The Mother of All Bailouts

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

The permanent emergency in foreign affairs is about to become the permanent emergency in economic affairs as well. Congress must not permit that to happen. Our representatives must not vote for a law that gives the Secretary of the Treasury unlimited authority to structure this bailout as he wishes, without oversight or accountability. That part is simple.

Once we’ve taken this astonishing provision off the table, we can talk about the substance of the bailout proposal.

I have expressed sympathy for the view that what we need is something similar to the RTC to put a floor under the market and allow banks to rebuild their balance sheets. Now, the analogy is not a perfect one, for two key reasons. First, and most important, the RTC did not purchase assets; it disposed of assets that landed in the government’s lap because the government insured the S&Ls. Therefore, there was no question of the government setting the right purchase price; the only price the government had to get right was the disposition price on the back end (and it did a pretty good job of that). Second, what is implied by the prior point, the assets came from firms that failed. The RTC was not out to save the S&Ls; it was out to prevent the commercial real estate market from completely imploding by holding onto assets until the market had recovered enough to absorb them.

By contrast, any analogous proposal to deal with the sub-prime mortgage crisis would have to purchase assets, because we are trying to prevent the wholesale bankruptcy of our major banks. If we only bought assets from firms that failed, we’d potentially be waking up to discover that Citigroup had gone under. And that’s what we’re trying not to avoid waking up to discover. Moreover, the public interest here is in an orderly and fair renegotiation of individual mortgages, and that’s a process that probably should have a political dimension. That’s a good reason for the government to want to wind up owning the individual mortgages rather than leaving workout entirely in private hands. In any event, if the government is going to purchase assets from operating firms, it’s going to need to set the price somehow.

How is it going to set the price? In public, Paulson is saying that he’s going to purchase the assets at “fair market prices.” But there is no market, and nobody has a clear idea of what is fair. Moreover, there’s a feedback mechanism inherent in setting the market price of anything – if a government intervention is able to stabilize the market and engineer a recovery, then housing prices won’t fall as far as they would if the government intervention failed or didn’t happen. Nonetheless, it’s safe to say that there is a widespread feeling that the write-downs that the industry has taken so far are substantially insufficient based on current trends in housing prices and the economy, and that there is also a widespread suspicion that Paulson’s plan is intended to hide this by buying from banks at somewhere close to their current marks. That would amount to a stealth bailout of the banks – yet another one, on top of AIG, and much, much bigger, one that would create the mother of all moral hazards, giving the greatest rewards to the worst actors, and that would, moreover, give the taxpayer no upside in the bailout, only downside. If that’s what’s really being planned, then the marketing of this plan is flatly mendacious and not only should the plan be opposed but Congress is going to have to question everything that comes out of the Treasury going forward.

Here’s what a bailout is supposed to be accomplishing. It is not supposed to be enabling banks to offload their assets at unrealistic levels onto the public, preserving institutions that have destroyed value and preventing necessary consolidation and deleveraging. It is supposed to be preventing a fire sale of assets by dozens if not hundreds of firms into a market that has no appetite for assets of this kind.

In fact, right now, there is money waiting to buy these assets. But it’s vulture money, money that knows it can control the pricing, and money that will price these assets to earn money in the most extreme downside scenarios that can be plausibly articulated. The selling banks have no leverage in negotiations. These guys are called vultures for a reason. They perform a useful public service in normal markets, just as vultures do in a normal ecology. But we don’t want the whole banking system eaten by vultures.

One way of thinking about the proper purpose of the bailout is that the government would be stepping in as the mother of all vultures, a benevolent vulture willing to buy for its best estimate of intrinsic value rather than for a steep discount to that value (which is what market value would mean in this environment). The question, then, is how to be a benevolent vulture rather than a sap. A possible solution to this problem would be for the government to get a grant of equity proportional in some way to the value of the assets purchased. That would give the firms who own the assets an incentive to put rational values on them (why give away more equity for free simply to get a price closer to their mark?) and to focus on assets that they really need to sell. But there are probably a dozen other possible solutions, assuming one isn’t trying to be a sap, which at this point is not at all clear.

The right price will drive some firms into bankruptcy. It will drive others into the arms of stronger firms. It will let others clean up their worst problems (at a cost of dilution of their equity) and then enable them to go out in the market to raise additional capital (something they would have difficulty doing now since nobody knows how far down is down – that’s why the government needs to put some kind of floor on valuations, because they are the only vultures with deep enough pockets to do it). What Treasury needs to do before a bailout is approved is what they have not done: articulate a process for valuation that is not a stealth bailout, but an above-board attempt to get a fix on the intrinsic value of these assets, and remove them from the market so that the prospect of a massive fire sale is no longer hanging over everything. Then we can work out how the government should renegotiate all those mortgages it will suddenly own.

The temptation for Congress is going to be to horse-trade, to try to get homeowner relief tacked on to Wall Street relief – basically, to give the Treasury what it wants and ask for some other goodies in exchange. This temptation has to be resisted. The urgent thing is to get the bailout itself right, and not to agree to something foolish and dangerous because of panic. Congress has got to be a part of that process.