Secretary Paulson's enabling act (8)

The Senate will vote on a revised bailout bill at 7:30pm. The draft is now 451 pages and contains tacked-on provisions, including the "Paul Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008," which would require insurers to treat mental illness equivalently to physical sicknesses for certain purposes. (And, to be fair, the tax credits for alternative energy.)

The relevant portions of the bill are 113 pages long. The bill would require Treasury to publish guidelines related to the execution of the TARP, including:

(1) Mechanisms for purchasing troubled assets.
(2) Methods for pricing and valuing troubled assets.
(3) Procedures for selecting asset managers.
(4) Criteria for identifying troubled assets for purchase.

The talking heads all seem to think that mechanism design should be left up to Treasury -- but of course it is just in that mechanism design that all the key decisions about moral hazard and the proper expenditure of tax dollars will be taken. (The Secretary is to buy assets "at the lowest price that the Secretary determines to be consistent with the purposes of this Act.") As long as this is a black box, the bill is completely indeterminate as between a simple transfer of cash to banks -- an underhanded and expensive recapitalization -- and a legitimate (although perhaps more fundamentally wrongheaded) attempt to relieve liquidity pressures. The bill's provision against unjust enrichment is a lame duck, forbidding the purchase of assets above their original purchase price, but not above their current fair value.

Sec. 102 of the bill is the House Republicans' Mad Hatter insurance plan, which grants Treasury authority to insure assets up to par (!) and again in no way specifies how they are to do so:

In establishing any program under this subsection, the Secretary may develop guarantees of troubled assets and the associated premiums for such guarantees. Such guarantees and premiums may be determined by category or class of the troubled assets to be guaranteed.

Leave aside the ludicrous reality that the people who wrote this section claim to be protecting us from state socialism. They ask Treasury to set premiums in the insurance program

at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.

It is harder to insure assets than it is to price them -- you need more data -- even when those assets are straightforward. Many of the structured assets under consideration are singular and do not belong to an obvious class of similar assets -- how, for instance, to measure the risk of default of some particular equity tranche of some particular pool of mortgages from Wisconsin in the first half of 2006? Even if we accept the imperfection of the needed comparisons, the market in these assets that could provide price data for an insurance estimate is shut down -- and the same agency that will be insuring the assets is the one that will be granted $700bn to distort or substitute that market. It's hard to see how Treasury could even begin to make good-faith efforts to implement the insurance program.

The mandate of the program has expanded ungraspably, with Treasury instructed to take 9 factors (not obviously reconcilable, e.g. numbers 4 and 5, etc.) into consideration in its implementation:

(1) protecting the interests of taxpayers by maximizing overall returns and minimizing the impact on the national debt;

(2) providing stability and preventing disruption to financial markets in order to limit the impact on the economy and protect American jobs, savings, and retirement security;

(3) the need to help families keep their homes and to stabilize communities;

(4) in determining whether to engage in a direct purchase from an individual financial institution, the long-term viability of the financial institution in determining whether the purchase represents the most efficient use of funds under this Act;

(5) ensuring that all financial institutions are eligible to participate in the program, without discrimination based on size, geography, form of organization, or the size, type, and number of assets eligible for purchase under this Act;

(6) providing financial assistance to financial institutions, including those serving low- and moderate-income populations and other underserved communities, and that have assets less than $1,000,000,000, that were well or adequately capitalized as of June 30, 2008, and that as a result of the devaluation of the preferred government-sponsored enterprises stock will drop one or more capital levels, in a manner sufficient to restore the financial institutions to at least an adequately capitalized level;

(7) the need to ensure stability for United States public instrumentalities, such as counties and cities, that may have suffered significant increased costs or losses in the current market turmoil;

(8) protecting the retirement security of Americans by purchasing troubled assets held by or on behalf of an eligible retirement plan described in clause (iii), (iv), (v), or (vi) of section 402(c)(8)(B) of the Internal Revenue Code of 1986, except that such authority shall not extend to any compensation arrangements subject to section 409A of such Code; and

(9) the utility of purchasing other real estate owned and instruments backed by mortgages on multifamily properties.

Again, a good faith effort to follow these instructions would result in the failure of the bill to accomplish any of its objectives.

Toothless provisions on corporate governance apply only in the case when assets are purchased directly from institutions in exchange for debt and equity; they

exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution

as well as providing for clawback of bonuses in cases of material inaccuracy in the statement of relevant criteria, and the elimination of golden parachutes -- but only for the five highest-paid executives, and only at public companies.

On the plus side, in exchange for asset purchases, Treasury will receive non-dilutable senior debt or equity warrants convertible to senior debt -- but "the exercise price for any warrant issued pursuant to this subsection shall be set by the Secretary, in the interest of the taxpayer."

And then there's the FDIC insurance limit -- raised to $250k from $100k. By any prudent ("actuarial," not to put words into our representatives' mouths) standard, the FDIC insurance fund is now underfunded by two and a half times. And the corporation is forbidden to fund itself adequately!

The temporary increase in the standard maximum deposit insurance amount made under paragraph (1) shall not be taken into account by the Board of Directors of the Corporation for purposes of setting assessments under section 7(b)(2) of the Federal Deposit Insurance Act (12 U.S.C. 1817(b)(2)).

But never fear -- to pay for this largesse, the FDIC's borrowing limits at the Fed will be lifted.

This would be a terrible bill even in the relatively competent hands of Hank Paulson -- what about Phil Gramm or John Corzine? It will stall the failure of insolvent banks and cast a veil of uncertainty over all those markets into which it intervenes. Cowardice, ignorance, and political expediency will ensure its passage into law.