statement means “FREE GIFT OF A LOT OF MONEY”.

    Because he is in effect suggesting that the Treasury pay CASH for “assets” that the financial system merely «doesn’t want».

    Why don’t they weant those assets? Fashion has changed and red is no longer the new black?

    Or is is that just like «expunging» is a euphemism for “trading for taxpayer cash” the word “asset” here is a euphemism for “losses”? Let’s see how the buffoonery above reads without using euphemisms:

    “Better to assist the financial system with [trading taxpayer cash] for [losses] it doesn’t want,”

    «than to assist by providing additional capital against assets it doesn’t want.»

    As easy as that! Of course shareholders who own companies with a lot of losses would rather pass on the losses to someone else for free than to be diluted.

  • Posted by JKH

    FG: Why can’t taxpayers be given equity in exchange for buying assets above the market price?

    Good question. I haven’t come to an answer on this. I know others feel strongly that equity or equity warrants are desirable, including many in Congress, but I haven’t seen the full light yet. It seems an obvious and deserved upside for the taxpayer. But my suspicion is that the quid pro quo of equity may impede some of the efficiency in the reverse auction pricing process and outcome. Also, I’m not sure that a systematic quid pro quo regardless of the seller is necessarily the right way to go. But I don’t know at this point, and would like to hear more discussion.

  • Posted by Dave C.

    EDITED SLIGHTLY FOR TONE; THE FIRST SENTENCE WAS REMOVED

    From Bloomberg,China Shuns Paulson’s Free Market Push as Meltdown Burns U.S.
    http://www.bloomberg.com/apps/news?pid=20601087&sid=aCl7bFUJzWRk

    According to Arthur Kroeber at economic research company Dragonomics Advisory Services Ltd. in Beijing, “China’s made it clear it won’t listen to these snake-oil salesmen who come from Wall Street, even if they’re wearing suits issued by the Treasury Department,” he said. “It’s strengthened the hands of all the people who are very skeptical about financial liberalization in China.”

  • Posted by Dave C.

    Please click the below link to sign Senator Sanders’ petition against the US taxpayer bailout of Wall Street:

    http://sanders.senate.gov/petitions/?petition=financial_crisis_1

  • Posted by Dave C.

    U.S. Treasuries Lose Allure for Asia, Europe Investors

    Sept. 24 (Bloomberg) — Investors outside the U.S., who own more than half of all Treasuries outstanding, say the government’s $700 billion plan to revive the banking system will diminish the appeal of the nation’s bonds.

    “The image of U.S. Treasuries as a safe haven has been tainted by the ongoing financial debacle,” said Kwag Dae Hwan, head of global investment in Seoul with South Korea’s $220 billion National Pension Fund, which holds about $14 billion of U.S. government debt. “A big question mark hangs over whether the U.S. can deal with an unprecedented amount of debt. That is unnerving all the investors, including me.” ”

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aeJQFuvxEkIM&refer=home

  • Posted by Dave C.

    Rehashed “Scare tactics” from the same Bush Administration wrecking crew:

    Iraq War:
    “mushroom clouds could accompany Congress’s failure to act on the war request”

    Bankster bailout:
    “financial Armageddon could accompany Congress’s failure to act on the bailout request”

  • Posted by JKH


    Some interesting financial analysis from the popularly loathed king of bonds, Bill Gross:

    “I estimate the average price of distressed mortgages that pass from “troubled financial institutions” to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.”

  • Posted by bsetser

    gross then implies that about $1 trillion (nominal) will be moved onto the treasury’s books –or roughly 10% of total mortgage debt outstanding.

  • Posted by Black Swan

    If the Treasury Secretary was really concerned with the lack of lending on Main Street, instead of taking trillions of dollars and pouring it down a rathole to further enrich his friends and postpone the inevitable collapse of the investment banking system (while he is still in office), he could lend the money directly to Main Street. The Government is already lending money on real estate(HUD), and, aside from the seller assist 100% loans, the FHA programs have held up fairly well. So why not lend to Main Street business, using prudent lending standards, at rates that give the taxpayers good returns on their money?

    As far as that bad mortgage paper is concerned, let it collapse. Then the Government can get the properties for free, as it did during the S&L crash. Government resales of those properties to the public will decrease the deficit. Domestic and foreign investors who bought that worthless asset backed paper, will just have to lose money. Bad investments should not pay off.

    Once the economy is running again, private investors can get back into the lending market, and the Government could ease out of it. The biggest problem today is counterparty default, and not just with credit default swaps. In this asset deflationary economy, no entity should lend money on any asset that is not worth considerably more than the money being loaned on it. Additionally, no entity should lend money to any party, without the reasonable expectation of being paid back in full.

  • Posted by Dave C.

    The core problem of US finance capitalism:

    “It’s built on the misguided assumption that capitalism can thrive without capital.”

  • Posted by Joe Rotger

    Tic, tac, tic, tac…

    The longer it takes for Congress to come up with a decision on how to handle the bailout, the better the taxpayer terms that Paulson will be able to extract from the failed banks.

    Although, if they take too long, there may well be no financial markets, which is the only hand that banks have left to play.

    After Barclays $2.5 billion bonuses for the NY Lehman office execs, my chips are on the bluff…

  • Posted by Blissex

    «“I estimate the average price of distressed mortgages that pass from “troubled financial institutions” to the Treasury at auction will be 65 cents on the dollar,»

    «a prospective yield of 10 to 15 percent to the Treasury.»

    That’s another good piece of dissembling, not dissimilar from «expunging» or «doesn’t want».

    Where are the numbers supporting this fantasy estimate? If there were numbers supporting this, MBS arbitrage would be making a lot of money for private equity, but they are careful not to touch anything.

    There is no shortage of liquidity in the USA: gov bonds return 0% nowadays, so large is the amount of liquidity.

    So why is nobody willing to play MBS arbitrage like the Treasury is? It is such a slam dunk! :-)

    Anyhow, since the Treasury has already declared they will try to pay prices that higher than market for the MBSes, of course the selling institutions will want to get rid of the worst securities they have and hold onto the best. So even if the *average* is 65%, the likely default rate of the stuff the Treasury will buy will be way above that.

    «gross then implies that about $1 trillion (nominal) will be moved onto the treasury’s books –or roughly 10% of total mortgage debt outstanding.»

    Well, the worst 10% of course; or else the bailout won’t work, because those are the «assets it doesn’t want».

    But note that about half of those mortages, the best quality ones are *already* on the Treasury books, because that half of total mortgages are with the GSEs already.

    Anyhow, suppose Gross is right and the returns he quotes are an easy as «a positive carry or yield spread of at least 7 to 8 percent», then why invest in this arbitrage only $1 trillion? That’s only around 70-80 billion a year of FREE MONEY that the market is leaving on the table for the taxpayer!

    The Treasure should borrow $5 trillion at 4% from gullible foreign investors, get their 10-15%, and make $350-400 billion per year, and use that money to fund a MASSIVE TAX CUT on financial system executive compensation; for example, abolishing all taxes due on bonuses to executives of financial companies, to incentivize them to create even more wealth for America! :-)

  • Posted by Blissex

    «The Treasure should borrow $5 trillion at 4% from gullible foreign investors, get their 10-15%»

    But wait as second, didn’t the Treasury just buy the GSEs for essentially no cash outlay, with their precious stock of $1.7 trillion of high yielding mortgages, the only cost being having to borrow less than 100 billion at 4%?

    Bonanza time! If buying just $1 trillion of mortgages and MBSes at 65% from the private sector and funding that borrowing that $1 trillion at 4% gives a net return of 7-8%, try to imagine buying $1.7 trillion by borrowing at 4% less than $100 billion!, or something like 6% instead of 65%.

  • Posted by Blissex

    «The Treasure should borrow $5 trillion at 4% from gullible foreign investors, get their 10-15%, and make $350-400 billion per year,»

    Warrent Buffett himself suggests this is the easiest, safest FREE MONEY on the table today:

    http://www.cnbc.com/id/26867866
    «BUFFETT: Well, I don’t want to leverage up. No one wants to leverage up in this thing. So, if I could buy a hundred billion of these kinds of instruments at today’s prices, and borrow non-recourse 90 billion, which I can’t, but if I could do that, I would do that with the expectation of significant profit.
    JOE: But the government can do that. You can’t. And that’s why the private sector can’t, even you, can’t save the system.
    BUFFETT: I can’t come close to it. But they have the ability to borrow. They can borrow much cheaper than I can borrow. They can borrow unlimited. They don’t have covenants. They don’t have — I mean, they are in the ideal position. So, for example, if I were hiring advisers, as I talked about doing to buy these things, I would tell those advisers, ‘Look it! People are buying these instruments to make 15 percent. So if you’re going to charge me any fees, I’m going to defer those fees until I get rid of these instruments later on. If I don’t make at least ten percent on my assets, you know, your fee goes down the drain. Because it should be a lead-pipe cinch to make 10 percent at the kind of prices that exist now.
    »

    But wait a second, he has something to say on price:

    «And there’s no one that can leverage up except the United States government. And what they’re talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that’s going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won’t do it perfectly right, I think they’ll make a lot of money. Because if they don’t — they shouldn’t buy these debt instruments at what the institutions paid. They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments.»

