Saturday, October 11, 2008

bailout (the sequel)

Back on September 26th (what seems like an eternity ago), I wrote:

If we are going to socialize the downside, we need to socialize the upside, too.

Really, the logic of the bailout, as proposed by Paulson, has been puzzling from the start. …

As I’ve said before, I’m highly skeptical of anything I can’t understand at least at a high level of abstraction. I still don’t understand why Paulson and Bernanke proposed to buy troubled assets rather than inject equity into troubled financial institutions. [emphasis added] Eventually, in Congressional testimony, Paulson suggested that the goal is “price discovery.” As I understand it, the argument is that there is insufficient liquidity in the markets to establish a true “market price” for a large volume of trouble assets. The Treasury, by buying up some of those assets, would establish a market price, everyone can mark their assets to market, confidence will be restored, financial institutions will trust again in the solvency of their counterparties, and everyone will start lending and borrowing again. That seems like quite a leap of faith to me.

Well, forget the original Paulson plan. It didn’t make sense, after all. As the New York Times
reports today, the plan now is to inject equity directly into the banks:

As international leaders gathered here on Saturday to grapple with the global financial crisis, the Bush administration embarked on an overhaul of its own strategy for rescuing the foundering financial system.

Two weeks after persuading Congress to let it spend $700 billion to buy distressed mortgage-backed securities, the Bush administration has put that idea on the back burner in favor of a new approach, which would
have the government inject capital directly into the nation’s banks — in effect, partially nationalizing the industry.

While the Treasury department says it still plans to buy up distressed assets, the scope of that plan is unclear. ...

The new plan to buy stock in banks, which has become the administration’s primary focus, comes closer to a partial nationalization of the banking system than at any time since the Depression. In exchange for providing capital, the government would demand some kind of nonvoting minority stake.

The surprising turnaround by Treasury Secretary Henry M. Paulson Jr., announced Friday as part of a coordinated plan to rescue the financial industry, has raised questions about whether he squandered valuable
time by trying to sell Congress a plan that he and other administration
officials had failed to think through in advance.

It also raises questions about whether the administration’s deep philosophical hostility to government ownership in private companies aggravated the financial crisis by delaying rescue action. …

Some experts said the delay in carrying out the Bush administration’s $700 billion bailout plan has only hurt its prospects for success.

“Even if it was adequate before, it’s not adequate now,” said Frederic Mishkin, a professor of economics at Columbia University business school who stepped down as a Federal Reserve governor at the end of August. “If you delay and create uncertainty, the amount of money you have to put up goes up.”

As recently as late September, the idea of letting the government acquire part of the banking system had been unthinkable in the Bush administration. To many officials, such intervention seemed like a
European-style government intrusion in the marketplace.

“Some said we should just stick capital in the banks, take preferred stock in the banks. That’s what you do when you have failure,” Mr. Paulson told the Senate Banking Committee on Sept. 23. “This is about success.”

Mr. Paulson told lawmakers it made more sense to jumpstart the frozen credit markets with “market measures,” by which he meant buying up assets rather than institutions. He staunchly resisted Democratic proposals to require that the government receive an equity stake in the companies it was helping.

But on Friday, Mr. Paulson not only confirmed his intention to buy up stakes in banks but gave the idea central billing. “We can use the taxpayer’s money more effectively and efficiently, get more for the taxpayer’s dollar, if we develop a standardized program to buy equity in financial institutions,” Mr. Paulson told reporters. Mr. Paulson refused to say whether the capital infusion program for banks would be bigger than the original concept to buy troubled assets.

Treasury officials said they hoped to make the first capital infusions within the next two weeks. That would be earlier than any government purchases of unwanted mortgage-backed securities. One reason for Mr. Paulson’s rapid reconsideration was that global financial markets have been going downhill faster than anyone had seen before.

