Hanky Panky!

Alan Blinder has described the sub-prime bailout plan as "Hanky Panky". The lack of clarity on many important things has raised serious apprehensions about the final cost to the taxpayer.

Briefly, under the Plan, through reverse auctions, aspiring sellers of the hard-to-sell securities would compete to offer the securities to the government. The auctions are supposed to jump-start the market for these securities and allow investors to value them on balance sheets. It is presumed that once banks’ balance sheets are cleansed of toxic assets, they would be able to tap fresh capital.

In the final analysis the plan's success or otherwise will be decided on how effective it will be in containing the crisis and how much it will cost the tax payers. The later will in turn depend on the prices at which the distressed assets are purchased and that at which they are finally sold off. Unfortunately on this and a few other thigs, the plan does not inspire confidence.

Section 8 of the plan reads, "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Some of the major omissions from and apprehensions surrounding the plan are

1. The plan has nothing to say about how the bad assets will be priced. Given the difficulty in even locating the deeply embedded risks in many of these securities, there are very few price discovery options. Unlike stocks, mortgage backed securities (each of them tied to thousands of individual mortgages, most of which are going bad as home prices continue to fall) are not traded on any exchange and the market for them is opaque - traders do business over the telephone, and days can go by without a single trade.

These debts originated as home mortgages issued by mortgage lenders, who bundled mortgages and sold them to investment banks, who in turn re-packaged them into bonds and sold them off to other investment banks, PE firms, hedge funds, and insurance companies. Many Wall Street firms then sliced and diced these bonds into structured products like Collateralized Debt Obligations, which ended up dispersing risks far and wide. And all of these were transacted as private placements.

In the hope that the government would hold these investments till markets recover, Fed chairman Ben S. Bernanke told Congress that the government should avoid paying a fire-sale price, and pay what he called the "hold-to-maturity price"(or the price that investors would bid if they expected to keep the bond till it was paid off). This raises many moral hazard concerns.

It is arguable that the present market prices (of the collaterals) are not a reflection of the underlying assets. Further, any effort to recapitalize these entites at fire-sale prices, is also likely to rebound as it will generate a cascade of downstream effects (margin calls etc) on the entire financial system. This would defeat the very purpose of the bailout exercise. Overpaying for these assets will benefit the greedy and reckless financial institutions at the expense of the tax payers.

Many economists have suggested the use of auctions and even reverse auctions to price them. The Treasury is veering around to conducting reverse auctions, so as to find which bank would sell the MBS at the lowest price, and hope that the competition among sellers would drive the price close to the actual value of the asset as judged by the banks. In any case, the pricing mechanism would be critical in determing the success of the plan.

2. The plan lacks clarity on the government role and the price that will be incurred by the existing shareholders. Any such plan should seek to minimize the costs to the tax payers and have an exit strategy that would recoup a substantial share of the tax payers money. One way to maximize shareholder returns is by taking equity stakes in the firms selling distressed assets.

Faced with a similar ciris in early nineties, the Swedish government forced the distressed banks had to write down all their losses and issue warrants to the government (options to buy the bank stocks), thereby effectively making government the owners. State guaranteed all bank deposits and creditors of the nation’s 114 banks, and two new agencies were formed - one, to supervise institutions that needed recapitalization, and another to sell off the assets, mainly real estate, that the banks held as collateral.

3. It is silent on how the homeowners will re-finance their mortgages, given the sharp declines in home values and tighter re-finance lending standards (like lending for only upto 80% of home values). The bailout plan addresses only the financial institutions and has nothing for the homeowners. This assumes importance given the fact that home prices continue to fall, and the market values of most homes have fallen far below the loan amounts. Without addressing this downstream issue, purchasing mortgage securities will only postpone a solution to the problem.

Update 1
Robert Reich describes the existing plan as a "blank cheque", and instead proposes five conditions. The conditions also includes giving bankruptcy judges the authority to modify the terms of primary mortgages, so that homeowners have a fighting chance to keep their homes. He also proposes a stimulus plan for Main Street, "It should extend unemployment insurance, freeze mortgage rates, and pass a stimulus package to create more jobs."

Allan Meltzer has another plan which proposes making loans which the financial institutions have to repay with interest. This was successfully tried out by Chile in 1982, and firms weren't allowed to pay dividends or employees and owners take their bonuses until they repaid the loans.

Greg Mankiw, one of the few mainstream economists to support the plan, quotes a "smart friend" in response to these issues. Pimco's Bill Gross, as expected of Wall Street opinion makers, argues that it is not a "bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic"! Responses to these are available here and here.

Here is a list of commentaries on the crisis by economists and commentators.

Update 2
More commentaries of the crisis here.

Update 3
Lucian Bebchuk of Harvard Law School has this plan, which proposes purchasing assets at fair market values and safeguards to protect tax payers.

Update 4
Finally SEC admits to regulatory and oversight lapses.

Update 5
Brad De Long supports Swedish style nationalization and not a bailout.

Update 6
NYT has this excellent overview of the actions that brought down AIG.

Update 7
Recapitalization of banks by direct injection of capital, as opposed to that proposed by the final version of the Paulson Plan (by purchasing distressed assets through reverse auctions), is likely to deliver much better bang for the buck. Because banks have debt-to-equity ratios of 10 to one or higher, a dollar spent buying an equity stake would support 10 times as many assets as a dollar spent buying up individual securities. Government could infuse capital by acquiring stakes in the form of common stock, preferred shares paying a specific dividend or some other form of equity. Further, in a declining market, price discovery becomes even more difficult and misleading.