    «And the big buyer, if they — they shouldn’t pay any attention to the cost of these instruments to the selling institutions. They shouldn’t pay any attention to the carrying value. In fact, one thing you might do, is if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay. You don’t want the Treasury to be a patsy.»

    So oops he actually thinks that the Treasury could make 10-15% returns but only if they bought at market price, which currently os around 22-33%. Try to imagine what the return would be if buying at 65% or the 85% that the Fed lends against junk collateral in its facilities…

    But in one respect Mr. Buffett seems rather optimistic:

    «But I’ll tell you, with Hank Paulson on top of it, you couldn’t have any better guy to do that. »

    Given that he has already promised to pay significantly more than market price.

  • Posted by Blissex

    «if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay. You don’t want the Treasury to be a patsy.»

    As to wanting the Treasury to be a patsy, Buffett has structured a deal for himself in which he buys equity in GS, not their bad paper, and the equity has an but guaranteed rate of return of around 16%:

    http://bigpicture.typepad.com/comments/2008/09/i-got-75b-but-i.html

    Given that GS seems to be one of the least risky investments one can make nowadays, shouldn’t any money that the Treasury were to give to other players deserve the same or better terms? Like a substantial chink of preferred, a chunky guaranteed return?

    Compare the Buffett deal with this eminent suggestion:

    «This plan is about government intervening in a required deleveraging process, rather than in a direct recapitalizing process. Either approach would improve capital adequacy for the system. But deleveraging assistance is the right choice at this time. Better to assist the financial system with expunging assets it doesn’t want, than to assist by providing additional capital against assets it doesn’t want.»

    versus Buffett’s GS deal and his suggestion that:

    «if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay. You don’t want the Treasury to be a patsy.»

  • Posted by Cedric Regula

    Mama Mia, even Buffett hasa turned inta a brain dead goombah…

    “BUFFETT: I can’t come close to it. But they have the ability to borrow. They can borrow much cheaper than I can borrow. They can borrow unlimited. They don’t have covenants. They don’t have — I mean, they are in the ideal position….”

  • Posted by Blissex

    «Mama Mia, even Buffett hasa turned inta a brain dead goombah…»

    Nooo. Cedric I like you contributions, but this is wrong. When Buffett says that the Treasure are in an ideal position to make money out of a liquidity arbitrage, he does so with the vital detail that the Treasury can do so only if they buy at what Bernanke and Paulson have called «firesale prices».

    Implicitly saying that if the Treasury buy at «maturity» prices, they are going to lose a lot of money:

    «if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay. You don’t want the Treasury to be a patsy.»

    Too bad that Gross, JKH, Bernanke and Paulson want it very badly…

  • Posted by Cedric Regula

    I challange da concept dat da treasury has or can borrow a “unlimited amounts of money.”

    We are getting to da point where dats not a slam dunk assumption no more. Read Brad’s posts on CB reserve growth. Or does it come from da private sector? Not here for 3.5%.

    Waddaya tink happens if da treasury tries to sell $700B bonds in da near future, or tries to raise it wid a “emergency” tax hike?

  • Posted by Blissex

    «Waddaya tink happens if da treasury tries to sell $700B bonds in da near future,»

    Well, if that premise doesn’t work, then the whole Paulson/Bernanke MOAB plan doesn’t work.

    Indeed if the Chinese stop being eager to fund the policies of the Republican party with unlimited amounts of low interest soft loans, a lot more than the MOAB plan collapses.

    I have argued before that the Chinese leadership may no longer be so interested in importing more USA jobs to China and more exporting more chinese production to the USA, and if will not be, then goodbye MOAB plan and a lot else besides…

  • Posted by Cedric Regula

    Ya, dada wad I tinks, ana Uncle Bruno tinks so too.

    Brad estimates Chinese reserve growth atta ’bouts $400B next year, ana dey already gots most of der old money here.

  • Posted by aim

    JKH, Great comment. Deleveraging rather than a direct recapitalizing is the choice. A broad based reverse auction sounds like a great way for the government to pay a reasonable price and help the banks help themselves. I was wondering how they came up with 700b for this plan. I believe I heard the Bernanke say that so far the banks have had about 500b in losses so far and therefore they need to recapitalize by about that amount. This sounds like where the 700b came from.

  • Posted by Blissex

    «the Chinese leadership may no longer be so interested in importing more USA jobs to China»

    Oops, I worded this badly — the “vendor financing” that the Chinese have been doing has the object to import USA *productive capital* to China.

    Since Chinese wages are way lower than USA ones, jobs would be anyhow to China, but it would be labor intensive, low value added jobs (plastic shoes, cheap toys, …), because of sunk capital costs in the USA and the cost of capital of moving them to China.

    But by keeping USA interest rates low and the USA dollar high the Chinese have made it profitable for USA companies to export productive capital (whole factories) and capital intensive (fairly high value added) jobs to China, which is much better for the Chinese (and for the Republican company bosses).

  • Posted by bsetser

    JKH — if you have more on why a swap that includes and equity component for the treasury wouldn’t work, i am all ears. I am among those who feels this is a necessary protection for the taxpayers against the risk of overpaying but if there is a good argument against it, i would like to hear it. I do think that there is something to the notion that the government is the only entity able to lever up on the scale needed to absorb all the paper the banks need to unload — tho obviously finding the right price is key.

    incidentally, i don’t think all this money would be borrowed from the rest of the world — at least not so long as US risk capital is coming home and the global current account surplus (china plus oil) looks likely to shrink a bit in 09. if the government sells treauries for cash and uses the cash to buy a lot of the banks assets, the banks end up with a lot of cash — which they might use to buy treasuries (making it an asset swap) or to repay their loans from the fed (allowing the fed to rebuild its treasury holdings). my sense is that this will be financed by an increase in domestic treasury holdings more than further growth in CB holdings (which will grow and will help finance the 09 fiscal deficit).

    remember, this thing could be done without any new market issuance: the gov could swap treasuries for the banks bad assets … avoiding any direct market issuance (if you can agree on the price of the treasury issue .. )

  • Posted by Dave C.

    To bailout the executive bonuses at Goldman Sachs from the level-3 garbage, the economic costs will be socialized to every holder of the US Dollar. Not even an apology from Paulson to US taxpayers for his brazen and unethical behavior….

    From Bloomberg, Paulson `Deficit’ May Push Dollar Down to Record
    http://www.bloomberg.com/apps/news?pid=20601103&sid=a61md3ksf9Po&refer=us

    Sept. 24 (Bloomberg) — Treasury Secretary Hank Paulson’s $700 billion proposal to bail out the U.S. financial system may send the dollar to record lows by swelling the budget deficit.

    Paulson’s proposal to buy devalued securities from banks would drive government debt above 70 percent of gross domestic product, the most since 1954. The annual deficit may balloon to as much as $1 trillion, a level that TD Securities Ltd. says could drive the greenback to $1.95 per euro. The currency reached an all-time low against the euro of $1.6038 on July 15.

  • Posted by Michael

    Why doesnt China/Saudi just unwind $1T of treasuries into the current money mkt bid, and reinvest the money into either broadbased US equities or Toxic debt? They will also front run these brutally cardboard senate hearings.
    China has a choice; break the system, or fix the system.
    But holding Treasuries yielding negative is a bad bet. Exhibit: money mkt’s
    They should deploy the capital if they believe the US will remain the powerhouse. Or they should liquidate and try to be the new powerhouse (which we will without a doubt fight for). no middle ground. for them to pick up the bill from the treasury at 1% is a weak strategic play. But I hope the do it for our sake…

    Great site – i read it daily.

    Mike

  • Posted by Cedric Regula

    Brad:
    “remember, this thing could be done without any new market issuance: the gov could swap treasuries for the banks bad assets … avoiding any direct market issuance (if you can agree on the price of the treasury issue .. )”

    Ya, been tinking about da swap concept too. But da treasury still prints dem up ana da banks gotta hold dem as capital base to make it market neutral. If dey decides to sell dems fur any reason, it ain’t market neutral. Or dey could give’s dem to da Fed to pay off der loans ana da Fed gives dem der subprime collateral back? Ana maybe US money bails on das stock market ana goes inta treasuries, pushing rates down’ta 3%. Could happen. Uncle Bruno been eat’n his heart pills like candy lately.

  • Posted by Twofish

    Bsetser: Now the state banks were already owned by the government, so it didn’t matter too much – apart from internal accounting — exactly how the system was recapitalized.

    It mattered a great deal. Different parts of the Chinese state act autonomously, and you have the same sorts of moral hazard problems that you have in any sort of bank bailout. In particular, if you refund the banks, how do you make sure that they won’t come back again.

    Blissex: If buying just $1 trillion of mortgages and MBSes at 65% from the private sector and funding that borrowing that $1 trillion at 4% gives a net return of 7-8%, try to imagine buying $1.7 trillion by borrowing at 4% less than $100 billion!, or something like 6% instead of 65%.

    This was the sort of conversation that got the Lehmann Brothers in trouble in the first place.

