The Paulson Plan - a brave new world

So the final draft of the Paulson Plan is out. I find my copy at the New York Times (PDF).

It's obviously quite a lengthy document so I'll refrain from too much analysis until I've had chance to read it and catch up on some of the press response. My initial impression is that it has absorbed a lot of the different ideas that were milling around Congress, provided authority to the Treasury Secretary to implement all of them, but left it to his discretion on which of them actually do get implemented and how, along with a set of stated aims for the intervention and a substantial framework for oversight.

In other words, we need to wait and see how it is implemented. This is simply the legislative groundwork for the Paulson plan. We don't actually know what his plan is yet.

To shift focus from the economics of the package, the equity warrants are the most significant aspect. They are non-voting but this is still, in a sense, a mandate to nationalise the finance sector. Given the USA's ideological commitment to a free market capitalism where the Government watches from the wings, this is a substantial coup. A philosophical Rubicon has been crossed here.

This is a test too, not for free market capitalism which has already flunked, but for the sort of partnership of State and commerce that predominates in most of the rest of the world. The provisions against excessive executive compensation and the requirements to use the rights over the mortgages to effect a kind of Jubilee on foreclosure could be (maybe) the seeds of an ideology where the public sector acts as the political conscience of industry. We should welcome this warily.

Unblocking the pipes

I've just seen this article on Bloomberg. It is actually rather reassuring.

I said before that the financial sector needs to contract substantially. To do this, it needs to deleverage and it seems increasingly likely that this is going to be hard because, once its trash mortgage portfolios are marked at a realistic price, large chunks of the sector are going to be insolvent. If you are insolvent, the value of your assets is not sufficient to meet your debts. The only way to resolve this impasse is through bankruptcy, passing the shortfall on to your creditors. This is what needs to happen to unwind the leverage and restore credit-worthiness to the system. It is good to see this is happening, and that the mortgage portfolios are being marked more realistically in the process.

It looks like the US legislature will be able to pass the Paulson plan in some form this weekend. Hopefully, it will be discretionary enough, and its managers will be astute enough, to use it to cushion this process of deleveraging rather than as a wholesale recapitalisation of the system. This latter action would only serve to transfer the gap between the value of assets and liabilities onto the public balance sheet rather than liquidating it. In other words, rather than allowing the banks' creditors to suffeer the consequences of their unwise investments, those consequences would be met by the US taxpayer.

The Paulson Plan - why not equity?

Along with a growing multitude, Sebastian Mallaby, in an article in the Washington Post has mooted the idea of forcing banks to raise capital directly by issuing new equity. Aside from a need for political expediency, I don't think this one will fly.

It looks like Mr. Paulson has taken the view that the problem is not that the banks are under-capitalised. The problem his plan is trying to resolve is that the banks have assets on their books for which there is no market and hence no reliable market price. This bailout is not, or at least certainly shouldn't be, about getting more capital into the banking sector. It is about removing that uncertainty from bank balance sheets.

Simply providing more capital to the banks won't remove that uncertainty, however it is done. The assets of unknown price stay on their books. What is needed, as the Treasury has diagnosed it, is to quarantine the assets. I think this is probably right.

Moreover, it is not as if banks haven't tried to raise new equity capital. Certainly they have in the UK with a number of rights issue. Largely these have not been all that successful. There just isn't an appetite for banking equity at the moment.

That would leave the taxpayer to buy the new shares. And, indirectly then, those "toxic" securities are still on the public balance sheet because they are owned by banks in whom the Treasury now has an equity stake. It's hard to see the benefit apart from some dilution of the risk. But the cost of that is that those mortgage-backed securities are still creating large uncertainties about banks' balance sheets.

The Paulson Plan - business as usual

So the response of a Democratic Congress to Paulson's bailout is in (New York Times and Washington Post).

Some things are sensible: the plan as originally drafted, clearly needed more oversight. And I think Mr. Paulson is wrong about executive pay. It's necessary to make the bill palatable to the public and any CEO who takes the golden parachute while his firm goes bust rather than participating is frankly going to have to get a new identity in Latin America.

Sadly, they didn't stop there and the thing risks becoming a political football. The push "for assistance for distressed homeowners" (NYT) is wrong-minded. Not because they shouldn't get assistance but that this does need to be a "clean bill". As a sidenote, I think 'focused' is probably a better word here. There's nothing clean about it. But the US Congress needs to curtail its usual dysfunction and get a bill passed. If it needs to be fixed later, so be it.

I'm doubtful this will happen though. Both parties are going to play to the gallery with this one.

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.