Thoughts on the Big Buyout

I think the federal government is much more likely than not to make money off of AIG, Fannie, Freddie, and whatever else it winds up buying. The underlying goal is to recapitalize the banking system--where a "bank" is anything that borrows short thus promising liquidity and lends or invests long--and to reduce the outstanding stock of risky assets to a level where the private sector is happy holding them at a reasonable price.

Can the government do this? Can it, by buying risky assets, simply extinguish risk? Isn't the risk simply transferred to Treasuries?

The answer is no. First of all, the size of the equity and risk premia we see in normal times tells us that the private market is really lousy at mobilizing the risk-bearing capacity of the economy. The government--or at least a government that balances its budget--mobilizes that risk-bearing capacity automatically, spreading it out via the tax system rather than having risk-bearing concentrated on equity, junk debt, and derivative holders.

The question, I think, is on what terms to do the nationalization, and on what terms thereafter to run the financial markest. I believe that we have to see a substantial expansion of the government's role. Organizations that promise liquidity--whether commercial banks, money market funds, insurance companies, investment banks, hedge funds, whatever--that do not match their assets and liabilities in duration need to be buying some kind of government-provided insurance. Thus not only the level of short-term interest rates becomes an administered, government-determined price, but the price of lower tail risk becomes the government's business to set as well.

Paul Krugman:

Crisis Endgame: On Sunday, Henry Paulson, the Treasury secretary, tried to draw a line in the sand against further bailouts of failing financial institutions; four days later, faced with a crisis spinning out of control, much of Washington appears to have decided that government isn’t the problem, it’s the solution. The unthinkable — a government buyout of much of the private sector’s bad debt — has become the inevitable.

The story so far: the real shock after the feds failed to bail out Lehman Brothers wasn’t the plunge in the Dow, it was the reaction of the credit markets. Basically, lenders went on strike: U.S. government debt, which is still perceived as the safest of all investments — if the government goes bust, what is anything else worth? — was snapped up even though it paid essentially nothing, while would-be private borrowers were frozen out.... [B]anks are normally able to borrow from each other at rates just slightly above the interest rate on U.S. Treasury bills. But Thursday morning, the average interest rate on three-month interbank borrowing was 3.2 percent, while the interest rate on the corresponding Treasuries was 0.05 percent. No, that’s not a misprint. This flight to safety has cut off credit to many businesses, including major players in the financial industry — and that, in turn, is setting us up for more big failures and further panic. It’s also depressing business spending, a bad thing as signs gather that the economic slump is deepening.

And the Federal Reserve, which normally takes the lead in fighting recessions, can’t do much this time because the standard tools of monetary policy have lost their grip. Usually the Fed responds to economic weakness by buying up Treasury bills, in order to drive interest rates down. But the interest rate on Treasuries is already zero, for all practical purposes; what more can the Fed do?... There’s only one bright spot in the picture: interest rates on mortgages have come down sharply since the federal government took over Fannie Mae and Freddie Mac, and guaranteed their debt. And there’s a lesson there for those ready to hear it: government takeovers may be the only way to get the financial system working again....

We don’t know yet what that “comprehensive approach” will look like. There have been hopeful comparisons to the financial rescue the Swedish government carried out in the early 1990s, a rescue that involved a temporary public takeover of a large part of the country’s financial system. It’s not clear, however, whether policy makers in Washington are prepared to exert a comparable degree of control. And if they aren’t, this could turn into the wrong kind of rescue — a bailout of stockholders as well as the market, in effect rescuing the financial industry from the consequences of its own greed.

Furthermore, even a well-designed rescue would cost a lot of money. The Swedish government laid out 4 percent of G.D.P., which in our case would be a cool $600 billion — although the final burden to Swedish taxpayers was much less, because the government was eventually able to sell off the assets it had acquired, in some cases at a handsome profit.

But it’s no use whining (sorry, Senator Gramm) about the prospect of a financial rescue plan. Today’s U.S. political system isn’t going to follow Andrew Mellon’s infamous advice to Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” The big buyout is coming; the only question is whether it will be done right.

Comments

[Kaleberg]

There are performing mortgages underlying all those derivatives. They are worthless now because each instrument has so many tiny pieces of so many mortgages. If the government can buy them cheaply, perhaps a few cents on the dollar, they could paste the underlying mortgages back together and get their hands on the cash stream that sits at the bottom. No one else has the money to do this, and no one else has the legislative and regulatory ability to deal with fractured and effectively untrackable interests.

Let's hear it for free enterprise.

[Roger Bigod]

" ... spreading it out via the tax system rather than having risk-bearing concentrated on equity, junk debt, and derivative holders."

My heart bleeds for those people, forced at gunpoint to accept ownership of that bad paper.