    Any time you see “free money” you are missing something.

  • Posted by Twofish

    Black Swan: So why not lend to Main Street business, using prudent lending standards, at rates that give the taxpayers good returns on their money?

    Because it doesn’t solve the big problem which is that in about a month, banks are going to be unable to pay depositors at all. If we had a liquidity problem, then there are some standard ways of dealing with that. But we have (or soon will have) a solvency problem.

    Personally, I think that Paulson and Bernanke are publicly wildly understating the severity of the problem in order to avoid panic.

    Black Swan: As far as that bad mortgage paper is concerned, let it collapse.

    That’s not an option. The bad mortgage paper is backing up people’s commercial bank deposits and if the government doesn’t bail out the banks through mortgage paper purchases then it will have to bail out FDIC with that goes broke, which is going to happen in a month if no deal gets passed.

    Black Swan: Once the economy is running again, private investors can get back into the lending market, and the Government could ease out of it.

    If you do have a general collapse of the financial system you are looking at a decade before people get back in again.

  • Posted by Jehu

    Dave C. Says:

    Rehashed “Scare tactics” from the same Bush Administration wrecking crew:

    Iraq War:
    “mushroom clouds could accompany Congress’s failure to act on the war request”

    Bankster bailout:
    “financial Armageddon could accompany Congress’s failure to act on the bailout request”

    **********************************************

    This come right out of a playbook writtne decades ago. This bailout is being sold just as NSC-68 was sold: with the use of language that is “clearer than truth.”
    I suggest you read this document by Steven Casey:

    http://www.lse.ac.uk/collections/CWSC/pdf/selling_nsc_68.pdf

  • Posted by JKH


    Brad,

    Having listened to Bernanke’s response to that question today, I heard several aspects within the explanation.

    Explicit in the general approach of the plan is the assumption that most of the selling institutions will be “going concerns” and that the problem is still more one of systemic illiquidity than systemic insolvency. Of course, this is a big assumption and is debatable, particularly from those who fear the worst. But with that as the Treasury/Fed working assumption, the plan itself makes sense in that it addresses the liquidity problem head on and does not attempt to target solvency per se. Solvency problems are therefore left to be tackled as one-offs outside of the plan.

    Bernanke said he didn’t want to “stigmatize” those institutions who participated in the auction by insisting that they issue equity or equity warrants to Treasury, thereby creating the impression they were in danger of further forced capital injections or even nationalization. He further suggested that this overhang might hinder efforts to recapitalize institutions requiring new equity through the private markets.

    Treasury wants the participation in the auctions to be as broad as possible, in order to get the best price, and achieve the best market clearing result. This is why they’ve insisted that participation be extended to include foreign banks with operations in the US. Mandatory equity dilution would be a marginal disincentive for those considering participation in that it will affect the economics for the price they are willing to put on assets offered to Treasury. Forced equity conditions will create worse asset pricing. Voluntary, unencumbered, competitive bidding should produce the best (cheapest) price for the assets, and the best direct result for taxpayers.

    I agree borrowing from the rest of the world won’t be necessary to fund this plan, and made that point previously. A short cut way of looking at this is that the required funding is only a balance sheet transaction (at least initially), which does not directly affect GDP related savings flows or the current account deficit. Your round-trip view of treasuries purchased by institutions with the new cash also clarifies it.

    I understand your final point, but I think the end result would amount to a market issuance of treasuries. There would be no reason for the selling institutions to hold $ 700 billion in new treasuries on their balance sheets; that would just amount to them remaining with leveraged balance sheets – albeit invested in treasuries. I suspect Treasury wants to encourage their full deleveraging, with perhaps some rebuilding of liquidity positions for ongoing new lending purposes. But consistent with the idea that this is only a balance sheet transaction, Treasury would have no problem finding the funds to finance it via Treasury issuance, other things equal.

    btw – Bernanke used an explicit number of 5 per cent of outstanding mortgages as equating to the $ 700 billion program size – $ 14 trillion outstanding, and $ 700 billion purchased (without allowance for either mark haircuts or additional throughput beyond the $ 700 billion balance sheet constraint – I fear he may have done this to improve the optics of the size requested).

  • Posted by fatbrick

    @Michael ,

    Cbs’ old treasure debts holding now are profitable. If they mark to market, they will book tremendous profits on their books.

    Buying toxic assets for US gov.? What is the return?

  • Posted by Dave C.

    Twofish,

    It’s sheer political nonsense that the US banking system is near collapse. Paulson and Bernanke are publicly wildly overstating the severity of the problem in order to create a panic to justify the taxpayer bailout of their Wall Street buddies.

    From banking industry expert Bert Ely,
    http://www.nakedcapitalism.com/2008/09/banking-expert-bailout-not-necessary.html

    One of the premises of the bailout bill is that the banking industry must have government help to get back on its feet.

    A banking industry expert, Bert Ely, who has a stellar track record in predicting crises and calling false alarms says that the banking industry can handle this mess internally and does not need subsidies.

    Bert Ely: I have run the numbers looking at the capacity of the industry to pay the tab. Assuming that bank insolvency losses don’t get way out of line, which I don’t think they will, then the industry can handle it. It’s not going to be cheap, but the banks can handle it and clean up their own mess.

  • Posted by Black Swan

    I am not an economist which is painfully evident by my question here but let me ask this. If we are in such a “liquidity” crisis why is my money market fund paying 2.25% interest? That is not a rate of return that suggests that capital is difficult to come by. My sense is that many CBs and IBs made bad investments and THEIR liquidity is bad but by no means did everyone participate in this bacchanal. BTW, my brother is refinancing his shopping center in San Diego (he is very conservative with 80% equity position) and he is having no trouble getting the loan.

  • Posted by bsetser

    black swan — my guess is that your money market fund will soon return a bit less, at least if it is in t bills ..

  • Posted by bsetser

    dc — i respectfully disagree with your assessment that the us banks are in rude health. all shorts of indicators suggest that they face real pressures raising short-term funds

  • Posted by bsetser

    JKH — the whole notion of buying bad assets to set a price floor under the equity of the banks to allow them to raise new funds from other investors (including other govs) is what leaves a bad taste in my mouth. it feels like trying to do a deal where the US guarantees against downside risk on future equity investment (without being compensated for it) by providing a lot of insurance against illiuquidty and insolvency just to avoid the appearance of government control.

    basically, put a floor under losses so abu dhabi and others want to come in with new cash — cause round 1 didn’t work out so well. that gives the upside to private investors/ the rest of the world while leaving the us taxpayer with the downside.

    i still don’t see why that is a good trade.

  • Posted by Black Swan

    Brad,

    Some US investment banks with tattered balance sheets are having trouble raising capital, but overall US Corporations are swimming in cash. Chicken Little Paulson crying that “the sky is falling down” simply isn’t credible.

    From London FT, record US Corporate cash levels
    http://www.nakedcapitalism.com/2008/09/corporate-america-sits-on-its-cash.html

    Corporate America waded into the darkest days of the credit crisis with more cash than ever before, a sign many of the US’s biggest companies have been bracing for signs that Wall Street’s problems will infiltrate the rest of the economy.

    Excluding utilities and financial institutions, members of the Standard & Poor’s 500 Index ended June with a record $648bn in cash and short-term securities.

  • Posted by Dave C..

    No Confidence in Bernanke’s Confidence Game
    by Mish Shedlock
    http://globaleconomicanalysis.blogspot.com/

    In Ben Bernanke’s testimony yesterday, it seems that in his view “the plan” essentially boils down to this: if the government can start buying this toxic stuff at a “hold-to-maturity price”, it will establish a price that everyone else in the markets can then use.

    The government plan is to tell the market what price to value these things at, and then everything will work out fine after that.

    The whole thing is so absurd. The market will continue to price these assets on their own accord, regardless of what some bureaucrat pays for them.

    Buying assets below or above what they are worth cannot inspire confidence any more than a game of three card monte can.

  • Posted by moldbug

    bsetser,

    If Bernanke’s statements about “hold-to-maturity price” are accurate, his goal is to use the $700B to restore normal, “liquid” or “MT-on” pricing to the MBS market. This strikes me as unlikely to work in the first place, and equity warrants make it almost impossible.

    TARP is basically a new bank which will set a price for various classes of MBS based on risk-free, MT-on interest rates and some estimate, source undetermined, of mortgage default risk. Everyone agrees that this price is much higher than the current MT-off or fire-sale price. (The fire-sale bid fluctuates wildly and seems almost meaningless – it probably represents speculation that the liquidity switch will flip or be flipped back on, rather than actual non-MT demand for doubtful payments in the distant future.)

    So: TARP buys $700B of securities at the MT-on price, and marks them on its books at this price. Result: the world has one more big bank with a large portfolio of mark-to-wet-dream assets. The banking system has $700B more dollars. Big deal – being solvent, it can raise capital already. I don’t see how this moves MBS out of the troubled-asset category. Banks do not buy troubled assets. There’s a basic coordination problem here which is not getting solved.

