The White House is trying to argue that the bailout isn’t so bad, it might not really cost $700 billion because some of the assets will appreciate in value.
I guess if you’re a politician, the biggest thing you worry about is that if the government has to spend a lot of money on assets, that means that there might be pressure to cut back somewhere else (rather than increase borrowing.) So when they say that the assets might end up appreciating, they’re looking at the silver lining from a budgetary perspective as well as encouraging voters to think that they really don’t have to cut back as much as $700 billion because, hey, we might even make money. If we make money we can even justify some new expanded government spending.
But from my perspective, the budgetary gains and losses are a trivial part of the story. Those are a transfer from taxpayers to the current holders of the assets. My real concern is the incentive effects for future prudence (reduced) and the weird misallocations of capital that will inevitably result. I also am deeply concerned about the rule of law and how such a program can possibly run in a non-arbitrary way.
If the government makes money on these transactions, it actually depresses me all the more.
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Sellers typically know more about the assets they're selling than buyers. It just stands to reason. If these assets were really worth more than the selling price, by the seller's rational calculation, the transaction wouldn't occur, unless the seller is under some kind of pressure to sell his asset for less than it's worth. Since the sellers, by all accounts, are the ones pushing this deal, any expectation of a profit for the buyers is prima facie bullshit.
Sellers typically know more about the assets they're selling than buyers.
If that were true, then I'd be out of business. In fact, distressed debt hedge funds do this kind of trade profitably all the time.
Paulson's plan means that the U.S. government will become the largest distressed debt hedge fund in the world – with no incentive at all to make money. Government has no incentive to make sure that it is not taking too much risk for a given level of expected reward. In other words, there is no disincentive for entering into negative expectancy trades. In fact, there's every incentive to do so (and as politicized as this will become, it is an inevitability). The government will not avoid negative expectancy trades and even if they do (accidentally) win on some of them, you can be sure that the risk adjusted return will be terrible. We know this because there are no guidelines to prevent them from doing so and it's unlikely that Wall Street's best and brightest will be lured to manage this portfolio when there is so much more incentive to figure out how to skirt regulation.
We're cooked.
Wall Street's best and brightest are managing the portfolio now.
"I also am deeply concerned about the rule of law"
I'm not worried about it, it died a long time ago.
The House Republicans are resisting the bailout; Hurrah!
Obama is claiming that he and McCain should not have been there because "the camera changes things". Sure it does, but that goes with the job of being President; so it sounds to me like Obama is not ready for prime time.
It seems to me that $700 billion might also have some opportunity costs.
Keep in mind I have a simplistic understanding but I assume the treasury is going to raise this money by issuing bonds (or, they trade bonds for the MBS, effectively the same thing).
With $700 billion worth of bonds coming on the market won't that drive bond prices down (interest rates up)?
Won't that make it more expensive to borrow money?
Marcus, you're right. Yields will definitely go up. Borrowing costs will increase also. Those of us who depend on leverage in our business are already bracing ourselves.
I should note that without the bailout, borrowing costs will rise anyway as credit spreads will likely expand further. Bailout or not, borrowing costs are going higher.
Wall Street's best and brightest are managing the portfolio now.
That's my point. They're not going to get anyone on the other side of the trade (buying for the TARP) smarter than the guys selling it to them. Government just won't be able to offer the necessary incentives.
"They're not going to get anyone on the other side of the trade (buying for the TARP) smarter than the guys selling it to them." No only that, but Bernanke even said that they didn't want to get too good of a deal because that wouldn't help the banks. Talk about incentives.
I keep hearing that, "there's no other option" and usually preceded by "I'm all for capitalism, but…" Failure is an option. i.e. WAMU had a price for its shares, happened to be 0.
I don't know if anyone has noticed, but the system has already collapsed. Everything they're doing right now is just to propagate the illusion that it hasn't.
And Jason, I keep hearing "I'm the biggest free market guy you'll ever meet, but I'm all for the short ban until conditions improve." So, we're all for free markets except for price controls and market manipulation (inefficient, at that). Fabulous.
"Everything they're doing right now is just to propagate the illusion that it hasn't."
It's worse than that. The plan attempts to shift the risk of years of poor investment decisions on to taxpayers. The naive hope that the plan might turn a profit has little bearing on its merit. The federal government can turn a profit on a lot of things, that isn't a justification to do so. I can only pray for gridlock.
I found out this week how few libertarians there really are.
How can anyone tell if government is making a profit at anything?
If the Government is so confident they will make money off this deal or at least lessen the cost by selling some of the assets in the future at a profit, why don't they just change the mark to market accounting rule and allow the firms to get those profits.
What's to prevent banks and other financial institutions from colluding with each other to off-load their toxic assets in Paulson's Cash for Trash program? The Treasury can't seriously call that "price discovery."
What's to prevent banks and other financial institutions from colluding with each other to off-load their toxic assets in Paulson's Cash for Trash program? The Treasury can't seriously call that "price discovery."
– Posted by: kurt | Sep 25, 2008 9:02:46 PM
Actually, it would seem to me the Treasury has the advantage in this regard as they effectively have a monopsony.
Banks might try and collude but like OPEC they're bound to fall victim to the prisoner's dilemma.
Of course, there could be collusion with the Treasury. That changes everything.
What do you guys think?
Professor Roberts,
I'd like to ask you guys to try and predict what the fallout of the bailout may be.
For example, if more treasury bonds means higher interest rates then that means lower demand for homes which means falling home prices which means more foreclosures.
Higher interest rates means less capital investment by businesses.
But maybe higher interest rates means lower gas prices as more money moves out of commodities and into bonds.
Now those are just uneducated, wild ass guess by me. I'd like to read something written by someone more informed, like you guys.
"How can anyone tell if government is making a profit at anything?"
I don't really think of "government" and "profit" in the same terms. Superficially, profit is just the difference between what you pay for something and what you receive for it on the flip side.
Instead, I think of profit as being the reward for risk-taking and achievement.
Not only do I not think of government and profit in the same terms, but I think it's a shame that people are starting to.
Marcus:
Having a monopsony in a product with a high price elasticity is relatively meaningless as it is a strong barrier to exercising any pricing power. Financial products by definition have very high price elasticity, except in very rare cases (Berkshire Hathaway or Google's IPO come to mind as having slightly more inelastic demand). There are any number of companies that have an absolute lock on products that no one really wants to buy, what difference does it make that they're the only hapless soul selling it.
Aschkan,
A monopsony is where there are many sellers but only one buyer.
In this case, we have many very willing sellers but only one effective buyer.
Now, maybe the Treasury is the only buyer because no one else is interested. That may be. Even so, they should be able their effective monopsony power to drive the sale price of these assets down lower than if there were many buyers competing for these assets.
I haven't heard one politician taking responsability for what is happening. Not one.
The disaster is now well under way, the question is how fast will the system bounce back. If bureaucrats take over, it will take decades…
I clicked through to the 20 comments because I was sure I'd see George defending the Bush/Paulson/Bernanke plan. That would have been rich.
The White House is trying to argue that the bailout isn't so bad, it might not really cost $700 billion because some of the assets will appreciate in value.
Rhetorical question: If this is such a good deal, then why aren't there enough other buyers, even at a lower price?
wow! we are now subsidizing the debts of wall street.How sad the rich now want welfare.
As far as politicians enacts policies for rent-seeking acts they will continue to doubts the free market.
We're cooked.
Posted by: Methinks | Sep 25, 2008 7:12:30 PM
This is the first time you engage in chicken little-ism.
All I hear is whining on this board. This deal HAS to be done to restore faith in the credit market ASAP. It needs to be done, and then we can move on to create greater transparency. But the last thing we need is doomerism and nay-sayers. Shame on all of you.
"With $700 billion worth of bonds coming on the market won't that drive bond prices down (interest rates up)?"
But if interest rates go up, won't that affect all of the adjustable rate mortgages? Won't that increase foreclosures? Won't that …
"If the Government is so confident they will make money off this deal or at least lessen the cost by selling some of the assets in the future at a profit, why don't they just change the mark to market accounting rule and allow the firms to get those profits."
Because mark to model accounting brought us the S&L crisis. We know better than to do that. Bernanke prefers mark to fantasy.
