Roubini on Paulson Plan

Nouriel Roubini has this scathing denuciation of the Paulson Plan. He writes,

"Specifically, the Treasury plan does not formally provide senior preferred shares for the government in exchange for the government purchase of the toxic/illiquid assets of the financial institutions; so this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the firms; with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.

Moreover, the plan does not address the need to recapitalize badly undercapitalized financial institutions: this could have been achieved via public injections of preferred shares into these firms; needed matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; suspension of dividends payments; conversion of some of the unsecured debt into equity (a debt for equity swap).

The plan also does not explicitly include an HOLC-style program to reduce across the board the debt burden of the distressed household sector; without such a component the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.

Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown."

In simple terms, the fundamental problem is that the Fed and Treasury thinks the mortgage backed securities are underpriced and they can create a market by recapitalizing the institutions holding these assets. It is hoped that this will lead to major upward revaluations, thereby allowing them to find their true value. As Paul Krugman and Roubini above argues, the problem is clearly one of too little capital in the market.

Update 1
Linkfest on the bailout from Big Picture.