    With an equity stake, in which banks accept dilution proportional to the difference between the MT-on and fire-sale prices, the bailout seems almost guaranteed to fail. Work through the logic: either the bailout will fail, or it will succeed. If the bailout will succeed, there is no reason for a bank to sell to TARP, because it can sell the MBS on the market later without any dilution. So no one will sell to TARP, and the bailout will fail. And if it fails it fails – so it must fail. Banks will hold tight and wait for the next bailout attempt, which will be even bigger and more dramatic.

    The absence of equity warrants at least ensures that there is no disincentive to sell to TARP. This plan is a long shot to begin with, and it doesn’t need anything that would make it longer. Sadly, it appears it will get it.

  • Posted by pseudorandom

    Twofish: The bad mortgage paper is backing up people’s commercial bank deposits and if the government doesn’t bail out the banks through mortgage paper purchases then it will have to bail out FDIC with that goes broke, which is going to happen in a month if no deal gets passed.

    And why is it better to bailout the banks rather than the FDIC? Good riddance to bad rubbish, right?

  • Posted by pseudorandom

    moldbug: If the bailout will succeed, there is no reason for a bank to sell to TARP, because it can sell the MBS on the market later without any dilution. So no one will sell to TARP, and the bailout will fail.

    This reasoning is not correct. Banks are not able to hold securities to sell later so even if they think the MBS may eventually be worth more than firesale, they may still be forced to sell at a discount.

    There is really no way to differentiate between illiquidity and insolvency because the outcome will depend a lot on what happens with the economy in general in the future – and we of course cannot predict the future.

  • Posted by Dave C..

    It’s important to realize that this bailout plan adds nothing to economic growth. The proposal will shift hundreds of billions of taxpayer dollars to purchase rotten financial assets from Wall Street institutions and banks for more than they are worth.

    It took our fine republic a few hundred years to run up $5.2 trillion in debt, but over the next three years Treasury borrowing could exceed $8 trillion, a staggering 60 percent increase in the real national debt.

    Trillion dollar deficits aren’t chump change! However, squeezing a trillion dollars out of the money markets of the world is clearly impossible and the only remaining option to fund the US Treasury’s insatiable appetite is through “monetization”. Monetization means that the Federal Reserve would step in and print up new money out of thin air and buy the Treasury debt. When that occurs, monetary growth rates would soar and, in turn, create very high inflation as too many dollars start chasing too few goods. Rising inflation forces interest rates up, and rising interest rates always have devastating consequences for the prices of financial assets such as stocks and bonds.

    http://www.financialsense.com/editorials/benson/2008/0923.html

  • Posted by Twofish

    Black Swan: If we are in such a “liquidity” crisis why is my money market fund paying 2.25% interest?

    Because last week the Treasury department put a guarantee of $50 billion against all money market funds. All those funds were about to collapse.

    Banking crises are like strokes or heart attacks. You could be feeling fine one minute and dead fifteen minutes later. Cash is like blood or oxygen. As long as it flows, you are still alive. But the second the cash stops flowing you have minutes before the patient dies.

    It’s like sinking in quicksand. As long as you can keep your head above the sand, you will live, but if your head goes under, then things get bad, very, very quickly. Right now we are waist deep in a mess. However, most people think that something is going to pass, because the consequences of nothing passing is so unimaginable.

    Think of it this way. Things are scary enough to get George W Bush to agree to caps on CEO salaries.

    Black Swan: Excluding utilities and financial institutions, members of the Standard & Poor’s 500 Index ended June with a record $648bn in cash and short-term securities.

    And that cash is in are largely in repurchase agreements and short term commercial paper. If commercial banks start failing those markets shut down cold, and it will be impossible to convert the paper and repos back into cash.

    Businesses and banks don’t store money in gold bars or wads of paper money. What they do is to hold short term (often overnight) securities, and then immediately convert those securities to cash as needed. If you have a meltdown, then everyone is going to be selling, no one is buying, and then no one can convert these short term securities back into cash.

    pseudo: And why is it better to bailout the banks rather than the FDIC? Good riddance to bad rubbish, right?

    See above. FDIC only insures accounts up to $100,000. These accounts have millions or billions in them.

  • Posted by moldbug

    pseudorandom,

    Of course some people need to sell. Some people are selling right now at the fire-sale price. TARP will certainly increase the troubled-asset price, but what I doubt is that it can eliminate the qualitative distinction between troubled and non-troubled assets – which is (apparently) its goal.

  • Posted by Twofish

    DC: It’s sheer political nonsense that the US banking system is near collapse. Paulson and Bernanke are publicly wildly overstating the severity of the problem in order to create a panic to justify the taxpayer bailout of their Wall Street buddies.

    Personally I think they are wildly understating the severity of the problem because they don’t want to panic people. It’s very bad situation. The one good thing about it is that it is somewhat refreshing to see politicians act more or less like adults when the fate of the world is in danger.

    As far as Ely’s comments, it’s the sort of neo-liberal, IMF-led, Washington consensus nonsense that I thought you were opposed to.

  • Posted by JKH

    Brad,

    I’m still not convinced 100 per cent either way. Specifically, I’m not convinced that forced equity participation is the right way to go. This requires more thought.

    Paul Krugman today makes an argument similar to yours.

    http://krugman.blogs.nytimes.com/2008/09/24/a-700-billion-slap-in-the-face/

    But Moldbug above notes a dysfunctional pricing consequence of forced equity, similar to one of my points.

  • Posted by pseudorandom

    Twofish: See above. FDIC only insures accounts up to $100,000. These accounts have millions or billions in them.

    That’s not a very good reason. If that’s all you are concerned about, the insured limit can be raised to $1M or whatever amount is reasonable.

    My own guess is this is only an excuse. The reality is Paulson and his friends do not *want* to give money to depositors or homeowners, but only to bankers. It is ideology pure and simple, masquerading as pragmatism.

  • Posted by Twofish

    JKH: Specifically, I’m not convinced that forced equity participation is the right way to go. This requires more thought.

    The problem is that we have a few days to weeks before the world financial markets go poof. One problem here is that you can think about it later if you give the secretary of the treasury power to think about the situation and come to a conclusion, but at that point it all depends on how much people trust the treasury secretary (and the answer is not much).

    I think that Paulson and Bush are doing something political clever because by conceding the point on CEO salaries they conceding the point with the most political benefit while giving up the least amount of equity participation. If you put in a cap on CEO pay, then the senators can go home and campaign that they were tough on Wall Street, whereas if you talk about “forced equity participation” people’s eyes will glaze over.

    One thing about politics is that people actually don’t care that much about how much money they lose in taxes. What they do care about is “good triumphs over evil” stories. If you give a human sacrifice so that the public is placated, then they’ll not care about how much it really costs them.

    The thing about is that I don’t think that any legislative caps on CEO salaries will actually have any real effect since it is trivial to find ways around them.

  • Posted by Twofish

    pseudo: That’s not a very good reason. If that’s all you are concerned about, the insured limit can be raised to $1M or whatever amount is reasonable.

    At that point we come back to where we are now. The problem is that I can say that I’m going to insure you up to a million or ten million dollars, but when things are stressed, people want to see money on the table, and if Congress isn’t willing to put money on the table, then all this talk about insurance is just pointless.

    pseudo: My own guess is this is only an excuse. The reality is Paulson and his friends do not *want* to give money to depositors or homeowners, but only to bankers. It is ideology pure and simple, masquerading as pragmatism.

    I don’t think so. Paulson and people that walk in his social circles have far more personal wealth than most people can imagine and they have more money than any human being can spend in one lifetime.

    Once you have $50 million in the bank, an extra $1 million or $1 billion just doesn’t matter. People in Paulson’s circle care about money only as far as it relates to scorekeeping.

    When you talk about $700 billion, the money that you have to skim off the top to give you and your friends more personal wealth than any human being can imagine is quite small. For example by making funding decisions reviewable by courts just gave about a billion or two to lawyers. Putting caps on executive pay just gave about $1 billion or so to accountants. If the bill goes through, it will be interesting to see who was able to sneak in what.

    Whatever you do or don’t do, one of Paulson’s friends is going to get rich, so I don’t think that personal wealth is very high on Paulson’s considerations.

    I think his big concern is that he doesn’t want to be remembered as the Treasury Secretary on duty when the Second Great Depression started. My big concern is that 1) I’m not as rich as Paulson so if the economy goes under I’m wiped out and 2) the last time there was a Great Depression there were some very unsavory characters that got into power.

    When times are good everyone is happy. When times are bad, people look for people to blame, and I’m going to be very high on the list.

  • Posted by JKH

    Twofish,

    Deadlines can be wonderfully effective in focusing and optimizing thought sequences.

    Evariste Galois documented much of mathematical group theory the night before he was killed in a duel.