I have faith in the credit market now. I only lack faith in particular borrowers holding particular (in)securities. We already have an orderly procedure to deal with them. It's called "bankruptcy". If many banks are now in this position, we may need some new banks, but that's not obvious until bankruptcy courts evaluate the matter. I don't understand the problem with this transparency, unless you happen to be invested in one of the banks holding the particular (in)securities and you don't want anyone knowing how you came to hold them and what they're really worth.
"My real concern is the incentive effects for future prudence (reduced) and the weird misallocations of capital that will inevitably result. I also am deeply concerned about the rule of law and how such a program can possibly run in a non-arbitrary way.
If the government makes money on these transactions, it actually depresses me all the more." Russ Roberts
As well you should be, Russ, as well you should be.
Point is, what are you and I going to do about it? Something concrete, or just more rhetoric?
Government is run amok and has been for many decades, it just has taken a lot of people a long time to see it because it hasn't slapped them in the face like this. The past hints have been somewhat more subtle however solid the hints were.
Again I say the problem is government, it is the enemy of the people of America.
That's the easy question. The answer is "more rhetoric".
Here's a bit more of my rhetoric. I'll try repetition this time.
The payroll tax surplus peaked this year.
The payroll tax surplus peaked this year.
The payroll tax surplus peaked this year.
This event is not unique to the Social Security system. Similar events are occurring in similar systems all over the place these days.
It's the rent seeking, stupid.
In this case, we have many very willing sellers but only one effective buyer.
Marcus, I'm not sure that's the case at all. There are other willing buyers out there but the banks don't like the bids. Paulson and Bernanke have already tipped their hand and said that they are willing to pay above "market" (whatever that is) price to have these banks offload their garbage. One desperate buyer with no incentive to make a profit and a bunch of sellers who know they have the buyer by the you know what is the scenario we have here. This will be an exercise in adverse selection.
This deal HAS to be done to restore faith in the credit market ASAP. It needs to be done, and then we can move on to create greater transparency. But the last thing we need is doomerism and nay-sayers. Shame on all of you.
Crusader, I hate to point out that by making this statement (it HAS to be done) you are also predicting doom. The issue is that I think we all recognize that the problem is grave. We either pay through the nose for an inefficient hedge fund to buy distressed assets at a loss or we suffer the consequences of the collapse of a fragile financial system made more fragile by interventions like this. Either way, it's going to be mighty painful for everyone.
"With $700 billion worth of bonds coming on the market won't that drive bond prices down (interest rates up)?"
It occurs to me that part of the plan must be for the Fed to then buy up the treasuries from the banks (thereby replenishing their depleted treasury stores) and flood the market with cash.
Does that have consequences for inflation?
Yes, Marcus. Politicians won't be able to raise income taxes right now. The tax increase may come in the form of inflation.
Yet…politicians are still pushing MORE zero down mortgages!!!!
I'm pretty squarely with Martin on this one. Despite all the warnings of what will happen if "banks" are rescued, nobody knows what will happen because no one can know what will happen. Why on earth would it be an imperative to introduce something we know to be value destructive (an unaccountable bid not seeking economic efficiency) into a system in order to make it better?
My power's still out in Houston, so I am willing to believe that maybe God came down and held a press conference on live TV last night explaining what will happen if the bailout isn't passed. Can anyone confirm whether that happened? If not, how exactly do we know the future?
Crusader,
You wrote: "This deal HAS to be done to restore faith in the credit market ASAP."
This makes sense only if there are NO alternatives that would "restore faith" in credit markets (whatever you mean by "restore faith"; this is another difficulty with what you wrote).
What economics illuminates is that there are alternatives everywhere. The choice that maximizes wealth is usually not found by blindly following a the lead of a small group of elected officials and their appointed regulatory czars. Follow the leader is a child's game, but history shows that adults who play it can end up with one Hell of a mess (remember that by following FDR's lead the Great Depression was prolonged).
So I see the current unwillingness of many in Congress to follow blindly as an extremely positive sign. I agree with Newt Gingrich that the Paulson/Bush/Bernanke Deal is such a terrible proposal that arguing about it and changing it (the more the better) can only make it less bad (and perhaps it will even morph into something reasonable).
