Baseline Scenario

The Baseline Scenario
No Way Out: Treasury And The Price Of TARP Warrants
Debating the Public Plan
The Paradox of Strategic Defaults
No Way Out: Treasury And The Price Of TARP Warrants
Posted: 29 Jun 2009 03:58 AM PDT
Buried in the late wire news on Friday – and therefore barely registering in the newspapers over the weekend – Treasury announced the rules for pricing its option to buy shares in banks that participated in TARP.
The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.
This is a mistake.
The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins.
In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion?
Treasury apparently sees corruption as an issue about personalities (i.e., WE aren’t ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.
This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund – including during the Clinton Administration, when the same people were running U.S. economic policy as now. It’s a good point and never easy for countries-with-potential-corruption to hear. It applies as much to the United States as to anywhere else.
Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: it is part of a much longer series of nontransparent decisions over finance. The attitude that “we can be nontransparent because we will never be corrupt” creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.
In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.
There is obviously unappealing midterm election risk in this pricing scheme and making a correction now – before major banks have participated – would be relatively straightforward.
(Primer on option pricing, applied to warrants; background on how we got here)
By Simon Johnson

Debating the Public Plan
Posted: 28 Jun 2009 08:01 PM PDT
Greg Mankiw weighs in directly (as opposed to beating around the bush) on the public plan. Here’s the summary:
Recall a basic lesson of economics: A market participant with a dominant position can influence prices in a way that a small, competitive player cannot. . . .
If the government has a dominant role in buying the services of doctors and other health care providers, it can force prices down. Once the government is virtually the only game in town, health care providers will have little choice but to take whatever they can get. . . .
To be sure, squeezing suppliers would have unpleasant side effects. Over time, society would end up with fewer doctors and other health care workers. The reduced quantity of services would somehow need to be rationed among competing demands. Such rationing is unlikely to work well. . . .
A competitive system of private insurers, lightly regulated to ensure that the market works well, would offer Americans the best health care at the best prices.
Whenever someone uses the phrase “basic lesson of economics” when discussing the U.S. health care system, you should be suspicious. As Paul Krugman says, “the standard competitive market model just doesn’t work for health care: adverse selection and moral hazard are so central to the enterprise that nobody, nobody expects free-market principles to be enough.”
I earlier tried to make this point in more detail: “lightly regulated” private health insurance is a fantasy, because the whole point of a for-profit insurer is to charge premiums that expect the expected payout under the policy; as a result, no sick person would be able to afford insurance. You don’t need adverse selection or moral hazard to explain this: if I know someone has an expensive form of cancer, I’m going to charge him $100,000 for health insurance, and he won’t be able to pay. The free market for health care is one in which sick people die, and smart people who ignore that point are being less than honest. (Or maybe they are hiding behind the phrase “lightly regulated” – if they consider the prohibition of medical underwriting “light regulation.”)
And if dominant market participants are the problem, then we already have that problem. Check out page 6 of this report (hat tip Krugman). In the median state in the U.S., the top two insurers have a combined market share of 69%.
Finally, it’s clear that the current system isn’t working – we have both 50 million uninsured people (plus many millions more who are not sufficiently insured against a major medical problem), and we have rising health care costs that will destroy the federal budget over the next several decades. So when Mankiw says we need “a competitive system of private insurers, lightly regulated to ensure that the market works well,” what is he saying? That we need less regulation than we have now? Or is he just talking about abstract principles?
By James Kwak

The Paradox of Strategic Defaults
Posted: 28 Jun 2009 07:00 PM PDT
Real Time Economics and Calculated Risk both discuss new research by Paola Sapienza, Luigi Zingales, and Luigi Guiso on homeowners defaulting on mortgages even though they have the money to pay them. According to their research, 17% of households would default when their negative equity reaches 50% of the house’s value. The argument is that public policy has not sufficiently addressed this problem, focusing instead on homeowners who cannot afford their mortgages.
Let’s make this a little more concrete. Let’s say you bought a house with zero money down for $300,000 in early 2006. A few years later, the house is now worth $200,000, so your negative equity is 50% of the market value. Yet only 17% of people in your situation would walk away from the house. The other 83% would continue to pay the mortgage, essentially throwing money away. Apparently people value the transaction costs of moving and the damage to their credit ratings at $100,000 (I think my numbers are approximately on the right scale – if anything they are probably low) – even after the fact that you can live in a house for free for several months before being evicted.
Or people are not as rational as economists would assume.
By James Kwak