The Paulson Plan - First Take

The profound disquiet I felt on Friday when the news broke about a massive bailout of the financial sector by the US Government bordered on physical nausea. It seemed utterly corrupt. Undoubtedly it has become necessary. But the derivatives spivs have been allowed to profoundly endanger the economy with their hubris and greed. They have been allowed to get away with it. And the US taxpayer has had to take on debts of $700 billion to salvage the situation. It seems contrary to any sense of justice.

Having spent today keeping up with the details emerging from the cabal on Capitol Hill I am feeling slightly better about it. I would have preferred to see the banks recapitalised by a government purchase of equity - that would have ensured that the taxpayer got to see the eventual benefits of the rescue as well as the cost. But I suspect, pleasantly vindictive though it would be to dilute the capital of these reckless companies, this would not be all that pragmatic. So no partial nationalisation, richly deserved though it is.

In the first place, that equity will probably not hold its value. The banking sector needs to shrink substantially (more on this in a subsequent post). Secondly, the subprime instruments on their balance sheets have attained a rather totemic quality. To restore market confidence this "toxic waste" needs to be isolated.

So the US Government is left trying buy the stuff, sticking it in quarantine for a few years, and seeing how much money the taxpayer gets back. The problem is, nobody has a clue what it's worth. The Paulson gambit seems to be that it actually does have some value, but that it is impossible to realise it in the present market. That is, the problem is one of liquidity. The alternative is that the banks are still lying about, or at least inventing, the valuation to keep their balance sheets from falling apart. This doesn't strike me as unlikely. So it is quite a big, and desperate, punt by the Treasury.

The final judgment will have to depend on how much Paulson pays. The banks and the government are both over the barrel on this, but the government can probably afford to drive a hard bargain. This will take nerve; and even with nerve it won't be easy. The difficulties in valuing this complex, toxic instruments are precisely what has led to their illiquidity and the attendant market panic. But if Paulson is right and the problem is liquidity and he gets a good price, in the long run the taxpayer shouldn't be too much worse off. So it may turn out that this is not the heist of the century after all.

I'm not sure how hopeful to be that it turns out not to be though.