It's not funded by taxpayers

[Now that Capitol Hill has agreed on a package, I hope we can all take a breath. My last article was titled "It's not a bailout; it's the dollar's credibility"; this is a follow-up.]

Seems to me the main sticking point that almost prevented an agreement on the falsely-named "bailout" package was the false impression that we taxpayers will have to reach into our pockets and somehow come up with seven hundred billion dollars on short notice. And I think that false impression resulted largely from the answer Jim Bunning got when he pressed Secretary Paulson for an answer to his question, "Where will the money come from?" Paulson, I think, answered too quickly; "The taxpayers" was his answer.

I wish he had said "bond buyers" instead of "taxpayers," because that's how it will really be funded. But he didn't. He said "taxpayers" -- and, unsurprisingly, that scared a lot of taxpayers.

I checked the wording of the not-a-bailout plan, and it clearly refers to Title 31 of the US Code as one of the main levers the Treasury will use to execute the plan: it will issue treasury bonds, bills, or notes as necessary.

When the Treasury sells T-bonds to willing buyers in the bond market, the transaction does not involve unwilling taxpayers. (Does Jim Bunning know that? How about Ron Paul? I'm not so sure.) In any case, I decided to build an eight-picture series of the "asset swap" to show why taxpayers need not be involved at any point in the swap.

Diagram 1:

The emergency situation as of last Friday. It would remain like this, or get worse, if Congress had not come together over the weekend.

Diagram 2:

Approval of the plan enables the Treasury to go to the bond market -- repeat, the BOND market, NOT the taxpayers -- to obtain funds.

Uh-oh, those new T-bonds indicate that the national debt increased, right? Yes, but please don't have a heart attack yet; keep going.

Diagram 3:

Proceeds obtained from the bond buyers are used to buy up the questionable mortgage paper from the financial sector.

Diagram 4:

Liquidity in the banking sector is restored; banks once again start lending small, medium, and large businesses the money they need to meet their payrolls. The danger of a severe recession or a deflationary depression has been averted. At the same time, the Treasury's rescue process, highly transparent to the public, starts sorting out the good paper from the bad paper. (Let's call this a "cleansing" of the paper.)

Diagram 5:

The Treasury, having made it easier to judge the value of mortgage paper, auctions the paper off. The highest-bidding banks and financial firms buy the paper back from the Treasury.

Diagram 6:

Now the Treasury has money to repurchase T-bonds from willing sellers in the open bond market.

Diagram 7:

If the Treasury's cleansing process reveals enough high-quality paper, auctioning it off could yield a breakeven -- or even a profit -- for the Treasury.

And even if the process yielded a loss, it would mean recovering the difference from the financial sector, or at worst, not buying back quite all of those T-bonds.

Diagram 8:

Can you spot the only difference between this and Diagram 1? Hint: The taxpayers' funds didn't get affected by the process.

Conclusion:
One of the most unfortunate aspects of the last seven days' dialogue, in my judgment, was the mistaken impression that "taxpayers" would somehow have to come up with "seven hundred billion dollars" on very short notice -- and hand it over to Wall Street CEOs. No wonder everybody was angry; clueless talking heads were on every channel, egging us on. I was walking past a TV from which the dangerous renegade Lou Dobbs was sarcastically perpetuating his version of that false characterization, but I didn't get to hear more than a few sentences of Dobbs's uninformed tirade. Reason: his voice always triggers the involuntary reflex of getting myself away from that TV quickly as possible.

Obviously, there are all sorts of details that need to be worked out regarding the cleansing and auction processes -- and there are all sorts of good ideas being floated for those, too. The credit markets have yet to speak today (Monday), but I'm glad Capitol Hill came through with a plan that has only a few ugly ornaments hanging on the basic Paulson/Bernanke package. This should be good news to the markets.

It should also be good news to the taxpayers, to Jim Bunning, and to Ron Paul, don't you think? (I doubt it will do Lou Dobbs any good; he's hopelessly locked into his schtick -- and in any case, I don't care.)

Comments

[Bob]

This is why your blog is the best in the whole 'sphere at explaining stuff like this.

When I heard about taxpayers being on the hook, I too chafed. That's because I learned a long time ago, from you, how things worked.

BTW, there was some nasty stuff in the bill that got eliminated (like 20% of all profits going to some ugly slush funds that also appears to fund some rather ugly activities). If McCains trip back to DC helped to get that nonsense eliminated he should be praised. And, if the other guy was content to leave it in he should be severely scolded.

[Doug]

Steve,

I certainly understand the rationale for your argument and I am by no means a finance/economics expert, but I do have an issue with your continued reference to this as an "asset swap". As far as I understand it, the typical asset swap involves just that - an asset exchanged for an asset, such as if people who held US bonds swapped the income from those bonds for the income from the "assets" held by the institutions at issue. Of course, if any private sector actors were willing to do that, we wouldn't have the current crisis. No private sector will engage in that transaction, because the institutional "assets" are not throwing any significant income and, at the present time, cannot be valued.

I think an honest description of this transaction is some type of leveraged buy-out. The government is taking on debt, in the form of bonds, to finance the purchase of these "assets" from the institutions in question. If, as you hypothesize, the value of the performing assets is in fact much more valuable than that of the non-performing assets, then your equation works out fine. The problem is, that's just a hypothesis at this point. The assets may well turn out to be virtually worthless - a lot will depend on the ulitimate number of underlying defaults. It also depends on what price the government pays the institutions for the assets. If it pays anywhere near the book value - which was largely based on computer models that assumed a rapidly growing real estate market - I think it's questionable whether the government will be ablet resell them at a profit. If the government pays closer to the marked-to-market value - which I doubt, since the bill appparently suspends mark to market rules - then it is highly likely that the deal will play out according to your analysis.

Doug

[Terry]

Thank you. These two posts are the first I've read/heard about this aspect of the "bailout." I've strained to hear anyone say what the bailout was really supposed to do and who would benefit. Not hearing anything satisfactory, my reaction has been as you described.

I still have one question. As I understand it, the Treasury Sec'y has quite a bit of leeway in pricing what he buys. What incentives does he have to buy low, given the unknown risk?

[inf4mia]

A few counter-points...

1) Government has never proven itself to be very good at making money or breaking even (where is their incentive to do so?).
2) These types of actions typically end up being far more expensive than we're first told (where is government's incentive to drive down costs?).
3) People in the market who understands these distressed assets better than myself or the Federal government don't think they can make money from these assets yet (i.e. they're not cheap enough). This unwillingness tells me that this plan has significant downside risk that no one else is willing to take. That should fact make us all pretty apprehensive about this bailout.
4) When you say, "And even if the process yielded a loss, it would mean recovering the difference from the financial sector, or at worst, not buying back quite all of those T-bonds." isn't this just saying, that the government's debt will rise by the amount of T-Bonds not bought back? In the end, the taxpayers would have to pay this money back which puts them firmly on the hook. No one really knows what the final number will be, or how much bad paper the Fed is going to have to buy. Paulson and Bernanke refuse to say that $700B will address the issue.
5) Paulson and Bernanke never saw the real estate bubble / sub-prime mess coming and were completely blind-sided. Additionally, the Fed's policy of cheap credit helped create the bubble in the first place. Now we're supposed to trust their judgment with even more responsibility?
6) If you subsidize something, you'll get more of it. The government is going to buy back these distressed assets at rates that are higher than what the market is willing to pay. This mitigates investors risk and encourages further risky behavior.

[Larry D'Anna]

Steve, you are missing one incredibly crucial point, and it undermines your entire argument: The possibility that the Treasury will buy these questionable assets at *above* *market* prices. This would indeed be a huge, unwarranted gift to the shareholders of these banks. And yes, it would ultimately be paid by taxpayers as interest on T-bonds.

It is absolutely crucial to ensure that this does not happen. Treasury must buy these assets at auction-prices, or it must take a (large) stake of equity in these banks in exchange for putting up the cash.

[cokezero]

If the process yeild a loss then Treasury will have to pay interest to the bond holders each year which comes from the tax payers.

In fact the tax payers are paying interest from day one the Treausry sells US Treasury paper to bond holders. Bond holders lend the money to the US for a price and that price is paid by tax papers. It's not free money.

The only way for this to work is to have Treasury pay way above market price for the toxic assets. Had they pay market price the banks would take the lost instantly and go bankrupt straight. This is not a liquidity issue as many suggest. This is an insolvency issue and buying at above market price is what this bailout really is about.

[cokezero]

I suppose the US can ultimately monetarize those 700 billion and debase the currency. So ultimately it's not just the tax payers who're paying for it but everyone who owns US dollar. Good job Treasury.

[Mike H]

There is no market price for these assets, because there is no market. The Treasury will pay more than the "mark-to-market" price, but will likely buy them from the lowest bidder up, so it will depend on how badly the banks want to get rid of the paper.

Suspending mark-to-market may be the most important part of the bill. If the regulators stop requiring it, the banks will want to sell far less of their paper and may largely make the not-a-bailout irrelevant. Still, that money is a good backstop for any problems we will have in the near future.

I just wish any profits would turn into a tax break instead of being used to pay down the debt. Any profit the Treasury makes is profit taken away from the private sector.

[Mike H]

Right after I posted that message I read about the bailout failing in the House...

http://www.msnbc.msn.com/id/26884523?GT1=43001

and I've been reading stories about how we're going to start turning back to the 1970's or earlier because that's apparently the only kind of "change" the candidates can think of:

http://www.msnbc.msn.com/id/26933982

Steve... I'm getting depressed, you've been through more than I have, but my optimism is deflating rapidly... it appears we are doomed to become more like Europe very soon. Could you help me out of this funk? I've always been a long term optimist, but it's easy for me to become irrationally pessimistic in the short term.

[AGoyAndHisBlog]

Define irony...

It seems that Paulson has shot himself in the foot (or perhaps the femoral artery) with his statement about taxpayers footing the bill for this. Can't think of anything that would have fed taxpayer (i.e., Congress' constituent) animus any more than that, and now Congress can't drum up enough potentially suicidal votes to pass it.

Paulson essentially guaranteed the failure of his own proposal with his erroneous statement.

[Doug]

goy,

Indeed, Paulson did shoot himself in the foot if it was a misstatement. Methinks, however, that he mistakenly let his view of the facts slip. Granted, no one knows the real value, if any, of this junk - the main reason for the current problem. But, I would guess that the statement is a true indication of Paulson's view of the worth of the lion's share of what the government would be purchasing.

More importantly, I think Paulson shot the rest of us in the wallet by failing to give the American people any idea of the basis for the $700B number or why action had to be taken in about 7 days. I can't count how many congresscritters and other people "in the know" who have said that legislation had to be in place by the time the asian markets opened last night or our entire credit system would come to a halt. Well, they didn't meet the deadline, and credit armageddon hasn't appeared yet. But, by imposing that deadline, rushing to get something done without giving many facts, and failing to meet it, our government folks pretty much guaranteed a negative reaction from the equity markets. In that respect, they really have created something of a self-fulfilling prophecy.

[Optimist123]

Today's vote in the House, killing the bill in question, renders this comment thread moot. As a result, I won't be wasting any more of my time on it.

Partisan political skills and tactics on Capitol Hill have once again trumped integrity and leadership. We needed Kumbaya speeches from Nancy Pelosi and John Boehner, but we got vitriolic partisanship instead, from both of them. Each side succeeded handsomely in "teaching the other side a lesson."

Because of those highly-skilled partisans in our esteemed House of Representatives, we will not get to step 2 of the 8-step sequence in the article above. Debating steps 3-5 is simply a waste of time. So, just re-read the caption below Diagram 1, and stop at the last comma.

This thread is finished.

[aaron]

This doesn't seem quite right, the taxpayer would pay and interest and for any shortfall.

[aaron]

pay for any interest and for any shortfall.

[Optimist123]

Aaron, the magnitude of the package, not to mentions the economic problem it intended to avert, approaches one trillion dollars. The debate is about the digits several zeroes to the left of the decimal point. Interest on whatever shortfall settles out, if there is a shortfall, is too close to the decimal point to qualify for the bigger discussion.

To put it another way: Are there any estimates of the likelihood that the shortfall plus interest will total $700 billion? My estimate: it's between zero and zero-point-two percent chance. In other words, I estimate that the chances are between 99.8% and 100.0% that "the taxpayers are on the hook for 700 billion" is false hyperbole that, unfortunately, could block the prevention of a severe recession, if not the next Great Depression. (Other estimates are welcome.)

The cost to taxpayers of preventing economic disaster has a good chance of settling out in a few years at zero plus-or-minus a few tens of billions. The false hyperbole about "taxpayers" and "700 billion" could kill the preventive measure, and thereby turn out to be one of the costliest misunderstandings in the history of this nation. (Trillions costlier than our failure to prevent 911, by the way.)

[joelsk44039]

You assume under your graphic scenario that "Worldwide T-Bond Buyers" will actually buy US-Issued bonds. If the credit crunch is real, won't their foreign access to credit and capital be affected? Won't this put a halt to their purchase of our bonds?

[Optimist123]

joelsk:
The USA will *always* be able to sell its bonds on the bond market; the main question is, what interest rate will the buyers demand? That depends on the buyers’ confidence in the dollar and in the US economy, relative to other currencies and the underlying economies behind them. (Key word: “relative”)

What do they think now? The dollar has been strengthening rapidly, especially against the euro (…not sure about the rupee; I’ve never had a reason to watch that currency). Deflation increases the value of dollars, which is one reason everyone wants to stop doing commerce and get into cash asap. Also, T-bill rates are near zero. Both are indicators of a flight to safety.

In short, it looks like we can plan on more than sufficient demand for US Treasury debt instruments, as usual. All the more reason to give the lenders the T-bonds they want, and leave the taxpayers alone, as we fund the rescue (“depression-prevention”) package.