    “Galois was so convinced of his impending death that he stayed up all night writing letters to his Republican friends and composing what would become his mathematical testament, the famous letter to Auguste Chevalier outlining his ideas. Hermann Weyl, one of the greatest mathematicians of the 20th century, said of this testament, “This letter, if judged by the novelty and profundity of ideas it contains, is perhaps the most substantial piece of writing in the whole literature of mankind.”

    http://en.wikipedia.org/wiki/Galois

    (Group theory is the mathematical theory of symmetry, of which there is not enough in the world)

  • Posted by Michael

    Since everyone agrees that the underlying problem is the decades-long excessive creation and utilization of debt as a substitute for earnings and savings (which is why credit card and auto loans, among others, are on the table for this bailout in addition to mortgage debt), I am deeply disturbed by the crisis-panic presentation which is used to override any long-term planning. Paulson and Bernanke repeat, in response to every Congressional question, the same words over and over: “We don’t know what the outcome will be, but all that matters is that you borrow this money and give it to us right now to pass on to the financiers, because the only alternative is total economic destruction.” The unfolding (and unavoidable) credit contraction may or may not reach a level of “economic destruction” in the near future – with or without this and other bailouts – but pouring more bad (U.S.A. never-to-be-paid back) debt into the over-indebted economy gurantees that the destruction will more “total” (e.g., foreigners stop buying Treasuries) when it comes.

  • Posted by Alan von Altendorf

    >> in about a month, banks are going to be unable to pay depositors at all <<

    I don’t accept this premise. Some banks are stuck with worthless Agency preferred or frozen swaps. That’s a bailout problem the Fed and Congress should address by directly helping FDIC insured deposit taking banks.

    There is no case for bailout of i-banks and hedge funds. Let them fail, merge, borrow from SWF or whatever. Has no effect on FDIC insured banks.

  • Posted by bsetser

    I am not convinced that if you in effect buy bad debt in exchange for a mix of cash and equity in the bank (or treasuries and bank equity) no one would paricipate. this is a chance for a host of institutions to do something that has eluded them until now, namely find a buyer of this stuff. if all you care about is getting credit going again, overpay for the assets and do a backdoor recap without getting any bank equity — or for that matter encourage the banks to write down everything to where they think the market value is, take a hit and then come in with enough preferred stock to make them whole/ able to lend again.

    on the other hand, i do think that equity/ moral hazard considerations – i.e. not bailing out existing management/ shareholders, see the principles i mentioned earlier from the 90s — suggest some element of risk sharing. there is a real risk the government will take losses.

  • Posted by Judy Yeo

    It’s precisely ‘cos a large chunk of the populace have a healthy suspicion of the real targets of rescue that the 700b (give me power, give me money) “deal” has stalled. As for confidence in those “distressed” assets (that has always seemed funny to me, c’mon, who’s the one in distress?), if they are the only ones having confidence in them right now, a reality check is needed; it’s sad when people start believing in their own lies, sorry, PR.

    Quarantining those bad assets , which is effectively what is happening now, is a bit of a slap on the wrist, not a broken wrist. Perhaps, the existing equity shareholders should prove their confidence, i.e. set up the scheme such that these institutions should be made to buy back those assets they are so confident of, at x price( probably at mid-range of historical cost price and current “market value”) at a certain date in future. Either way, at least there’s a recourse for the taxpayer.

    This is probably an old idea but nonetheless not too popular, one suspects!

  • Posted by Cedric Regula

    twofishes:

    Tanks for da little stories ’bout da commercial paper markets, but Uncle Bruno sez it don’ta work like that.

    In fact, it’s been da banks dat have poisoned da money markets wid der crappy fraud paper.

    Ana now dat everyone’s good an’ scared about dat, da government is issuing a ton of treasury fodder to feed government paper only funds, and give everyone a “safer ” alternative. Dats why da government tought dey had to guarantee commercial funds.

    If it was like da old days where GE issues 90 day paper to finance da gap between accounts payable and receivables, or even Pizza Hut ordering ingredients dey don’t sell for 90 days, den we wouldn’t have a problem.

    But here’s a article on The Reserve Fund ana where der problems came from.

    “This year alone, big banks and fund management companies have pledged more than $10 billion to rescue affiliated money funds that were caught holding mortgage market securities that were deteriorating rapidly in value.”

    “Specifically, the fund’s management, which boasted as recently as July about its cautious approach to the current crisis, determined that its stake in debt securities issued by Lehman Brothers Holdings, with a face value of $785 million, was essentially worthless, given the investment bank’s filing for bankruptcy protection. As a result, the fund said, its per-share value fell to 97 cents a share.”
    http://www.nytimes.com/2008/09/17/business/17fund.html?_r=1&oref=slogin

  • Posted by JKH


    Willem Buiter also thinks equity warrants and other “ornaments” would be dysfunctional:

    “Consider some of the ornaments Congress wants to hang on the Christmas tree:

    • Caps on the executive remuneration for executives of companies making use of the facility created under the plan. A figure of $400,000 has been bandied about. From the perspective of fairness, 25 cents would probably too much for some CEOs. Indeed, tarring, feathering and running out of town may well be justified in certain cases. But it would stop the banks from making use of the facility for the very reasons that make the Congress want to punish the CEOs of the banks. If it is true, as many in Congress argue, that greedy and irresponsible CEOs have risked their banks, and imperilled the wellbeing of their communities and the stability of the US economy as a whole, in the pursuit of private gain, then these same CEOs would surely once again risk their banks, imperil the wellbeing of their communities and the stability of the US economy as a whole to avoid the $400,000 cap. “Duh”, as my two teenage kids would say. I know there are too many lawyers in Congress, but surely there must be someone with half a brain?

    • Amendments to (personal) bankruptcy laws making it easier for homeowners who cannot service their existing mortgages to remain in their homes rather than face repossession. This would be both inequitable (why should tax payers who stuck to mortgages they can afford be asked to subsidise the mortgages of those whose eyes were larger than their stomachs?) and inefficient (it would discourage future mortgage lending). Individual homeowners are also not important for systemic stability.

    • Other cookies and goodies for those with mortgages they cannot afford to service (see the previous bullet point).

    • Equity stakes for the government in the banks it purchases toxic assets from. This also would discourage banks from accessing the facility, if the acquisition of equity by the government represents a transfer from the bank rather than the quid-pro-quo for a capital injection by the government.

    • Warrants for the government (options to acquire equity in the banks during some period at a set price). See the previous bullet point.”

    His is the best overall analysis in my view. He splits the problem into two parts – liquidity and solvency – and proposes dealing cleanly with each: liquidity support without ornaments, and forced debt for equity swaps to tackle solvency.

    http://www.voxeu.org/index.php?q=node/1706

  • Posted by vlade

    A couple of comments:
    I agree with JHK that buying the bad debt is recapitalization. It changes the balance sheet, i.e. the denominator in the capital ratio, not the nominator (the equity).

    Now, there are four scenarios really, with two by two combo: Bank is strong (as in having enough equity already), or weak. Bank has written off the bad debt to below of what it can sell to TARP or not. Now, TART (typo intentional) will help strong banks that written of the debt (they will book profit, and their better capital ratio will let them lend more). It will kill weak banks that didn’t write off – they will have to book loss, and have no equity to write it off from. It’s uncertain what it will do to the remaining two categories, as there can be any combination (i.e. weak bank with deep write-offs can all of suddenly turn into strong bank with profit, or a strong bank with no write offs can be killed by the forced write-offs – even if they don’t sell the stuff to TART, as it will give them a price they will have to mark against).

    So, the strong – that don’t need it – will be stronger, the weak will be weeded out. If that’s the goal (and it wouldn’t be a bad thing in itself), I’m sure we can get a cheaper way of getting there.

    On the other hand, a true recapitalization (i.e. an equity injection) offers, I believe, much more options. For example, if nothing else, you can do the above and use it to write off the bad debt – and have the upside too (as you then effectively hold it to maturity and see what happens). You also can do other things with the equity, for example (if you are a strong bank, which written things off), even buy some of the toxic stuff from other people, because you can get it at a distressed price but you now have the capital to hold it, and you believe it’s at panic prices.

    You can also lend more money (which is the whole goal of the exercise, i.e. starting to lend money again), because injection of 1 billion makes much more difference to the bank than removing 1 billion of the balance sheet! I.e. Assume we have a bank A that had 100 billion in assets, and 6 billion in capital, for a ratio of 6%. TART buys 10 billion of the assets at the price to which A written them down (so that we don’t have the nasty profit/loss problem). A can now remove funding for those 10b assets, so it’s balance sheet shrinks to 90b, and has a capital ratio of 6.6%, for a spend of 10b. Or, you invest 1b in equity, and A now has 100b of assets (which it has to fund), but 7b in equity, for a capital ratio of 7% – for a cost of mere 1/10th of what you’ve just invested, with a potential upside to the investor(taxpayer) too!
    I could be wrong – in fact, I could be telling you that the earth is flat – so please tell me if I am, but at the moment I think equity injection would be cheaper, provide more options, give taxpayer the upside as well as the downside, and overall more efficient.

  • Posted by Twofish

    Alan: I don’t accept this premise. Some banks are stuck with worthless Agency preferred or frozen swaps.

    Actually very few FDIC-insured commercial banks have direct exposure to complex derivatives. It’s the indirect exposure that may kill a lot of them. A borrows from B, B borrows from C, C borrows from D. D blows up. It works it’s way back to A. The problem is that the system is set up so that at each step of the way, the problem gets larger so by the time it gets back to A, it’s a huge snowball.

