"Which Bailout Plan is Best?
Which plan is best, the original Paulson plan where the government buys bad paper directly, the Geithner plan where the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, or straight up nationalization?
Last March, before Paulson had announced his plan, I said that I thought it was time for the government to begin aggressively purchasing toxic assets to solve this problem once and for all:
I’m starting to think that the Fed should drop the term part of the TSLF and instead trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don’t limit trades to banks.
The Fed would act as “risk absorber of last resort.” Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. ...
I still think that this would have worked then, I called the government a "risk absorber of last resort," and the prices of the assets at that time were high enough to keep banks solvent. But it would have involved a massive transfer to the banks without giving taxpayers any share of the upside. In addition, as time has passed and prices have fallen, solvency issues have come to the forefront - the balance sheet problems are no longer hidden by overpriced assets - and the solvency problems must be addressed directly. That means that if there is no separate program to provide an infusion of capital, simply removing the toxic assets from the balance sheets through government purchases at current prices - prices so low that the banks are insolvent - won't be resolve the problem.
So if it was to work, the Paulson plan had to be amended, it needed to both get assets off the banks' books somehow, and it also needed to provide recapitalization in a way that is politically acceptable (which means no giveaways - the asset purchase plan I proposed above would have been a giveaway without some sort of redistributive mechanism attached to the plan).
So which plan is best? Any plan that does these two things, removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has these two features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. The plan for nationalization most certainly has these features, but it has political problems as well.
So I do not take a binary (or, I suppose, trinary), either/or approach to the proposals where I think one plan will work and the others will fail miserably. All three plans have their pluses and minuses. The politics of the Paulson plan make it a non-starter, I have no quarrel with the view that it constitutes a giveaway that is not justified, so the only way the Paulson plan will work is if we can convince people that equity stakes or some other mechanism makes the plan sufficiently equitable. I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. So all three plans do the requisite things - get assets off the books and provide recapitalization - and each comes with its own set of political worries.
So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action.
The post quoted above was from over a year ago, and we had been aware of growing problems in the financial sector for some time before that. There were programs in place, but nothing of sufficient scale to get the bad paper off the books, so we've been at this for a long time without any big, decisive, effective policy action. What's important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We've been spinning our wheels for too long, and it's time to get this done. We can't wait any longer.
So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.
You make fair points, and, at least since last September and versions of this idea became possible, you recognize what I thought then, and still do, is the main problem with buying TAs, and that is the huge political downside if this plan blows up into a huge loss.
In September, I was worried that William Gross,for example, who's a damned smart guy, would cause conflict of interest problems big time working for us, if Pimco made money in some way and we lost a ton of cash. Now, I'm worried about the same thing. We'll lose a bunch of money, but Pimco et al will do well.
I understand that, theoretically, this can work. But I still believe that there's a huge potential political and social downside.
One final point: As far as I'm concerned, the mechanics of the plan today, including TALF, are all versions of William Gross's plan put forward in the Sept. 27th version of the WaPo. I'm not joking in feeling that the comments today about this version of that plan seem like reinventing the wheel for the tenth time since that column. There's something about reading blogs and the press daily that has made this crisis seem like a Twilight Zone episode. If I hear that CDOs and CDSs can't be priced one more time, my head is going to explode.