You know, reading all the various writings by economists on what may or may not happen if we do or don't do this or that and observing how few of them are in agreement on much of anything, it seems to me to demonstrate that macro-economics is mostly bullshit.
Methinks,
I forgot to thank you for the link on naked short selling. It was very informative. Thanks.
I'm not too worried about incentive effects on the financial institutions. Enough of them have folded or been bought out that it will be a long time before any of them pull this crap again. They're smart, and I think they understand.
The bigger risk, I think, is in the move to bail out homeowners who hyper-leveraged their residences. These people often don't understand all the risks. If they all end up OK because of a government bail out, then they are far more likely to do something similarly stupid in the future.
Banks, now, won't let them do this with their homes. But, they may still over-leverage their retirement investments. In five years, I don't want to hear about all these people who lost their retirement savings by buying a bunch of stock on margin, and then demanding that the government pay for their retirement.
Marcus, you're very welcome. I thought you would enjoy it.
it seems to me to demonstrate that macro-economics is mostly bullshit.
Ah yes! The difference between micro economists and macro economists is that micro economists are wrong about specific things and macro economists are wrong about things in general.
I hope I can contribute to these discussions at some point.
I am just very, very, very glad I have been introduced to this blog.
There are more libertarians out here than you think.
The bigger risk, I think, is in the move to bail out homeowners who hyper-leveraged their residences. These people often don't understand all the risks. If they all end up OK because of a government bail out, then they are far more likely to do something similarly stupid in the future.
I've said it before and I'll say it again: If we've learned not to extend 70x leverage to the likes of LTCM (which was filled to the gills with the brightest minds in finance – including Scholes of the Black-Scholes model), then why the hell are we levering average Joes 100x or higher? And by government mandate, no less. Worse, government wants to lever the worst credit risks the most. Only government can be this stupid. It takes the idiocy of government to learn exactly nothing from mistakes.
But, they may still over-leverage their retirement investments.
That won't happen. Banks & brokerages are cutting leverage across the board. Professional traders with low volatility returns are seeing their leverage cut substantially. We're bracing for more leverage cuts in the industry. Brokerages will likely to raise their thresholds well above SEC regulations to qualify for Reg-T margin accounts (retail accounts) and will likely increase the haircut on Portfolio Margin accounts as well as Broker Dealer and JBO accounts. Leverage is coming down, not going up. Part of the reason is that brokerages themselves have had leverage cut and part of the reason is that, unlike government, they try not to repeat the exact same mistakes.
Maybe I should clarify my concern, the fact that the government will be a monopsony buyer doesn't change the fact that they must either hold securities to maturity or liquidate them in an orderly fashion. If they're a monopsony buyer in the secondary market, then they are also essentially a monopoly seller the minute they soak up all the garbage debt.
Again I say the problem is government, it is the enemy of the people of America.
The real problem is that many people don't get that.
You may be right from a utilitarian point of view. I have no opinion in that regard, but bailing out Wall Street is a bigger immorality than bailing out a poor family drowning in debt.
The Keynesian, too big to fail philosophy, which many "Keynesians in Drag" also willingly embrace, is a bigger fascist threat than too small to fail philosophy. It is feudalism, which usually the way societies were organized for most of history.
You may be right from a utilitarian point of view. I have no opinion in that regard, but bailing out Wall Street is a bigger immorality than bailing out a poor family drowning in debt.
Why? Wall Street is in the position it's in because it lent money to the poor family which was also a poor credit risk, usually at the behest of government. Both the poor family and the lender acted imprudently. Your robin Hood argument borders on "to each according to his need from each according to his ability" mantra and creates some mighty perverted incentives.
Just to be clear, I don't think anything is too big to fail. In nature, things don't grow too big to fail. Such monsters can only be created by government and should be allowed to fail and/or be dismantled.
By the term "government", you mean that cartel called the Fed, then I agree to an extend. But then cartel itself works in the interest of the bankers. They provide with the necessary inflation when the bankers are in trouble.
But if you mean specific, bills or policy passed in congress, or for that matter an executive order, then I disagree. I am not aware of any such statutes that required wall street to load the poor fools with teaser rates, negative amortization mortagaes, High LTV ( more than 100%) mortgages etc. Those were all creations of the "smartest guys" in wall street. Did Fed create the environment for it? My answer is a resounding yes, but they didn't force them to do it.
