Bad Plan vs Good Plan

Paulson’s $700 bn bailout plan for Wall Street rejected by Congress yesterday seems to be predicated on the basis that, as my father used to say, “Plan beats no Plan”. 

The original version provided:

  1. No relief for homeowners even though in many cases the mortgage brokers concerned indulged in misrepresentation, deceit, and even outright fraud contrary to state laws.
  2. Buying bad loans off the banks at more than they are worth (by implication at vastly more than they are worth).
  3. Doing nothing to restrict the excesses of the bonus culture.

This was only lightly and toothlessly amended in the final form that was put to the vote yesterday.  

To cut through the fog, its effect would therefore be to nationalise the banks accumulated bad debts paying them something like their (fantasy) face value.  But the banks have been very busy filling their boots with bad debts over the last few years; $700bn may well not be enough – it seems generally agreed that the figure was more or less plucked out of thin air so one has to ask, “Would the Chinese, Japanese etc who the money would have to be borrowed from to pay off the bad banks be willing to lend it?.   Its a big ask indeed – especially if the real figure is two or three times higher!

One has to ask whatever happened to moral hazard?  The idea that, in a free country, people should bear the consequences of their own actions – good or bad.  I am near enough to being a libertarian to think that’s rather important.

Paulson’s plan is undoubtedly very good for foolish bulge-bracket bankers but I remain convinced that it is very bad for anyone else.  Call me old-fashioned, but I have a quaint belief that democracy involves government of the people for the people by the people.  That said something must be done, but it must be something that works to relieve the pressure at the point where the shoe pinches in the real economy and for ordinary people. 

The clearest exposition of a good alternative plan I have come across that does exactly comes from John Hussman at Hussman Funds (H/T naked capitalism).  This is well worth the read.

To summarize briefly some highlights: his analysis is that to understand what goes wrong when a bank fails, you have to consider it through the perspective of the balance sheet.  Failure happens when the bank’s bad debt erodes its shareholder equity to near zero.  When this happens depositors begin to make withdrawals forcing the bank to liquidate assets at fire-sale prices.  This kicks off a vicious circle that ends in bankruptcy.  He proposes that the best approach is for the government to interrupt this process by injecting capital directly into the bank in the form of a ‘super-bond’.  This would provide an extra layer of protection for depositors and the financial system enabling the good core of any failed bank to be cut out surgically and sold or restarted. 

We are likely to need to do something here in the UK before many more days have passed so we are not entirely spectators here.

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