This isn't like the bank bailout of the Depression. In general, that was due to exogenous forces that wiped out reasonably run institutions. It isn't like the S&L bailout. That allowed the institutions, many fraudulent, to go down and recovered the value of assets. This is rotten.

[Neal]

The problem of leverage has not been considered. Many of these deals are leveraged to the point where a purchase price of less than 95-98 cents on the dollar will wipe the investment out.

There simply is no room for buying at a significant discount. As a result, the US government will have to buy far above fair value and suffer the losses that the private entities would have suffered.

Why do you think that there isn't buying and selling of these pieces of paper? There would be a market at 35 cents on the dollar but the deal won't be made. The deal can't be made with even a minor discount because this will wipe peole out.

[Paul Dug]

The long-term threat seems to be in the caveat:

The government--or at least a government that balances its budget--mobilizes that risk-bearing capacity automatically, spreading it out via the tax system rather than having risk-bearing concentrated on equity, junk debt, and derivative holders.

Republican "starve the beast" policies have for years run up deficits under their own regimes to tie the hands of any Democratic administrations that might follow. If previously they did this in spades, now they are doing it with a backhoe. We mortgage our future to the financial market, and starve every other government programme to pay. Once again it would seem to be a deeply subprime mortgage that we are being sold.

[João Carlos]

I fear that Brad is blinded by ideology or, worse, despair. Let me put some points:

1- the GOVERNEMENT cannot value assets better than the MARKET and I am sure that the banks will trade their more poisonous assets by (for now, see bellow) good T-bonds;
2- the Bailout will not save the mortagages and will not save the house prices, the losing wealth will continue to make the consumer retreat: the Bailout will not stop recession, remember suppy side don't work (see more bellow about an alternative plan);
3- to say that the the taxpayer will have some profit with the Bailout is punditry, house prices will need years before regain prices, so the derivatives and the assets the government will buy;
4- other derivatives will get poisonous soon, because comercial building are starting to go down and credit card will be, so be warned other tsunamis are coming and aparently the government will buy them all; the Black Hole will surpass $ 1 trillion and I start to think that $ 2 trillion is conservative estimate;
5- the public debt will skyrocket, so the public debt's service; that is enough for anyone is not a punditry to say the taxpayer will lose money, if the asstes someday reagain some value or not; and any sensible person can start to thin that US itself will go bankrupt;
6- see #5 above and say me how much time for the foreigner investor see they will pay for it if they continue to buy T-bonds;
7- they are rescuing the banks, say me how much time for the foreigner investor perceive that they can buy T-bonds, but not US companies;
8- maybe all the effort is only buying time, and it is inevitable the banks will go down: the banks will trade bad assets for (for now) good T-bonds, but if the foreigner investor decide they had enough and US lose its AAA rating... the banks will go down with the USA;
9- see #5,#6, #7 and #8 above and say me how much time before the foreigner investor perceive that if they want to buy US companies, they need make the T-bonds go down;
10- it is a MASSIVE health transfer from the poor (the taxpayer) to the rich (banks owners), this argument is enough for a lot of honest people; everyone know that the bank's bosses will never pay for it, it Bush we are talking here; if you don't understand it, let me ask: any talk from Paulson about re-regulamentation? No. We will don't see it and we too will not see these guys going to jail, because they don't break any law... there are no law saying that leverage is crime!

If you want to make any sensible thing and waste the taxpayer money for mantain artificial assets prices, buy residencial houses. That will save the house prices, the mortgages and the consumer. Repeal the taxes cuts for pay for it.

But you believe that the governement exist only for Bailout the rich with the poor (the taxpayer) money.

[João Carlos]

I fear that Brad is blinded by ideology or, worse, despair. Let me put some points:

1- the GOVERNEMENT cannot value assets better than the MARKET and I am sure that the banks will trade their more poisonous assets by (for now, see bellow) good T-bonds;
2- the Bailout will not save the mortagages and will not save the house prices, the losing wealth will continue to make the consumer retreat: the Bailout will not stop recession, remember suppy side don't work (see more bellow about an alternative plan);
3- to say that the the taxpayer will have some profit with the Bailout is punditry, house prices will need years before regain prices, so the derivatives and the assets the government will buy;
4- other derivatives will get poisonous soon, because comercial building are starting to go down and credit card will be, so be warned other tsunamis are coming and aparently the government will buy them all; the Black Hole will surpass $ 1 trillion and I start to think that $ 2 trillion is conservative estimate;
5- the public debt will skyrocket, so the public debt's service; that is enough for anyone is not a punditry to say the taxpayer will lose money, if the asstes someday reagain some value or not; and any sensible person can start to thin that US itself will go bankrupt;
6- see #5 above and say me how much time for the foreigner investor see they will pay for it if they continue to buy T-bonds;
7- they are rescuing the banks, say me how much time for the foreigner investor perceive that they can buy T-bonds, but not US companies;
8- maybe all the effort is only buying time, and it is inevitable the banks will go down: the banks will trade bad assets for (for now) good T-bonds, but if the foreigner investor decide they had enough and US lose its AAA rating... the banks will go down with the USA;
9- see #5,#6, #7 and #8 above and say me how much time before the foreigner investor perceive that if they want to buy US companies, they need make the T-bonds go down;
10- it is a MASSIVE health transfer from the poor (the taxpayer) to the rich (banks owners), this argument is enough for a lot of honest people; everyone know that the bank's bosses will never pay for it, it Bush we are talking here; if you don't understand it, let me ask: any talk from Paulson about re-regulamentation? No. We will don't see it and we too will not see these guys going to jail, because they don't break any law... there are no law saying that leverage is crime!