Totally agree. There aren't anything that is too small to fail either.
I was weighing between two immoral acts, first, bailing out the too big, and second, bailing out the too small. I am not making any argument in favor one over the other. What ticks me off, is people who maintain a soft sympathy towards the big, and none at all towards the small, then use a utilitarian argument like "The bigger risk, I think, is in the move to bail out homeowners who hyper-leveraged their residences."
That is an example of what I spoke about in the last sentence. You obviously didn't get fired up by Chris's comment.
To make my self clear – "No bail out, no welfare, regardless of where you belong in social or economic strata."
Wanted to add that, libertarianism is not just an economic philosophy, but mainly a moral philosophy. Libertarian economics derives itself from the moral philosophy of liberty. Incentives are subordinate to the main idea, which is liberty.
I'm very skeptical of this theory. If the problem were limited to the mortgages of poor families, the bailout wouldn't include "commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages". The Bailer Out in Chief has authority to buy a credit default swap on a bond sold by General Motors to finance the purchase of an office building. If it's all about subprime mortgages to poor urban minorities, you need to explain why this language appears in the draft proposal.
But if you mean specific, bills or policy passed in congress, or for that matter an executive order, then I disagree.
Yes, that's what I mean. the CRA, for example. Look also to Fan & Fred and their effect on the mortgage market. The CRA does actually force lenders to lend to poor credit risks at below market rates. Wall Street didn't lend to these people directly. It's job was to create ABSs by packaging the loans into CDOs and MBSs. Investment banks did not originate the loans.
I was weighing between two immoral acts, first, bailing out the too big, and second, bailing out the too small.
I think you fail to see how connected they are. There is nothing moral about allowing people to defraud lenders just because lenders have, practically by definition, more money than the borrower. It is immoral to breach a contract whether you are poor or not. Nobody held a gun to these people's heads and forced them to buy a house. The people who will be punished by bailing out the poor shirker of responsibility is the responsible poor guy who has yet to buy a house and has less access to credit than the average Joe. To do that to that guy is immoral.
In fact, to shove regulations like the CRA down lenders' throats and then scream that it's immoral to bail them out after they've made imprudent loans that the government virtually forced them to make may be more immoral. You realize the CRA rendered credit analysis moot, right?
I'm not making an argument for a bailout, just disagreeing with your stance on which activity is less moral. I'm arguing for no TARP and a demolition of Fan & Fred, along with the CRA.
You obviously didn't get fired up by Chris's comment.
I'm too bored to be fired up. Which comment are you referring to?
If it's all about subprime mortgages to poor urban minorities, you need to explain why this language appears in the draft proposal.
Rent seeking.
(BTW, I was simplifying a bit. It's also about overly tight credit spreads – which is not controlled by the Fed – and it's a lot about widening Fan & Fred's "conforming loan" definitions to include things like Alt-A loans, which encouraged more Alt-A and other loose lending and it's about everybody thinking we're in a "new paradigm" where risky is not risky.)
Did CRA contribute to the current crisis? It very likely has. Did F&F create an effect on the market? yes, it certainly has. But these distortions existed in the market for many years. What changed over the last few years? The answer is extremely lose monetary policy. Government is at fault.
However, Nobody forced the bankers to give them 125% LTV loans, 0% for 1 year loans etc. These were creations of the Wall-Street. Nobody asked the hedge funds to invest in this stuff. Nobody asked the rating cartel ( another creation of regulation ) to rate these junk the way they did.
So, yes, it is the fault of bureaucrats and politicians, and government in general, but I don't hold the view that bailing out Wall Street is somehow less harmful than bailing out the Main Street.
In conclusion, there is no need to call each other "Robin Hood". We are mostly in agreement.
Yeah, Oil shock, I think we're saying we don't want to bail out dumb borrower or dumb lenders. My only disagreement was with the claim that one bailout is more moral than the other. I don't disagree that lenders were stupid and shouldn't be breaking out the tin cup.
Incidentally, not to pull anyone away from this blog, but Arnold Kling at EconLog is furiously posting some really interesting things with updates on new proposals coming from congress. Don't know if you know that.