Wednesday, October 01, 2008

Why I Thought TARP Was Bad

TARP (the "$700 billion bailout bill") is now dead, and the markets had their hissy fit, then bounced back, and are now continuing to be grumpy. I was going to write a "top ten reasons TARP is bad" blog, but that's water under the bridge. But I've had enough people ask me why I didn't like it, let me try to spell out my (highly convoluted) thinking.

My main concern with the entire process of congress trying to get behind a bailout bill is that it's not really clear what problem they're trying to solve. The way I look at it, we have four groups of beleaguered souls:
  1. Home owners who are unable to pay due to the lack of refinancing. Home owners get in trouble if they either overpaid for the house and don't have equity (which means they aren't eligible for a loan large enough to refinance) or their credit isn't adequate in the current climate.
  2. Banks that, due to making poor investments (read: mortgages and their derived products) are no longer solvent.
  3. Companies unrelated to the housing market who are unable to get financing (short or long term) to do business because of problems in the more mundane parts of the credit markets.
  4. Everyone else (let's call them "tax payers") who have seen the value of all of their savings depleted due to a weak dollar. (This group is not usually mentioned as part of the crisis, but I think it is long to leave them out...the dollar has been severely bruised over the last few years, and the treasury spending half a trillion dollars or more is only going to make it worse. Tax payers lose twice - in the taxes they pay and in the value that is inflated away.
Groups 1 and 2 are fundamentally at odds with each other - every bit of relief granted to home owners makes insolvent banks that much worse off, and vice versa...either the home owners pay up (somehow) and the banks' mortgages are good, or they don't and they're not.

I believe that different action is required to address different problems. My issue with the treasury plan is that I don't see any scenario where buying things helps a lot. (That is actually not true - it's close to true though.)

If the treasuy buys distressed assets, then the question is "at what price". If the price is high, this helps solvency (if the toxic waste is worth what the banks thought it was, they're not insolvent), but the tax payers take it on the nose. The government's only alterantive would be to somehow force home owners to pay up - I don't see any way they can do would be water from a rock.

If the price is too low, then this is good for home owners (because the treasury can pass the savings on to the home owners by writing down the mortgage and refinancing) but it just locks in bank insolvency.

If there were some kind of middle ground, then theoretically the treasury could do both. That is, if banks wanted to sell at a lower price than is likely to be reclaimed from holding the assets, then there would be a win-win situation. But if it was likely that the assets would return to that price, we wouldn't be having this crisis. In other words, when it comes to sub-prime the problem is solvency, not liquidity. (If the problem was liquidity, then this could be solved with repos and other loans, and no permanent buying would be necessary.)

I am all in favor of the government buying and writing down mortgages to market price. In that case, TARP is problematic because it doesn't set a clear mandate for the treasury to do that - it lets Paulson pay as much as he wants.

I expect the government to be a very gentle bank -- I can't see the treasury foreclosing very effectively - the political blow-back would be too strong. So I think you can make an argument that treasury shouldn't own mortgage-derived products at all, but for now I'll say that if they do, they need to buy them so cheaply that they never have to put the screws to home owners to pay taxpayers.

There are two groups of economic thinking on the crisis: one group believes the fundamental problem is liquidity. (I am in this camp.) When liquidity is the problem, the solution to insolvent banks is to let them go bankrupt, wiping out equity and part of the junior debt. The assets are then resold to someone who can do something useful with them and business continues. This scheme effectively "clears" market conditions by punshing debt-investors in banks. To me this is more than just acceptable - it's necessary. If we have a policy of bailing out financial institutions in a way that protects debt holders, financial debt will be priced as if it has a government guarantee, and the next insolvency crisis will be a lot worse. All investors earn their returns by buying risk - bond holders bought risk and now they need to collect it.

The other group of thinking is that banks are undercapitalized. In this school of thought, liquidity won't help if there essentially isn't enough money to loan out. TARP could help this in that one solution is for the government to buy equity stakes in banks, something permitted by the bill. But then we get into a big set of problems: does the indication that using TARP is necessary indicate weakenss on a bank that causes a panic? Does the risk of government buy-in at a low price scare off needed private-sector investment? Does government buy-in at a high price protect equity investors that do not deserve protection?

My answer to this is: different solutions for different problems.
  • The fed should continue to use its balance sheet to provide liquidity to "mundane" credit markets (commercial paper and friends). If the fed needs a bigger balance sheet, I'm okay with that; that's one use of government money. Since everyone goes to cash and T-bills when things get scary, expanding the balance sheet seems okay to me.
  • Insolvent banks should be closed down and rolled up quickly and quietly to "clear" markets by wiping out equity and junior debt holders in the financial industry. It has to happen. When we look at the "bubbles" the real bubble was in financial services - that is, wall street making collectively too much mony off our GDP by taking a percent. That can't continue - the financial mechanism is over-built and needs to shrink, and that means losses for investments who bought at the top. No one would have suggested propping up - or Country-Wide!
  • Fanny and Freddie should be used sparingly to provide refinancing in some cases. In other words, the government should continue its policy of subsidizing mortgages. We've been promoting home ownership this way for a long time - we really can't stop now, at a time when mortgage financing is difficult to come by. Fanny and Freddie are a mess, but they're on the books like they always should hav been, so at least we can understand how much we're in for.
Financing would be aimed at home owners who would be able to pay their mortgage if financed at sane market rates (e.g. a fixed rate, not the ugly end of an ARM), and applied in cases where the banks can be convinced to write down the loan to bring the home owner above water.

These points aim to do several things:
  • Keep liquidity flowing to business. We're in for a recession -- that's inescapable and happens any time one sector is massively overbuilt; we couldn't not have a recession given how many people were involved in making houses. We really don't need more houses!
  • Help the market "clear" as fast as possible. There is only so much we can do because you don't know which mortages will be bad until more of them reset. But generally we should aim to let the market find its "real" price, rather than slow the decline. Only once bonds and houses are priced fairly will economic activity resume. (Just watch a home buyer in this market - the big fear is "what if we haven't hit bottom yet".)
  • Prevent a foreclosure spiral in housing prices. The danger is that foreclosures force housing prices to artificially "undershoot" to a lower-than-bottom price, which causes foreclosures that otherwise would not have happened. The government needs to ensure that there is enough mortgage lending to prevent this from happening due to a lack of credit.
So there it is. In my next blog I'll solve world hunger.

No comments: