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Good call on the name call-put...

I think if you re-read my comments I could be called nothing but conflicted on this issue.

However, people whose knowledge I trust (Bernanke and Paulson) presented a solution and told me the problem was severe.

I groused, I complained, but I would have accepted the advice.

Pelosi and Gingrich were pathetic. Pelosi doesn't think there is a real problem and bangs folks over the head politically. Gingrich wants the perfect solution in a time-frame that precludes perfection.


So maybe someone here can explain to me why having the Fed temporarily (for 6 to 24 months) reduce reserve and capitalization requirements, lower the Fed fund rate and step up open market and other operations to support that, and encourage (perhaps by temporarily reducing the rules and discount rate) use of the discount window by banks wouldn't be a perfectly viable alternative to Paulson's (now modified by congress) plan?

*please* address this point:

The usual way that government bailouts of banks happen is that the government gets a EQUITY stake in the distressed banks in exchange for recapitalizing them. The bailout plan that was defeated today left open the possibility that the Treasury would bail out these banks by buying assets from them at prices MASSIVELY above their market value, without receiving anything of comparable value in return.

Please, explain to me why you think the shareholders of insolvent banks deserve this massive unjustified gift at public expense.

Please explain why the treasury should not receive an equity stake, as it did in the case of AIG, as Sweeden did in '92, and as is the standard practice in cases such as this.


You are not correct that market prices reflect the actual value of these instruments. The market price is about $0.22 on the dollar when any rational valuation of these securities over their 7-15 year lifetime shows them being worth at least $0.70.

The problem may actually be that the market for these securities isn't actually broad enough. I'd like to buy some at $0.22 but I can't find them securitized into anything with a price of entry below $25K.

Also, don't forget that if part of the terms of buying these assets at market but below liquidation value is to take equity then the pricing will adjust upwards to compensate for the value of the equity. Equity or warrants are hard to be exact about but are generally easy to value. Warren Bufffet just did it with Goldman.


I'm not so sure Steve. I read today that the Fed was pumping money into the system which I assume is by the normal method (lowering interest rates by auctioning enough new treasury bills until the target rate is hit?) to the tune of 600 billion. Granted the chocolate chip/turd mess(great metaphor) may be left to the banking/financial services industry to sort out, but the ability to supply ready credit for business to continue with their day to day requirements would be alleviated no?

One thing that concerns me with your previous post (which explains the asset swap plan very vividly) is that it would not be implemented quite so neatly. Two examples: Social security and the Nuclear Waste Fund. The Nuclear Waste Fund is a fund that is paid into by rate payers (customers of nuclear utilities) to finance the ultimate disposal of spent nuclear fuel and radioactive waste that comes from nuclear power. Utilities have been paying (and by extension their customers) for over 2 decades. Even though legislation has this as a separate fund (which is in the billions on paper), it finds itself in the budget calculations and the money sits in the general treasury with every other source of revenue. It is not even a tax (by definition). The waste fund is essentially a box full if IOUs (part of what you refer to your site as government held debt). Same thing with Social Security. The money that comes into the treasury, ostensibly earmarked for the "trust fund", but exists in the form of IOUs as well.

In summary, the Asset Swap/Bailout money would be given to the financial institutions so that the government can take title to and repackage the turds and the chips and resale using the proceeds to buy back the resulting debt. Assuming it worked (and even if it didn't) about two months later this will all be forgotten and the extra monies raised by the selling of treasury bonds will end up in the general treasury and the next president will miraculously find himself with a surplus. Steve your blog really proves that money has become such an abstraction that the Heisenburg Uncertainty Principle applies!

I agree that "Method 1" is the preferred way to learn. Therefore, we should add to our knowledge base the views of the top 100 economists in the country (3 Nobel winners) who oppose the bailout, then act on their advice.

Judging from the tone of the abrupt ending to the prior thread, it appears that there's little room on this blog for skepticism or reasoned disagreement. However, I will take one more stab at this. In the ten days since Secretary Paulson demanded sweeping discretion regarding the dispostion of $700B in new public debt, I have tried to get the answers to 3 basic questions from those "who already know":

1. If this is truly the crisis that's being portrayed, why should Secretary Paulson, who apparently didn't see it coming until the last second, be in charge of the solution? No answer.

2. Why $700B? According to Forbes, apparently no particular reason: http://tinyurl.com/5ygr2m

3. Why did the legislation have to be passed by the open of the Asian markets, YESTERDAY, or our credit markets would cease functioning? No answer and, apparently, no truth. Is the new witching hour Wednesday at 4:53 PM EST?

If those "who already know" want the rest of us to sing along, maybe they should take a minute to teach us the words.

The problem is we have a very incompetent Fed Chairman, and a very incompetent Treasury Secretary who did not present a clear picture, and expected taxpayers to "trust me".

If the facts are as you maintained, why didn't Paulson draw some pictures, show some slides, answer some questions? Politicians are politicians, at least 95% of them are despicable. Their highest priority is to preserve their jobs. If the Treasury had presented a more coherent picture, it would be much easier for politicians to explain their votes back home. Instead, Paulson predicted Armageddon if taxpayers failed to cough up $700 billion. His various bailouts, AIG nationalization, and direct lending to banks have not worked out too well, why should taxpayers believe this would work? Another stupid thing is he plugged the $700 billion from thin air to calm the market, instead the enormous sum spooked the taxpayers.

Paulson should be fired for being so incompetent and so incoherent.

God help us with an Obama administration, a filibuster-proof Democratic Senate, and a lopsided Democratic House. I shudder to contemplate it. Pelosi said what she said to defeat the bill, stupid Republicans fell into the trap and sounded like crybabies who were blamed for its failure to pass.


I am not American and from the outside I consider that your house of representatives has acted in the best way to protect the interest of the American citizens. I am not against a plan to save the American banking system (and who knows if that means saving the World banking system too), but not the way it is proposed. There are bankers who have made bad management decisions and have bought "toilet papers" believing that those were lotto winning tickets. Why have the American citizens to now re-buy this toilet paper so that those bankers do not have a loose? That is not the way how you should protect your banking system. If the bankers have made bad management decisions, the shareholders have lost the value of their investment: end of the story. If these companies were not banks, we would be speaking about bankruptcies. As they are banks, we have to avoid the generation of a "financial panic" (please correct my English if this is not the expression). The government, thus, has to intervene the banks if they are bankrupt but that does not mean given citizens money to their shareholders but getting the control of the bank to protect the customers' accounts and incidentally telling the shareholders hat their investment has dropped to 0 (they are bankrupt anyway). This method has been used in Sweden and Spain at least: there were no "financial panics" and the citizens did not gave away money to well-related people. Unless this is done the same way in the US, it seems to me that certain lobbies expect to gain the 5% of the US GDP for them and their friends.

Larry D:
(1) Equity action isn't in the plan (except maybe some warrants), but is another action the govt could take; eg, preferred stock positions.
(2) What market value are you talking about? If there are NO BUYERS, there is NO MARKET. Tell me what YOU would bid for this: a sealed, opaque shopping bag containing 1000 pieces of paper, each piece GUARANTEED to be either a $10 bill, or a piece of confetti. What is your bid? ...OR, would you maybe rather wait until the govt opened the bag, so you could get a peek at its contents before bidding?
(3) The "gift" is not so much the money as the time to sort out good from bad paper.

(1) The Fed's injection is helping, but is not unfreezing the credit markets. Perception trumps everything else, and the worldwide perception is that the only safe place for money is cash or short term Treasuries.
(2) You're right. "Money" (regardless of its form -- seashells, gold, or federal reserve notes) is nothing more than the PERCEPTION of value. It's a certificate that bridges the time between my production of something of that value and my purchase of something else of that same value. Perception of the value of near-money assets has plummeted, that's why there's a rush AWAY from commerce with one another and towards just plain money sitting stagnant in our accounts. When the money stops moving, goods and services stop moving in the opposite direction. Definitely not good.

I saw that. It's title should be "Three platitudes by a nonrandom sample of tenured economists."
My reactions:
(1) "The plan is a subsidy to investors at taxpayers' expense" -- An unfortunate perpetuation of the falsehood that taxpayers will have to come up with $700 billion.
(2) "The terms... must be crystal clear ahead of time" -- Unbelievably naive determinism. Good thing these folks didn't design the Apollo moonshot capsule, because it wouldn't have had any thrusters for mid-course corrections. They should lookup the terms stochastics, heuristics, cybernetics, adaptation, and selection -- before agreeing so quickly to sign onto three platitudes.
(3) "we ask Congress not to rush" -- Well, they got their wish. I bet the champagne corks are popping in academia today, don't you?
(4) "we ask Congress... to wisely determine the future of the financial industry and the US economy for years to come" -- I confidently predict it will take Congress far longer than "years to come" to "wisely determine" anything.

(1) Paulson is like everyone else on the planet in at least one respect: he can't predict future tipping points with certainty. If we fire him, we'll need someone better at predicting them than he is. Any suggestions?
(2) $700B is the most the Treasury could have in play at any point. Like a $700B-capacity silo, with $50B/month flowing into the top and $50B/month flowing out the bottom. It's a wide spot in the pipe.
(3) Why before the Asian markets opened? Because PERCEPTION is reality, and contagion spreads quickly.
(4) When's the next witching hour? Who knows? Maybe there is no tipping point, and there is zero possibility of a severe recession (or The Greater Depression). Who is forecasting that? (Certainly not Bernanke, the leading expert on what caused the Great Depression and how it could have been prevented.)

luiscar: There was both stupidity and dishonesty on both the buying and the selling side of mortgage markets. All of them deserve to become very poor. One way to do that is to nuke the economy, making everybody very poor. However, I do not support the nuclear option -- but I remain open to alternate solutions.

I found out my congressman voted against the bill. This makes me furious. I am voting for McCain, but now I'm thinking of voting against my Republican representative. Voting against this bill showed an utter lack of leadership and a major gap between his values and my own.


I think you missed my point on Paulson. If you go back and look at his comments on September 15, after rejecting any Lehman bailout, he waxed rather eloquently about how it was inappropriate to put taxpayer money risk because our financial system is sound. On September 19, he said we needed to take immediate action on the asset acquisition plan (I will try to avoid using any potentially divisive language in referring to the bill) to avoid a complete meltdown of our credit system. If you think this is merely a failure "to predict future tipping points with certainty", I guess we have a fundamental difference on the meaning of "future". But, in answer to your call-out: Paul Volcker, Steve Forbes, just off the top of my head.

On the $700B figure, the point is, he can't defend that number because Treasury pulled it out of thin air. Tough for me to put a lot of faith in someone who flatly insisted to Congress that a lesser number or phase-in was insufficient, but who can't give any real-world basis for the figure he put up.

You are right, PERCEPTION IS REALITY, especially in the equity markets. I think you just proved my point. By predicting dire consequences if the legislation wasn't complete by Sunday or yesterday (as reflected in your post above), a severe negative market reaction was virtually guaranteed. Since there was apparently no real basis for that artificial deadline, it was irresponsible to publicly insist on it.

Look, I agree with you that this legislation, outside of the sheer size and push for rapid passage, may be the best and, perhaps, only real solution to the problem (whether you want to call it an asset swap or bailout, or LBO is irrelevant). The government may be the only actor that can really get these assets off the books. In fact, in light of the massive intervention any plan will effectively present, I would actually prefer that the government take an equity stake in the firms or these assets to the insurance plan some republicans seem to be urging in a vain attempt to justify it as "a free market solution". I would rather see the taxpayers in a Warren Buffet type position than an AIG position. But, it seems to me that those who have urged immediate passage of this plan have not taken even the most basic steps to either explain why immediate action is necessary (other than unsupported conclusive statements of impending crisis, which is not helpful) or why this is the only plan that can work. They may have a case for either or both, but they are not even coming close to making it.

Doug: Agreed, the explanations have been incompetent to nonexistent. They have a near-airtight case that the credit market is frozen, but they haven't come close to making the case. (The "LIBOR spread" -- LIBOR minus T-bill -- was scaring Michael Darda when it was 300 basis points; today was a lot larger than that when I saw it -- and, oddly enough, the CNBC talking heads are mostly smiling, apparently because they're watching the DJI improving instead of the credit markets deteriorating.

There's plenty of incompetence and game-playing everywhere -- starting years ago with mortgage buyers and sellers, and government regulators who thought zero-down-payment interest-only loans for "affordable housing" was a great idea.

Steve, I just do not understand what gives you *any* confidence whatsoever that the Treasury will in fact "look inside the bag" as you put it. Doesn't it seem much more that they will simply set the price for these assets the same way they set the $700 billion figure: completely arbitrarily.

Perhaps if this were some other administration that didn't have a history of seeking extraordinary powers by exaggerating threats; perhaps if they didn't have an eight year stench of self-dealing and corruption; perhaps if the bill were not *specifically* *designed* to avoid any possibility of oversight; perhaps if there were any reason at all to even suspect that Paulson is acting in good faith; perhaps in another world, with another administration, this sort of "just trust us" plan might be acceptable. But it absolutely boggles my mind that anyone is even talking about, even theoretically considering the possibility of handing this sort of raw, unchecked power to *this* administration.

Last post from Larry:

Get off the "this administration and Paulson" thing. Bush will be gone in a few months as will Paulson. The problem will still be here even if this thing gets done. Better to spend your energy contemplating who is best to deal with it come January. I'd like to see both Obama and McCain announce their cabinet ahead of time.


Any thoughts about about other derivatives that we don't know about hanging on to the CMO"s and God knows what else that could go off?

More to consider...

I've been spending a lot of time on the mechanics of preventing a liquidity freeze from crashing the system. But one additional consideration, as someone already mentioned, is a bank's capital situation: If a bank's shareholder equity is equal to (or less than) the value of its crummy loans, it will have a solvency problem on top of the liquidity problem. For a bank to survive, it needs to be (both) sufficiently liquid, and solvent. Here is an article addressing the solvency issue in detail: http://tinyurl.com/4vemu4
(I'm not sure saving individual banks is as high a priority as restoring system wide liquidity, however.)

Question for discussion: Should the banks with a solvency problem be allowed to fail? Without having researched that angle to the degree it deserves, my initial gut reaction is yes. Depositors and system-wide liquidity would move to the adequately-capitalized banks (eg, JPMorganChase, Wells Fargo, BankAmerica).

"Question for discussion: Should the banks with a solvency problem be allowed to fail?"

That would certainly be a highly popular political solution right now. And I'm glad you mentioned John Hussman. He writes:

"The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost." -- http://tinyurl.com/4karwk

Steve, the article you linked says:

"The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them. "

This is the point I've been trying to make. If these assets are bought at market prices it still leaves these banks insolvent, which is hardly going to unfreeze the credit markets. Therefore we can pretty much deduce that the plan is not to buy them at market prices, but at some significant premium. This would be in effect no different than simply *giving* these banks free money to pay their bills.

Some people are arguing that the market price for these assets is wrong, and that time will tell that they are worth more. Maybe this is true. I sure as heck don't know. But it's entirely irrelevant. If you think mortgage-backed securities are undervalued then I suggest you go buy some, and I wish you the best of luck. But I do not want the US Treasury to be making that gamble with seven times ten to the eleven dollars of new bonds. Right now, at this moment, the value of these assets is what they can be sold for. The idea that these assets will rise in value is pure uninformed speculation and wishful thinking. They could just as easily go down even further.

We do not need new, "innovative", extraordinary methods to deal with this crisis. There is a known method with a long track record of proven success: recapitalize the banks with new equity.

Sell Treasury bills . . . but M2 is around 7.7 trillion dollars. 700B is about 9% of that.

M3 is about 14 trillion. $700b is 5% of that.

Is it going to be ok to suck that much money into Treasuries?

Larry: Two questions...

(1) What's wrong with the Treasury "overpaying" for assets that are now highly undervalued because of the mark-to-market rule (...which, by the way, will be revoked and replaced soon by FASB)?

(2) Why should all near-insolvent banks be propped up, instead of letting the weakest ones fail? With the FDIC soon to hike its guarantee from $100K to $250K, what's wrong with shifting their depositors to stronger banks?

Selling new Treasuries does not increase or decrease the amount of reserves in the system. The treasury will take in money from its bond sales, then spend it on asset buys.

Remember Steve, there is no something for nothing. When somebody gets something for nothing, somebody else gets nothing for something. Here is the script to the crisis.
On a serious note...

Steve, to answer question 1, there's nothing wrong with it in principle if the assets are truly undervalued as you say. But I have no idea why you and so many others believe this to be true. What does the mark-to-market rule have to do with it? I'll admit I'm not an expert on this, but it seems that if they truly were massively undervalued then someone, somewhere would want to buy them.

To answer question 2, I'd say propping them up with new equity is rather similar to letting them fail. In both cases the existing stockholders get wiped out, or nearly wiped out. In both cases the profitable parts of the business continue to operate. In both cases they are taken over by new management.


I'm not sure it's entirely fair to "blame" mark to market rules for any distortion in the market value of these instruments, as Newt Gingrich and even Steve Forbes have done, without exploring the full story. As I understand it, many, if not all of the institutions involved first used mark to market to show paper increases in the value of these things on their books: When the real estate market was booming and these securitized derivatives were in high demand, the financial whiz kids at the institutions realized that they could inflate their capital and equity (and therefore trigger big bonuses for themselves) by marking these things up to market, without actually having to sell them. Since mark to maret was never intended to be used for highly illiquid instruments or instruments that are primarily income-producing and, therefore, not held for immediate sale, the marked up to market book value of these things is not any more accurate than the present marked down to market book value. When added to the questionable initial values set by computer models making certain generous assumptions about an ever-increasing real estate market, the current mark to market values may be a better estimate of their value (or lack thereof). This is why I don't necessarily agree with Forbes and Gingrich that changing the current mark to market rules would really solve the problem, because I think at this point everyone knows the emperor has no clothes. That is just my understanding from what I've read and heard.

We all know one thing, these assets are very difficult to value. I suppose if everyone were willing to suspend belief and agree that the book value of these instruments is accurate, then suspending the current mark to market rules would indeed "solve" the problem, at least in the short term. I would have to see banks start loaning money to each other based on the assumption that the book value represents the true value before I believe it. If we could solve this problem while allowing the institutions to keep this stuff on the books, as opposed to having to create a federal bureaucracy to handle them, I would be all for it.

This is why, if those who claim to know the facts would simply take the time to convince me that we are indeed facing a halt in the credit system with something other than "trust us, we know," I have no problem with the government taking radical action to prevent the problem. Unlike a lot of folks who have a problem with this deal, I have no illusions that our credit/financial system is some kind of pristine free market. That's also why I would prefer the government to take some kind of equity position in any rescue deal, as opposed to simply guaranteeing losses without sharing in profits. However, as I've indicated before, right now I feel like those who are pushing this deal are acting like the global warming folks, telling me that we have to do something now to avert disaster, but not really making a strong case for their position.

Larry and Doug:
Mark-to-market created (a) the death-spiral "opportunity" at least a few of the smart-money short sellers jumped on to get rich by taking over-leveraged investment banks down, and (b) the shrinking market cap of the survivors, many perfectly sound.

So, whose fault is it? There are plenty of potential fall guys: (1) the m-2-m rule that created the opportunity? (2) the regulatory rules that allowed naked short selling? (3) the short sellers? (4) the CEOs who allowed too much risk to creep into their balance sheets? (5) the boards of directors, who failed the owners they supposedly represent by not serving as a check on CEO overconfidence -- undoubtedly influenced by the fox-guarding-henhouse problem when the Chairman is also the CEO?

Take your pick. I pick (1), (2), and (5).

M-2-m (1) created an arbitrage opportunity for anyone with enough money, and the federal government, at this point, is the only entity with the *ability* to come up with enough; now all it needs is the *desire*.

I believe (2) is being fixed, or already has been.

For progress towards fixing (5), see my article below titled "What shall we do about the board of directors?" ( http://tinyurl.com/46clgu ) Also note that solving (5) also fixes (4) from within; it's far better to give owners more clout for rewarding/punishing CEOs than to give that power to a government regulator, in my judgment.

The jobs of the whiz kids who underestimated risk (by not asking the question "what if house prices went down on my watch"), and of the CEOs who allowed that to happen on their watch, are now at risk. Too bad risk assessment wasn't managed properly -- in small chunks over a longer period of time. This shakeout is an example of learning something new, the hard way.

Anyway, m-2-m was part of the problem, and yes, I think it created undervalued assets on balance sheets.

The great thing about abolishing m-2-m is that prices can now become whatever we think they should be, without "irrational" market forces distorting them.

Price of oil? I'll take $60 a barrel but no more. A 3-bedroom home in Palo Alto? $150k fits the fundamentals as I seem them. Ribeye at Ruth's Cris? I think $15 for a nice cut is just about right.

I'm really looking forward to finally paying what I think is the right price for everything! Go Congress!

I guess my point, which I probably took too long to make, was the m2m is only the "cause" of the problem if you ignore its use to increase the book values without ever actually testing that on the market.

Let's say, for discussion sake, I accept 3 points: (1) immediate action is required to prevent a complete credit lock-up; (2) these securities/derivatives are currently undervalued; and (3) the only way to get the credit markets moving again is to replace these assets with some asset of value in the hands of the affected financial institutions. Well, given the size of the bureaucracy that will be necessary to execute the Secretary's plan will take too much time to put into place, even if the House had passed the rescue bill on Monday (one look at the Senate version will confirm that). So, the real solution is for the Fed to alter its TSLF program. It could do that tomorrow. Instead of accepting the securities as collateral for 28 day loans, the Fed could essentially purchase the assets by either: (1) outright purchases or (2) Extending the applicable term to 1, 2, or 5 years.

Steve, I believe corporate "whiz kids" certainly share some of the blame. I also believe that the rating agencies' "whiz kids" played a larger part in this mess.

The rating agencies simply did not properly valuate these assets and exposed the market to heightened risk because of their negligence. Corporate "whiz kids" built their flawed analysis on the poor research the rating agencies did.

oops... wrong topic... sorry guys.

Steve, I believe corporate "whiz kids" certainly share some of the blame. I also believe that the rating agencies' "whiz kids" played a larger part in this mess.

The rating agencies simply did not properly valuate these assets and exposed the market to heightened risk because of their negligence. Corporate "whiz kids" built their flawed analysis on the poor research the rating agencies did.

> Mark-to-market created (a) the death-spiral "opportunity" at least a few of the smart-money short sellers jumped on to get rich by taking over-leveraged investment banks down, and (b) the shrinking market cap of the survivors, many perfectly sound.

I've been noting the "death spiral" aspect of the M2M concept, too. I do think it's probably something that ought to be required in an investment portfolio for the awareness of investors -- what the company is worth if it was forced into bankruptcy proceedings tomorrow is relevant to my decision to invest in the company -- but that is not the same thing as the legal rules for liquidation and such.

Further, M2M seems "honest" only when you don't think about it much. Is it an "honest" valuation of a company at the absolute top of a market (i.e., can you trust it to represent future valuation of a company?) If you say "No, it probably isn't" to that, then how is it any different at the bottom end of the market? Admittedly, you can never really know where either of those is, but you can certainly make a reasonable guess "this is not a typical market right now -- valuations are very low/high".

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