    Alan: There is no case for bailout of i-banks and hedge funds. Let them fail, merge, borrow from SWF or whatever. Has no effect on FDIC insured banks.

    There are no more I-banks in the United States, and hedge funds actually don’t seem to be having too many problems. The big problems are in the insurance companies, European banks, and regional banks.

    One thing about finance is that you quickly find out how interconnected you are with everyone else. You just can’t say save me and screw everyone else.

  • Posted by RebelEconomist

    jkh,

    Lovely story about Galois. I cannot help wondering, though, whether if he had gone to bed early, his hand might have been steadier and he would have got the other guy!

    While I often disagree with Bernanke’s ideas, he usually does make a reasonable case, so it has been puzzling to watch clever people like him floundering, with little rigour, to justify the TARP. It took several days for its proponents to explain why the plan excludes taking equity stakes. And then, listening to Bush talking about the need to avoid pension fund losses, the penny dropped. The reason why they do not want to “make the bankers pay for their mistakes” is that the bankers are the people. The debt hole that the US has collectively dug for itself has been filled with froth. I suspect that if any solution involving liquidation and a government backstop such as nationalisation was adopted, the economy would probably proceed without too much disruption, but the illusion of prosperity would be shattered. The flow of cash and services from assets like stocks and houses might well turn out to be much the same, but their owners could no longer expect to realise as much as they would like for their retirement by selling those assets. They would either have to start saving more, or accept poverty later. The motivation of Bush, Paulson and Bernanke, is to avoid this revelation on their watch. Since they are as responsible as any of their predecessors, with the possible exception of Greenspan, this is exactly why it is of the utmost importance that the TARP does involve dilution of existing shareholdings.

  • Posted by JKH

    I’ve think I’ve figured out more specifically what’s been bothering me about this.

    Treasury is proposed a liquidity intervention that is essentially a function of market determined prices. E.g. the reverse auction is a market pricing mechanism. This is not a forced confiscation of value. Treasury is essentially acting on a market view (that longer term value exceeds current fire sale marks) in order to stabilize market liquidity.

    Given the market sensitivity of the primary pricing function, any additional “ornaments” included in the package will have a value and cost that is implicit or embedded in the price of the debt transaction.

    E.g. equity warrants demanded as part of the package will increase auction bid prices for debt sales.

    In other words, no additional free lunch is exactable for the taxpayer (however deserved), when the main piece of the puzzle is a flexible market determined price.

    In order to deal with equity, there needs to be a separate mechanism on the back of this liquidity proposal, such as proposed by Buiter, or otherwise.

    Sequence, sequence, sequence …

  • Posted by running bear

    Vlade,

    This is what Buffett did with his preferred, which are counted as Tier 1 capital (equiv. in ratios to equity) but bear a senior guaranteed dividend but junior to bonds. Other banks have used similar with and without conversion options.

  • Posted by Dave C..

    I’m sure Paulson and Bernanke couldn’t care less, but the US reputation around the world is in tatters after this bankster bailout legislation. It’s so bad that even the Italian Finance Minister was quoted making jokes about the US monetary mismanagement:

    “Greenspan was considered a master,” Italian moneyman Giulio Tremonti says. “Now we must ask ourselves whether he is not, after bin Laden, the man who hurt America the most. … It is clear that what is happening is a disease. It is not the failure of a bank, but the failure of a system.”

  • Posted by Dave C..

    Savers will be punished under the Bankster bailout legislation
    http://www.financialsense.com/editorials/litle/2008/0924.html

    The sad fact is, this bailout is all about saving borrowers from themselves. If you were leveraged up to the eyeballs and loaded to the gills with debt, then the Paulson-Bernanke plan is a godsend… like a helicopter coming to pull you off the roof of your house as the floodwaters sucked at your ankles.

    But if you actually avoided this whole mess by shunning excess risk and keeping a good amount of cash in the bank, then guess what — it’s upstanding citizens like you who get to pay for the whole thing. The money to make the bailout happen will ultimately come from one place: the pockets of the American taxpayer.

    Some will say it’s not necessarily a given that the taxpayers will lose money on this bailout deal… that it’s possible everything works out and that the $700 billion doesn’t go up in smoke. Maybe we’ll get our money back, or at least a portion of it.

    But the people who say that are also the ones who never thought we would get here in the first place. And it’s hard to see the difference, in principle, between a Bear Stearns or a Lehman Brothers assuring me I’ll get my money back vs. Uncle Sam doing the same thing. Shouldn’t it be up to you and me to decide who we write checks to?

    As the dollar craters in the coming months, and the cost of living rises, savers will continue to be punished. Money in a mattress is decidedly no good at this juncture. Cash is most definitely NOT king, in the sense that paper money just gets more and more worthless when the printing press is chugging away like there’s no tomorrow. That’s what it’s doing now.

  • Posted by Dave C..

    Congressman Ron Paul is urging everyone to “Call Their Senators and House Representatives Now to Protest the Bankster Bailout Bill” !!!!

    From Congressman Ron Paul

    “With a Rasmussen poll finding support for the bailout at an anemic seven percent, some members of Congress are afraid to vote for it. Call them! Let them hear from you! Tell them you will never vote for anyone who supports this atrocity.

    The issue boils down to this: do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are about to be looted in order to subsidize the fattest of cats on Wall Street and in government? Do we care?

    When the chips are down, will we stand up and fight, even if it means standing up against every stripe of fashionable opinion in politics and the media?

    Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.”

    In liberty,
    Ron Paul

  • Posted by vlade

    running bear: So, if it’s good for arguably the best long-run investor in the world (or the most lucky one, who cares), why isn’t it good enough for the other US taxpayers?

  • Posted by JKH


    Ron Paul is dangerous.

    Not because he promotes Austrian economics.

    Because he promotes it while being financially illiterate.

  • Posted by Dave C..

    Is Ron Paul wrong? So JKH where do we go from here with US taxpayer bailout madness. $85 billion for AIG, $30 billion for Bear Sterns, $200 billion for Fannie Mae, $50 billion for GM and Ford, $700 billion for the latest banking bailout. Pimco’s Bill Gross states that we may need another $500 billion on top of that. The Airlines are now also lobbying for a taxpayer bailouts. The US government now practically owns every damn mortgage across the country. Is that still not enough?

  • Posted by Cedric Regula

    Uncle Bruno calls da current administration “compassionate conservatives”, but I tinks Uncle Bruno is being fascist[EDITOR'S NOTE:(sic) Facetious] wenna he say dat.

    Merril just estimated next years fiscal deficit at $900B.

    Uncle Bruno tinks Ron Paul is kinda a kook too, ana who wanna put Uncle Sam on da gold standard now? But uder dan dat maybe Ron Paul might be way more financially astute dan what we gots now.

  • Posted by LB

    i’ve been reading here for a week and want to thank you all for such an intelligent and spirited discussion.

    being one of those like Ron Paul and millions of others who are financially illiterate (at least in comparison to the esteemed company here), i have a couple questions that i wish to ask for someone to clear up so that us less than knowledge about the pitfalls of this thing can decipher more clearly.

    1> is there anything to be read in the fact the Fed withdrew $125B out of the open markets in the last 5 days in the midst of a supposed ‘liquidity crisis’?

    http://www.gmtfo.com/RepoReader/OMOps.aspx

    2> is there anything to be read into the ‘timing’ of this that it is synchronic with the ability of hedge fund investors to pull out of funds at the end of each quarter (9/30)?

    please excuse me if these are ignorant questions, but i thought i would ask people who understand these things much better than i before arriving at any nefarious conclusions, as it’s critical for all of us to separate fact from propaganda (on either side) at this juncture.

    thank you.

    p.s. 2fish: I think that Paulson and Bush are doing something political clever because by conceding the point on CEO salaries they conceding the point with the most political benefit while giving up the least amount of equity participation. If you put in a cap on CEO pay, then the senators can go home and campaign that they were tough on Wall Street, whereas if you talk about “forced equity participation” people’s eyes will glaze over.

    i agree with this completely, i think they were willing to cave on this all along. they knew they were going to have to give up something for the congressmen to be to ‘appease’ their constituents.

    whether real ‘compromise’ happens is in how materially changed will be section 8 in the proposal.

    the hidden kicker for me is who’s going to be hired to administrate this and how much will the fees be?

    this is an immensely tangled web and it’s going to take a lot of work to untangle it.

    wonder if whoever ‘whoever is’ is going to bill by the hour…

  • Posted by Blissex

    «On the other hand, a true recapitalization (i.e. an equity injection) offers, I believe, much more options.»

    Including control of the board, the right to see the books, and the right to sack the executives.

    In other words something that is absolutely unacceptable for Bush, the Business Roundtable and JKH.

    As JKH sort of says, there are two cases here:

    * The financial system is solvent but illiquid, as Paulson & Bernanke pretend, and then the financial system does not need th Fed’s money and they can just co on strike with credit.

    * The financial system is not solvent, and they have no option but to take the Fed’s money, and they are just calling in their campaign donations to the Republicans and Democrats to get free money.

    If the first case applies, all the Treasury needs to do is to lend to the bastards as a low interest rate, not buy their most worthless paper. In other words, bigger “friends of the RNC” facilities.

