Thursday, September 25, 2008

Secretary Paulson's enabling act (5)

With his characteristic lucidity, Lucian Bebchuk has written a very short paper (13pp) which says (almost) everything that needs to be said about the Paulson bailout proposal from a policy perspective. If you read only one thing this week about the bailout, make it this.

Edit: Bebchuk makes his case in Friday's WSJ.

Bebchuk limits himself to the premises and scope of the action proposed this week by Treasury: given, in other words, that the plan is proposed in good faith (i.e., it is not an attempt to distribute largesse to selected firms or actors, it is not a power-grab by Treasury or Paulson personally, it is not an attempt to buy the election for McCain, etc.), how ought it to be designed?

The pricing problem
Bebchuk states plainly the fundamental hypothesis about the state of the financial markets that underlies the policy proposal:
Because of the substantial presence of these illiquid troubled assets on the balance sheets of financial firms, the Treasury believes, financial firms have difficulty raising capital, are subject to risks of creditor runs, and are reluctant to carry out fully their role in financing the real economy....

The Treasury believes… that financial firms cannot currently sell these assets even at their reduced fundamental value… money managers that would otherwise be willing to purchase financial assets at any price below their fundamental value do not have sufficient liquidity to keep prices at fundamental values.
Given this premise, the problem is then, straightforwardly, a) whether government should introduce the needed liquidity into the markets (as opposed to private actors), and, b) how the assets to be purchased are to be priced.
The current plan gives Treasury the “freedom to confer massive gifts on private parties,” and so Bebchuk suggests at a minimum that the statute be altered to require Treasury to pay no more than fair value for troubled assets.

That begs the practical question, though, how fair value is to be assessed. “A situation in which a Treasury in-house official bargained one-on-one with a financial firm over the value of an asset would raise serious concerns.” It is nearly impossible to imagine how Treasury could assess the hold-to-maturity value of $700bn in complex securities under the time constraints supposed to be operative — Paulson has in his testimony to Congress suggested that Treasury might need to exercise the full $700bn of authority during the Congressional recess — even were the distribution of the performance of the underlying assets known. In this case, to value the underlying requires an additional prospective judgment about the macroeconomy (and in the case of individual mortgage pools, of particular market segments or regions) at a time of profound uncertainty: that is, at a time when Bush is going before the American people to warn, essentially, of the Great Depression. And exercising any effective oversight over those judgments would be difficult or impossible.

Nor do the sellers of these assets need to misrepresent their value in order to game an auction process. Even if Treasury bids as often overestimate as underestimate the value of assets for sale, sellers need only accept the high bids and reject the low.
And, realistically, the feasibility of and incentives for collusion are high: these assets are concentrated in the hands of relatively few actors, who are capable of coordinating their auction behavior.

Bebchuk therefore proposes dividing the pool of liquidity to be injected into the market among perhaps twenty managers: that is, rather than Treasury acting as a single buyer, funding an artificial market for the assets to be purchased. Competition amongst the managers could serve as a check on the price of the assets; and each manager could be incentivized based on the final profits of their fund. Bebchuk even suggests that qualified managers be asked to bid the profit cut they would be willing to accept for the privilege. Since Bill Gross has said in public he would manage Treasury’s fund for free, it shouldn’t be hard to find qualified people.
The point, of course, is that it’s possible to write stronger — much stronger — protections of taxpayers into legislation that accomplishes Paulson’s stated aims.

The capital problem
Bebchuk asks us to separate the asset-pricing question — a question, if Treasury is correct, of liquidity — from the question whether, independent of the illiquidity of asset markets, financial firms are undercapitalized. Providing capital to those that are is a legitimate aim of policy, but should be done “directly, aboveboard, and for consideration.” Capital infusions, in other words, should be and can be priced separately from asset purchases.

Bebchuk therefore proposes allowing Treasury to purchase newly issued securities from financial firms. This is superior to providing capital by overpaying for assets because it would compensate taxpayers for their transfers to banks; but also because the capital firms require may not be in proportion to their holdings of illiquid assets.

Bebchuk appears not to have read the Dodd proposal — since the equity participation granted to government under that plan would vest after the final asset sales, in a proportion of 125% of the shortfall, it is not subject to his criticism that under plans which give government equity, “government would still need to assess how much it is overpaying for the purchased troubled assets and what new equity tickets would provide adequate consideration for the amount overpaid.” But other problems (like the consequences of outstanding, hard-to-value, undilutable Dodd obligations on the books of financial corporations that might wish to undertake corporate actions) make his plan to untie equity from asset purchases preferable.

The problem is, of course, that while it is true that “some financial firms would need a capital infusion but would not wish to make significant use of the government’s willingness to purchase troubled assets,” this is precisely what Paulson’s plan is designed to obfuscate. Which is why Bebchuk does a third, greater service in setting things out so plainly.

Persecution and the art of writing
Hobbes writes:
Feare, without the apprehension of why, or what, PANIQUE TERROR; called so from the fables that make Pan the author of them; whereas in truth there is always in him that so feareth, first, some apprehension of the cause, though the rest run away by example; every one supposing his fellow to know why. And therefore this Passion happens to none but in a throng, or multitude of people.
Bebchuk’s criticism is constructive, in that his plan is designed to Treasury’s stated objectives better than Paulson’s. But it is also illustrative: of the hasty and unclear thinking which is dominating a hasty and unclear legislative effort; of the disparity between the rhetoric of crisis employed by the administration and the actual shape of their plan.

That is, in times of panic it can be useful to write as if panic were not a factor in human affairs: because it is only then that one can begin to ask how, and to what ends, that panic has been fostered and turned. Make no mistake that President Bush’s address to the nation was on the order of shouting fire in a crowded theater; as the old Leninists used to say, it was an attempt to “sharpen the contradictions:” and railroad Paulson’s plan through Congress.

Qui bono?

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