Norris

This is quite good and shows how psychology is at the bottom of Paulson's plan...and how Bush may have blown it yesterday by the way he described it.


new_york_times:http://www.nytimes.com/2008/09/26/business/26norris.html

By FLOYD NORRIS
Published: September 25, 2008
It’s not easy to run an economy without a functioning financial system.
This country barely has one, and it is far from clear that will change even if the White House and Congress can reach an agreement on a bailout plan.
Even as the stock market was rallying on signs that bailout talks were progressing early Thursday, the credit markets showed signs of additional distress, distress that could deepen if the stalemate continues.
In concept, the plan put forth by Henry Paulson, the Treasury secretary, is really quite simple: Give the banks lots and lots of money. Once they have money — and are no longer stuck with many of those strange assets left over from the discredited financial system that imploded — people will have confidence in them.
There is no guarantee that confidence will emerge. But even if it did, the second assumption is even less certain to prove correct. If the banks have all that money, will they be willing to go back to lending, or will they continue to show the caution that has been the hallmark of the last year? Is a bank’s capital something to be conserved, or put at risk?
One lesson of the last 18 months is that when the government promises aid to a financial institution, if needed, the pledge does more harm than good. What the public hears is that an institution needs help, which means it is not a good place to put your own money. Speculators sell the stock, and they buy credit-default swaps.
When the price of the swaps goes up, others get worried.
Mr. Paulson decided that problem could be solved by funneling hundreds of billions of dollars to banks, whether they needed it or not.
Since his criteria for getting the money did not involve any actual need for it, the hope was that none of us would think badly of the banks that get the cash.
The concessions demanded by legislators could change that in important ways, giving healthy banks possible reasons to turn down the plan — and perhaps raising suspicions about the others.
It has been a year since Mr. Paulson started trying to find a way out of this mess. The latest plan is not all that different from his first idea, announced last October. Then he wanted the banks to set up what became known as a super-SIV to buy dicey assets from the regular SIVs, or structured investment vehicles.
The fear then was that the banks would have to put that junk back on their own balance sheets because those who had financed the SIVs wanted their money back. The assumption was that the banks had plenty of capital, and that getting beyond the problem would end the crisis.
It turned out the banks did not have plenty of capital and the problem was much larger. That idea died. This plan is a super-SIV on steroids, with the cash to be put up by the government.
Under the Paulson plan, the government would buy mortgages and mortgage-backed securities for more than they are worth, which should make banks happy to sell.
Not that the Paulson plan puts it so bluntly. Instead, it returns to the wondrous fiction that penetrated the super-SIV debate, that assets are worth what someone says they are worth, rather than what someone will actually pay. The assumption underlying that proposal was that the assets were really O.K. — they had AAA ratings, did they not? — but that their market value had temporarily fallen because of unreasoning panic among investors.
Financial companies have been saying for months now that market prices for mortgage securities were unreasonably low, although none of them seemed eager to buy at those prices. Among the companies that most vigorously pushed the idea were the American International Group and Freddie Mac, which could be a sign that such protestations served to scare rather than reassure.
The Fed and the Treasury think that the prices have fallen too far. Contrary to what President Bush said in his speech Wednesday night, the plan proposed by his administration did not call for buying such securities at “current low prices.” As Ben Bernanke, the Fed chairman, explained to legislators this week, the price the government would pay was to be the “hold-to-maturity price” of these securities, not the “fire-sale price” they would now fetch in an open market.
And how would that price be determined? Mr. Bernanke thought “auctions and other mechanisms could be devised that would give the market good information on what the hold-to-maturity price was for a large class of mortgage-related assets.” That strikes me as dubious at best. Auctions of disparate securities with one eager buyer and sellers of varying desperation may show something, but it is unlikely to be the “hold-to-maturity value.”
To estimate such a price, you need to make assumptions on how many defaults are likely, and how severe the losses will be, for each group of mortgages that was securitized. The correct answer will depend in large part on how long house prices fall, and how severe the recession is. If you think you know all that, then you can make a good estimate of value.
The nature of securitizations is that the losses arrive in lumps. A given security might meet all its payments if the mortgage pool backing it suffered losses of 5 percent, and be wiped out if the losses reached 6 percent. Change your assumption a little, and the value may change a lot.
But coming up with any kind of fair value was not the real objective. Instead, the goal was to recapitalize the banking system by placing a floor under the prices of securities that never should have been issued.
It appeared on Thursday night that any deal between the Bush administration and Congress would include requiring the government to get equity stakes in banks that take the money, and forcing banks to follow standards set by the Treasury Department to limit excessive or inappropriate executive pay.
Those provisions were needed to assuage public resentment at bailing out Wall Street, but if they are not just window dressing they could reduce the possibility of getting every bank to take the money, unless the government is prepared to pay a lot more than the real value of the securities. Healthy banks may be unwilling to surrender equity, or agree to limits on executive pay.
If that happened, this bailout plan, like those before it, could be perverse even if it is adopted. If your institution takes the help, that means it needed it. Customers may flee.
Mr. Bernanke is right to say that “if the credit system isn’t working, then firms can’t finance themselves, people cannot borrow to buy a car, to send a student to college, to buy a house.” It is possible this plan, if successful and widely used, would recapitalize a lot of banks, enabling them to increase lending. But there is no assurance they would.
Unfortunately, many banks have problems that have nothing to do with mortgages. A report by David Keisman of Moody’s warns that in the crazy credit boom that ended last year, many bank loans to overleveraged companies lacked normal protections for the lenders. Recoveries on defaulted loans, he says, “could be far lower than historic averages.”
That could hurt the lenders, and the holders of collateralized loan obligations. It could also hurt the companies that wrote credit-default swaps that promised to pay if loans defaulted. Fears of such developments could encourage banks to hold on to the cash they get from Uncle Sam.
There is nothing to stop the government from buying up corporate loans and securities, as it proposes to do with mortgages and mortgage securities, but at some point you start to wonder whether you really want the government deciding whether to grant concessions to individual borrowers, whether they are homeowners or companies. Is it possible that contributors to the right politicians could be favored? Is it possible that someone will at least suspect that happened?
Members of Congress have been pushing to assure that some mortgages taken over by the government will be modified to help homeowners. That could help the economy in some areas, but it also could increase the cost to the government.
In a triumph of optimism, the negotiators were reported to be talking about what would be done with the government’s profits — assuming there are some. Most profits would go to pay down the national debt, with the rest going to help the housing market.
Until now, the excesses of the last credit boom have defied all efforts to stabilize a crippled financial system. This plan, if finally approved, will be Mr. Paulson’s legacy. If it does not work, a new administration will have to think of something else.
Floyd Norris’s blog on finance and economics is at nytimes.com/norris.