    But why is then the Treasury trying to inject new free capital into the system instead of just lending it, given that the Fed has been doing the latter? Obviously because the second case is true.

    «current administration “compassionate conservatives”»

    That’s probably the most elegant joke I have seen in a while, thanks a lot, I’ll use it elsewhere.

  • Posted by Dave C..

    The entire financial bailout scam is an “in-your-face ripoff” of the taxpayers to benefit politically-connected Wall Street banks especially Goldman Sachs. We are now even worse than Nigeria for political corruption and thievery. Trillions of dollars have been stolen, looted, embezzled and misallocated into white elephant programs across the United States. There has never even been an apology from Paulson, Bernanke or Greenspan.

  • Posted by JKH


    LB – my statement on Ron Paul was uncharacteristically harsh. Without going into detail, I think he deserves it, because he misrepresents the operation of the current system. It was clear yesterday he has no understanding of the financial architecture of the proposed bailout package or its context. So in my view he’s a poor and non-credible advocate for Austrian economics as a general alternative – not that Austrian economics doesn’t deserve good advocates. And nobody deserves to be called financially illiterate – unless they attempt to proselytize from a position of ignorance and distortion. The questions you ask are quite good, in my opinion. I won’t be presumptuous in attempting to answer them. There is an well versed reader and blogger by the name of RebelEconomist who may wish to do that.

  • Posted by Cedric Regula

    JB:

    Good question, but me an’ Uncle Bruno don’ts know much about fomc operations since we dont’s follows it much, tinking dat it’s kinda like worry’en ’bouts a feather duster whenna ders howitzer shells falling all around.

    But one explanation could be is da fed injected treasuries inta market to pull out cash so’s dey could pump most of dat cash from dat $180B “liquidity infusion” inta europe. Da ECB got $100B ana da swiss got $25B.

    Da numbers add up, but thisa wild conjecture on our parts.

  • Posted by Murph

    Brad: “if you have more on why a swap that includes an equity component for the treasury wouldn’t work, i am all ears”…

    ‘We the people’ should limit our downside risk to the maximum degree possible.

    However, the control and influence which comes with Government is chilling to contemplate.

    The Fannie / Freddie debacle teaches us valuable lessons about State influence and participation in large Corporate entities, which we’d be wise to heed.

    With shares, and possibly even warrants, the Government would become the most monstrous “activist shareholder” ever. 535 pet projects and priorities would be injected into every shareholder meeting…

    There must be a way to limit downside risk while avoiding these pitfalls ?

  • Posted by JKH


    Cedric Regula,

    I think you and Uncle Bruno are correct.

  • Posted by JKH

    Blissex,

    I have nothing in principle against the idea of mass upside down equity crucifixions for deserving Wall Street CEOs. I’d just like it to be done in an orderly fashion.

  • Posted by Twofish

    Blissex: The financial system is not solvent, and they have no option but to take the Fed’s money.

    Actually they do have some choices. People and corporations start behaving very strangely when they are near death. The big problem is that when a financial firm is near death and knows it, they start taking huge insane risks as well as finding hostages (i.e. give me what I want or I make this bomb strapped to me go off and destroy the world financial system).

  • Posted by LB

    JK: after watching Paul’s line of questioning of Bernanke yesterday, i’m leaning toward agreement of your position. it was an odd time to make such an obtuse argument, unless he was willing to hammer the conclusion to the argument clearly down his throat so the average person could see through the ruse.

    i also think that he is getting a bit drunk on all the attention he’s getting from the media and is dangerously close to becoming a tool of those he claims he is fighting against.

    in some ways, he’s an elitist himself in different colors. i heard him say that most americans don’t even know where georgia (the country) is. perhaps that’s true, but i believe that more americans know where it is than he’s willing to accept.

    thank for your gracious reply. my original comment was directed to the fact that most of us who will be severely affected are in the middle of a crash course in the most complex nature of high finance and macroeconomics that we have ever studied, even if some of us did study it at the collegiate level.

    it is imperative for those of us who have a bit of a grasp of this to humbly attempt to communicate it in a way so the rest of us can wade through the muck and not fall into the traps of functional ignorance and propaganda.

    cedric & unkle: we’re all just taking wild stabs at this, yes paisano? at least yous guys math adds up.

    $25B to the swiss? interesting…

  • Posted by Twofish

    Bilsex: But why is then the Treasury trying to inject new free capital into the system instead of just lending it, given that the Fed has been doing the latter? Obviously because the second case is true.

    Yup, and one thing that worries me is that Paulson and Bernanke went from “everything is fine and can be taken care by the private sector” to “Oh my God the world is falling apart” around the time of the Freddie/Fannie/Lehman/AIG bailouts, when they got to see the books for the first time.

    Whatever they saw, the rest of us are going to find out soon.

  • Posted by LB

    2fish: Whatever they saw, the rest of us are going to find out soon.

    maybe…

  • Posted by Cedric Regula

    Here’s da info on da $180B plus fed move. Uncle Bruno tinks its because Libor rates is rise’n again, an’ ders a lotta goombahs wid HEW tied to LIBOR. Somehow bouncing dollars ofa da uder side of da world helps dat.

    ========================================
    “The measures taken by the Fed and other Central Banks on Thursday include the authorization of the Federal Reserve’s $180 billion expansion of temporary reciprocal currency arrangements, or swap lines, to provide dollar funding for both term and overnight liquidity operations by the other Central Banks.

    The Federal Open Market Committee has also authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of US dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion.

    In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of US dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.”

    http://www.globest.com/news/1248_1248/washington/173897-1.html

  • Posted by moldbug

    JKH,

    Your analysis of the equity warrants is concise and compelling.

    Ron Paul is just a nice old man. As with all politicians today, his words are not to be interpreted as representing his own personal philosophy, as if he was Thomas Jefferson, or something. He speaks for his advisors, and his advisors in recent years have displayed a lamentable pseudo-populist streak, more aimed at getting 5% of the vote than at being right. The point of this is anyone’s guess.

  • Posted by RebelEconomist

    LB,

    I am not quite as informed as jhk would have you believe – and you do have to be well informed (eg about tax payment dates) to interpret these things – but Cedric’s explanation sounds reasonable. It depends on how the add implied by the dollar lending by foreign central banks is treated in the figures you link. If the foreign central banks lending is not included in the figures, and the Fed makes some offsetting reduction in their own lending when the foreign central banks lend, the withdrawal by the Fed may indicate that the foreign central banks are drawing the swap lines down. I would also expect the Fed to reduce their repo lending when they buy securities, which they have been doing to assist money market funds, but the amounts you mention are too large for that. I doubt that a run of withdrawals over five days is associated with government flows and I am sure that it has nothing to do with investors’ hedge fund redemptions which would involve purely private sector transactions.

  • Posted by agog

    That circumstances have bounced Twofish out of his customary sang froid is very worrying indeed.

    Via FT Alphaville today we learn that Tim Bond of Barcap is no less concerned: “Conditions more or less resemble a bank run on the system…Unchecked, the current crisis would turn into a self-reinforcing vortex of defaults, bank capital contraction and deep recession within a matter of weeks.”

    Whatever the flaws in what Paulson/Bernanke are hatching we may be in situation where we can’t let the perfect be the enemy of the good.

  • Posted by Dave C..

    Bloomberg article quoting Yu Yongding from the China PBoC:

    —–
    China’s huge holdings of U.S. debt means it must bear a large proportion of the “burden of sorting things out” in the U.S., Yu said.

    “China is very worried about the safety of its assets,” he said. “If you want China to keep calm, you must ensure China that its assets are safe.”

    Yu said China is helping the U.S. “in a very big way” and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

    “It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,” he said. “China knows what to do. We don’t need your intervention.”
    ——–

    I believe these are call conditionalities. Robert Rubin was a master at using them against 3rd world countries that borrowed from the IMF/US Treasury. It seems like China may start forcing conditionalities onto the US. LOL.

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=anZHfo6tQi60

  • Posted by pseudorandom

    Twofish: when things are stressed, people want to see money on the table, and if Congress isn’t willing to put money on the table, then all this talk about insurance is just pointless.

    Funny how the government guarantee of money-markets seems to have had a sizeable effect in calming them. Similarly with the debt of FAN/FRE/AIG as soon as government backing was made explicit.

    It is outrageous to claim that government guarantees are pointless. And in offering a guarantee the government most certainly is putting money on the table.

    Twofish: Once you have $50 million in the bank, an extra $1 million or $1 billion just doesn’t matter. People in Paulson’s circle care about money only as far as it relates to scorekeeping.

    That’s what you’d think. The greed of some of these guys is very irrational and seemingly boundless. Think about how hard they fight to avoid paying taxes.
    http://online.wsj.com/article/SB121297088214955885.html

    Twofish: For example by making funding decisions reviewable by courts just gave about a billion or two to lawyers. Putting caps on executive pay just gave about $1 billion or so to accountants.

    Once again you are tossing around big scary numbers without justifying them in any way.