If you want to make any sensible thing and waste the taxpayer money for mantain artificial assets prices, buy residencial houses. That will save the house prices, the mortgages and the consumer. Repeal the taxes cuts for pay for it.

But you believe that the governement exist only for Bailout the rich with the poor (the taxpayer) money.

[Frank Dean]

I believe Prof. DeLong is being disingenuous. He is propagating the claim that the credit crunch is driven by a mismatch between long term assets and short term liabilities. This is the bank run theory. That is, financial intermediaries made sound loans and investments; the problem is that they can't meet their short term demands for payment.

This is not a "reality-based" claim. Financial intermediaries have made immense investments in real estate loans that will never be repaid. With the economy in recession, the volume of non-performing and never-to-perform loans will only increase. The run is not the result of mismatches in the term structure of the financial intermediaries portfolios, but because people know that some folks aren't going to get paid, ever.

The Fed is taking these actions because it has no choice, not because it thinks these assets will pay off later. By inflating, the Fed can ensure that in nominal terms these investments will pay off. In real terms, it is hopeless. The alternatives are years of economic stagnation as the lawyers fight over the scraps, or wholesale nationalization and default (apparently unthinkable in the USA). Inflation is the most efficient way for the US government to impose a settlement on creditors and debtors.

Perhaps the US dollar is now finished as the global reserve currency.

[Neil B]

(I tried to post this at the "Three Ways" thread but Typepad kept screwing up over and over - so I'll try it here, the same point applies well enough:

Well Brad, I understand you are trying to make the best take on this crisis and the resultant, fawning "Beg-out" (Whale-out, Bales-out?) as an objective, responsible economist - however, a more critical, small-p partisan take is needed. I didn't have time to read the whole piece, so sorry if I'm missing something. However, note that "world markets soar" precisely because the US establishment has decided that "the government" - that is, taxpayers - will bail out and support the financial establishment because "we just can't let it fail" etc. Well. Isn't that an interesting irony about "free market capitalism" as I noted in a previous thread and elsewhere. Remember, “Freedom means freedom to fail, not just to succeed” etc? (I say this with all due respect for genuine conservatives, like I suppose Ron Paul, the crowd at American Conservative magazine, Reason, etc, who would and presumably will oppose such privatized-gains/socialized-losses pandering.) After all the whining from conservatives about net "welfare" for the lowly (which was phony anyway considering the child tax subsidies for families up to around 100k, etc.) now we find that it's OK to make just about everyone people pay to pick up after other people who make more money (even if the market would fail) than 99.9% of the rest of us.

A commenter at WaMo named Tom Nicholson called it “wealthcare” – Bush’s biggest and final legacy - hah! The least the public (on whose shoulders this approx. $1T bailout rests like the World on Atlas’ shoulders – what if *we* shrugged, not the hokey Randian “real producers” at the top) can do is, to demand the following as quid pro quo:

1. Take away the special tax breaks for the upper classes such as lower capital gains rates, which they never deserved in the first place (after the fact trading accomplishes nothing, why not reward initial investment and nothing else?) Make them actually pay in the mid thirties for every kind of income, but I'm OK with a break on estate taxes (since paying out cash for receiving illiquid value can be a PITA.)

2. Administer "social welfare" like universal health care with no apologies, it's the least we can get back in return. (McCain health advisor John Goodman's arguments that everyone really has UHC/health insurance just because they can go to an emergency room are rancid plutocratic snot. Just read his quote from e.g. http://politicalticker.blogs.cnn.com/2008/08/28/mccain-adviser-everyone-in-us-has-some-health-coverage/ and you think, either deliberate snarky satire or the man is literally a monster - so what does that say about who he advises/ed?)

3. Hard-ball oversight of the whole financial system, massive required transparency, firmly enforced, harsh and timely rules and punishments, in effect let MoveOn or Ralph Nader loose to decide how to regulate the finance industry and corporations. Well, rationally in the true public interest, but no quarter to the playahs for their own sake.

