Wednesday, October 01, 2008

My thoughts on the bailout situation

A friend of mine has asked me for my feel on "the whole bailout thing." If you don't know what he's referring to, feel free to crawl back under your rock. If you don't care, don't bother to read the rest of this; you won't find it interesting.

My interpretation is that nobody has a freaking clue what's going on. But here are my detailed thoughts:

1) Is a bailout necessary?
I have no idea. I don't pretend to understand complicated financial markets well. I tend to trust McMegan's judgment on economic issues, and she's somewhat ambivalently in favor of it, but I remain somewhat skeptical. But none of the powerful people pushing for the bailout have ever tried to convince me of it's necessity. The congresscritters, bankers, and other people calling for a bailout are merely running about screaming "the sky is falling!" and trying to get something passed before anyone can look closely at it. This does not inspire confidence. To top it off, Pelosi used her speech leading up to the vote on the last proposal to take partisan potshots, which is hardly going to convince me of the gravity of the situation. Politicians: if it actually is a crisis, start freaking acting like it's a crisis.

2) Is this bailout necessary?
I doubt it. We don't even really have a plan. The plan is just "give Paulson $700B and he'll figure out how to use it to buy stuff to fix things." This raises several questions:
2a) What are we buying?
The only description I've seen is "distressed assets." This means that we'll be buying the crap that banks can't offload because nobody will touch it. They're almost certainly undervalued in many cases, but nobody's sure which ones are undervalued and which ones are stinky crap. These are risky assets, which is why markets have locked up.
2b) What are we paying for it?
Yes, I know, $700B total. But on any given transaction, how are we going to price the assets? Nobody wants to buy them, so there is no "market price" above zero. The only serious suggestion I've seen is to use a reverse auction, in which the government buys the distressed assets from the people willing to take the least money for them. It is very difficult to make an "apples to apples" comparison with securities this weird and complicated, so you end up with a decently sized asymettrical information problem. This method also takes a long time, contra the chicken-little attitude displayed thus far. This also presents a third question:
2c) From whom are we buying?
This is an important question. This is a bailout, and so the point is not to get the most assets for our dollar, but to prop up as many of the most important firms as we can for our dollar. This is in clear conflict with (2b), where the money is suggested to go to whoever will take the least for their pile o' crap. (2b) almost certainly ensures that at least a few otherwise solvent firms will offload their crap to Uncle Sam for a pittance to clean up their balance sheets, leaving less money to help the liquidity of the firms who truly need it. How many will be truly distressed and how many will be opportunists cleaning house, we have no real way of knowing a priori. I see no easy or straightforward way to reconcile (2b) and (2c).

3) How are we trying to avoid creating a moral hazard issue here?
As far as I can tell, the government isn't even trying. We should be aiming to prevent banks from out-and-out failing, while still forcing them to take heavy losses to punish the idiotic behavior that but for our intervention would have killed them, in order to discourage such risky behavior in the future. No plan seems to have any mechanism for preventing banks from metaphorically walking off unscathed.

To sum up, I am (tentatively) against any of the bailout plans that fail to seriously address the above questions. Get back to me once our politicians start thinking of this less like a naked power grab and opportunity for graft and more like a mission to prevent the economy from exploding.


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