    Twofish: Whatever you do or don’t do, one of Paulson’s friends is going to get rich

    Yes I know. The old “Goldman bankers are such amazing geniuses they will always make money” theory. It remains to be seen how smart they are if their cronies at the Treasury are not allowed to rig the rules to favor them.

  • Posted by Rien Huizer

    1. This is a package presented few days before Congress god on its election holiday
    2. It is the last gift the Bush administration can make to an interest group, and one that will be as difficult to evaluate later, as the money spent in Iraq.
    3. It does not matter that there are alternative ways to solve the problem (assuming even that we are all talking about the same problem, because I doubt we do. The real problem is the real economy, the economy of the many little people. They have many votes, may become angry and emotional. The problem is hardly a systemic crisis. No one believes at this stage that banks will collapse and moneymarket funds etc will not trigger a systemic crisis in excess of what we’ve already got). It does not matter because an outgoing administration with nothing left to lose will only be interested in enriching its own sponsors.
    4. So the question is, what will it take to satisfy both republican last minute diners and democratic populists?

    Of course there are far better ways to solve a problem like this, but who would benefit from that?

  • Posted by gillies

    “You asked me my opinion as an economist,” Bernanke said with a smile.
    “Unfortunately, this is a matter for psychology.”

    (senate hearing)

    so if bernanke testifies thus, can it be that we are into a phase where the psychology of the situation, and the politics of the situation, move faster than the economic measures can take effect ?

    the lending and property boom was fuelled by the economically illiterate – and the unwinding may be no different. the opinions of the ignorant are maturing very fast.

    as one of these, i have the view that the $700 billion, now so stunningly big, will turn out to be inadequate in retrospect. bernanke’s grey face tells all. already he sees the economic graduates of 50 years hence specialising in what went wrong in 2008 – the year banks lost faith in banks.

  • Posted by gillies

    we, the economically illiterate, simply are curious to know – exactly whose money is it that you propose dropping out of helicopters ?

  • Posted by Twofish

    pseudo: Funny how the government guarantee of money-markets seems to have had a sizeable effect in calming them. Similarly with the debt of FAN/FRE/AIG as soon as government backing was made explicit.

    The guarantees only worked because there was cash on the table. The government guarantee of money markets came out of a $50 billion fund. Freddie and Fannie bailouts came with a cash injection of $1 billion with more to come. AIG came with a $85 billion loan. The trouble with all of this is out of cash, and the FAN/FRE/AIG bailout is just a minor prelude to what is about to happen.

    pseudo: Once again you are tossing around big scary numbers without justifying them in any way.

    One billion is not a big scary number.

    Anyone the number for one billion for lawyers comes from the fact that JPMorgan set aside $2 billion for the purchase of Bear Stearns and $6 billion for settling lawsuits from the purchase.

  • Posted by pseudorandom

    Twofish: The guarantees only worked because there was cash on the table. The government guarantee of money markets came out of a $50 billion fund. Freddie and Fannie bailouts came with a cash injection of $1 billion with more to come. AIG came with a $85 billion loan. The trouble with all of this is out of cash, and the FAN/FRE/AIG bailout is just a minor prelude to what is about to happen.

    I am not sure what you are getting at. Of course a government guarantee means putting cash on the table. When did I ever suggest otherwise? This discussion started when I suggested that government money could be provided to the FDIC to directly insure depositors instead of to the banks. You claimed that it won’t work because government guarantees were pointless.

    Twofish: Anyone the number for one billion for lawyers comes from the fact that JPMorgan set aside $2 billion for the purchase of Bear Stearns and $6 billion for settling lawsuits from the purchase.

    It is not a comparable situation. BSC was at that times being sued by investors in its hedge fund and by others and had potentially huge civil judgement liabilities. The Treasury has no such problems. Of course they will need lawyers and accountants to examine assets etc, but why would they be setting money aside for damages which is why JPM needed that $6B.

  • Posted by Twofish

    pseudo: This discussion started when I suggested that government money could be provided to the FDIC to directly insure depositors instead of to the banks. You claimed that it won’t work because government guarantees were pointless.

    I’m saying that government guarantees without cash are pointless. If you want a government guarantee with cash, it will cost you about ohhhh $700 billion, which brings us back to the current situation.

    The problem with with paying depositors directly through FDIC is that for FDIC to pay out, a bank has to fail. The minor problem is that if you have dozens of banks suddenly fail at once, you freeze the money markets, and this causes spillover affects. The major problem is that if you have a bank fail, then any credit default swaps on that bank will suddenly get triggered and you start having dominoes fall.

    Those CDS are really turning into explosive devices, and trying to figure out how to keep them from exploding is really tricky. If you pass legislation that invalidates CDS’s, then all of the people that are holding CDS’s have to mark to market and you might end up with major insurance companies going under.

    OK so you pay depositors before the banks fail. At this point, you basically have what Paulson is suggesting.

    pseudo: It is not a comparable situation. BSC was at that times being sued by investors in its hedge fund and by others and had potentially huge civil judgement liabilities.

    That’s not how securities lawsuits work. Every time there is a corporate restructuring, the lawyers show up and threaten to derail it. It doesn’t matter if they have a good lawsuit or not, throwing the deal into a courtroom will slow things down.

    So what will happen is that the lawyer comes in. You ask how much it will cost to drop the suit. They give you a number. If it isn’t too high, you write the check. No one cares what the final ruling of the judge is.

    pseudo: The Treasury has no such problems.

    Yes they will. Congress is likely to throw out Paulson’s original language and make Treasury’s actions reviewable under the APA standard of “arbitrary and capricious”. Under those standards, any competent administrative law firm can take any decision that Treasury makes, and then have the Court tie up that decision for months. So if the Secretary of Treasury wants to do something quickly, he now has to call up the law firm that is making the lawsuit, ask them how much they want, and if the price isn’t too high, he writes out a check to the law firm to drop the suit.

    pseudo: Of course they will need lawyers and accountants to examine assets etc, but why would they be setting money aside for damages which is why JPM needed that $6B.

    Because Congress has just changed the law so that law firms will be able to shake down Treasury for cash. That’s how the game is played, and the lawyers just made about a billion. I’ll be very curious to go through the final bill to see how ended up with the real payoffs.

  • Posted by Twofish

    You don’t think that the bill is going to have a real impact on CEO salaries do you? It’s not that the legislators are crooked, it’s that to have a watertight bill you need about six months to a year and we don’t have time. So what is likely to happen is that there is going to be very strong language in the bill against CEO salaries. This will give the senators and congressmen political cover to go home, and in three months when some clever accountant finds a loophole, people would have forgotten about all of this. This means that the accountants get about a billion.

    Part of the issues is that people really don’t want to save money or really care about how much it costs them. They want a human sacrifice and they will get one, not that I’m against it. For that matter most CEO’s aren’t against it since they know that the rules will have lots of holes in them. This isn’t because the congressman are crooked. It’s because to make something watertight you need to spent a year and maybe fifty pages of legislation.

    One consequence is that the CEO’s that were competent are the ones that are going to get hit hardest by restrictions on CEO pay. The incompetent one’s aren’t CEO’s anymore.

  • Posted by pseudorandom

    Twofish: So what is likely to happen is that there is going to be very strong language in the bill against CEO salaries. This will give the senators and congressmen political cover to go home, and in three months when some clever accountant finds a loophole, people would have forgotten about all of this. This means that the accountants get about a billion.

    We can sit here and make up assumptions to justify some pre-determined conclusion. Or we can start from objective facts and evidence, and allow them to lead us to a conclusion.

    You don’t know what is going to happen in the future. All your arguments are based on hypothetical scenarios based on highly questionable premises. If you want to just assume that some clever accountant will find a billion dollar loophole, if you just assume that some clever banker will figure out a $10B arbitrage, if you just assume that some clever lawyer will find a way to shake the Treasury down for $10B etc… then anything can be justified. What objective reason do we have to assume any of this?

    Twofish: The incompetent one’s aren’t CEO’s anymore.

    Once again sweeping assertions unsupported by fact. Last I heard the CEOs of WaMu, Morgan Stanley, Wachovia were all still around..

  • Posted by RetroactiveDownsideRiskRequired

    The Mortgage Forgiveness Debt Relief Act of 2007 removed the last incentive for borrowers to remain in “their” homes. This law must be rewritten and retitled the Patriotic Mortgage Repayment Act of 2008.

    The Patriotic Mortgage Repayment Act of 2008 – If a borrower defaults on a mortgage and the market value of the collateral is insufficient to repay the money borrowed, the Treasury will recover 105% of the residual borrowed but unpaid amount using IRS collection methods and interest schedules. Such a law would prevent the general population from bailing out the speculators that purchased more house than they could reasonably afford. These wannabee flippers took grandma’s life savings out of the bank, now the bank has collapsed and the FDIC is having to pay off grandmas. The least these deadbeats should do is repay 100% of grandmas’ money to the treasury plus 5% as a handling fee.

    It should be trivial for the borrower to meet his obligation. After the foreclosure sale recovers 60% of the original loan, the payments on the remaining 40% loss should be well within the budget of even the biggest speculative wannabe flipper real estate genius that bought at the top of the market using grandma’s money.

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