Credit markets seized up and all but stopped functioning, making it impossible for most companies to borrow money on more than an overnight basis. Bank stocks plummeted, making it much more difficult to shore up their balance sheets by raising more capital from investors. …

By the closing bell last Friday, the Standard & Poor’s 500-stock index had suffered its worst week since 1933. A growing number of analysts argue that Mr. Paulson’s original plan, called the Troubled Assets Relief Program, would have been unhelpful and possibly unworkable. Some noted that Mr. Paulson presented Congress a legislative proposal that was only three pages long and that Treasury officials have yet to provide details how the auctions will work. …

But as the financial markets spiraled further downward during the last 10 days, a growing number of top-tier institutions, including Goldman Sachs and Morgan Stanley, became worried about their own survival.

“The crisis in confidence goes way beyond the actual losses that will be incurred from debt securities,” Mickey Levy, chief economist for Bank of America, said in an interview on Friday. “It’s truly incumbent on policy makers to address that crisis.”

Treasury officials began canvassing banks and investment firms about the possibility of having the government buy stakes in them itself. The new bailout law gave the Treasury the authority to buy up almost any kind of asset it wanted, including stock or preferred shares in banks.

Industry executives quickly told Mr. Paulson that they liked the idea, though they warned that the Treasury should not try to squeeze out existing shareholders. They also begged Mr. Paulson not to impose tough restrictions on executive pay and golden-parachute deals for
executives who are fired.

Mr. Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government would only acquire “nonvoting” shares in companies. And officials said the law lets the Treasury write most of its own restrictions on executive pay, and those restrictions can be lenient if they are applied to a set of fairly healthy companies.

Four weeks wasted because of Paulson’s rigid free-market ideology (combined with too much concern over dilution of existing bank shareholders – a constituency whose interests Paulson seemed to be elevating above those of the taxpayers and the national financial system). But now that his old firm, Goldman Sachs, is worried about its survival and supports direct equity infusions (as long as Treasury does “not try to squeeze out existing shareholders”), it’s OK. Fortunately, Barney Frank and Chris Dodd insisting on writing the bailout bill so Treasury had the authority for direct equity infustions.

And Paulson is still refusing to exercise responsible fiduciary oversight of the taxpayers’ money by taking seats on the boards of the banks receiving equity infusions. (Of course, we still can’t impose restrictions on executive pay or golden parachutes.) Why, exactly? Because that would be “socialism,” I guess. Someone needs to tell Paulson we’ve already crossed that bridge.

And when is he going to announce that the US is guaranteeing all bank deposits, not just those under $250,000? It’s going to happen – why waste more time?

This is not increasing my confidence in Paulson.

For background, here is a good explanation (“
You Can't Rescue the Financial System If You Can't Read a Balance Sheet”) as to why direct equity infusions could work where the purchase of toxic assets would not:
[T]he sequence of bankruptcies that we've observed among U.S. financials has been almost exactly in order of their gross leverage (the ratio of total assets to shareholder equity). The reason for that is:

1) as the assets of a financial company lose value, the losses reduce the asset side of
the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent. Let's return to the basic balance sheet of a typical financial company before the writedowns:

Good Assets: $95

Questionable Assets: $5


Liabilities to Customers: $80

Debt to Bondholders: $17

Shareholder Equity: $3


Now let's write down the questionable assets - not all the way to zero, but to $2:

Good Assets: $95

Questionable Assets: $2


Liabilities to Customers: $80

Debt to Bondholders: $17

Shareholder Equity: $0


…Now, let's go back to the previous balance sheet. The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here's the result:

Good Assets: $95

Cash Proceeds from Sale of Questionable Assets to
Treasury: $2


Liabilities to Customers: $80

Debt to Bondholders: $17

Shareholder Equity: $0


Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the “quality” of the balance sheet, but you've provided no additional capital. At best, you've allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.

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.

A better approach would be for the government to provide capital directly …

Banks with weak balance sheets need equity infusions. Overpaying for bad assets is just a disguised equity infusion where the taxpayers get no ownership interest in return.

Paulson understands balance sheets, of course. The only explanation I can come up with is that he just wanted taxpayers, not bank shareholders, to take the hit.

1 comment:

Renee O said...

G-day Russell! I want to subscribe to your blog please. Are you going to dial your “little sister” Renee in?

Renee O