Brad, please come down more off the wonk and deal more directly with what this *means* to us as a society, OK? And it wouldn't hurt to deign to dip into your own comment section once in a while. People like Kevin Drum, Hilzoy and Steve Benen do it some, and it is de rigueur for some reason in the science blogs.

[PSP]

I just wish that the bill for this bailout would be funded by a dedicated sales tax on securities rather than tax the rest of us.

Think of it as moral hazard, if you wish. Or just consider the benefits of the Journal editorial page and its ilk forcing every republican forever to promise to repeal the stock broker tax.

[Oskar Shapley]

Since the government has already sinned by intervening into the sacred market and now we aren't naive virgins anymore let's go just one step further.

The government should intervene into the core of the problem. It should start buying houses directly.

Current predictions are that home prices will continue falling throughout 2009,2010. If this goes on like this then we can expect many, many more bankruptcies.

It is now quite clear that there was an overproduction of homes and the problem will not solve itself as long as the overhang is present on the market, because it depresses the prices even further.

You need an government agency which would start buying houses to take them off the market. Not selling them off or renting, but excluding them from the market. I can even imagine burning or buldozing them just like Brazil had to do with coffee during the Great Depression. If you are uncomfortable with such waste, one can convert those houses into some kind of community centers, storages, etc.

Its the only quick way to make the discussed good rare again.

[Neil B]

PSP: Absolutely. Why should the rest of us have paid sales taxes on other products anyway. Have a sales tax on literally everything while we're at it, including commodities, currency, whatever. I was shocked to find out years ago, I wouldn't have to pay a sales tax if I bought gold, silver. etc. like I would buying coffee or a lawnmower.

[The fastest growing municipality was Las Vegas]

the unit is going to be trillion

The basement layer of big shit pile is the mortgage. Many of those do not have value as the mortgage holder can not afford to pay. soon we will have a pick-up in unemployment so more people will not afford to pay. Does anybody want to buy a couple of dozen golf course/residential developments? the unemployed middle management that was expected to play are too proud to get jobs there as greens keepers.

It looks like the immediate beneficiary of this are the IBs still standing. It was getting close to panic time as GS too would have failed. As to long term profiting from this massive central planning move, yeah, sure, the markets! In the meantime we will have higher interest rates, rising costs of middle class living, and lots of unintended consequences in the markets.

too much to say to have time to golf clap for the brilliance of Paulson Bernanke

[The fastest growing municipality was Las Vegas]

the first step is the taxpayers buying up the certificates of confiscation by the gross

wherever you read the "govt" buying up big shit pile, slot in the "taxpayer."

is part of the bail-out going to include restating the appropriate IB and mortgage originator "results" since 2001? stupid question

[The fastest growing municipality was Las Vegas]

Bernanke, theory, Paulson, practice, helped dump big shit pile in the first place. How will their actions transferring the risk to the tax payers clean up big shit pile? Isn't this flinging the crap on all of this?

Bernanke, politicized fed, and Paulson work for the unluckiest czar ever.

Also we're adults playing kick the can, all of this is going to be wound down in the future when American adults are more honest about themselves and will be willing to pay the bills of the past.

[Arun]

Why did the S.E.C. four years ago allow Lehman Brothers to increase its debt ratio from 12 to 30?

Government may be the answer, but not this government, this administration. Maybe not even this Congress.

[Name]

Face it folks, what we're seeing is nothing less and nothing more than the largest in history transfer of wealth from the poor and middle-class to the already wealthy, the final chapter of the Bush/Repug master plan to destroy everything but the hyper-wealthy and business. The saddest part is the proles aren't even cognizant of their impending doom. In any other nation we'd be seeing a rebellion by now.

[Jon]

Congress needs to hit the pause button; they are ready to let the Bush crew risk $700B of taxpayer money in a blink of an eye. The world will not fail if the legislation is not passed next week; just people will have time to realize that the taxpayer needs protection against this administration. If Paulson, Bush, and Bernake can get us to the point where Congress must authorize $700B of purchases within one week, how can we have any confidence that they will manage this authority any better than they have managed things up to now.

If things are this dire, Paulson and Bush should resign, just like any failed CEO.

[samdog]

Has anyone considered that the Fed, Treasury, & Mr Bush--and you might as well throw in virtually the entire rotten-to-the-core US Congress--are simply buying HOURS, not months or even days--so they can pack up and get their assets out of Dodge before the 'real' collapse happens? Oh sure, I know, I'm just being cynical (but just to be on the safe side, I got totally out the market yesterday for the first time since 1981, while the headlines still proclaimed 'Market Soars!'.