Tuesday, July 15, 2008

Paulson's huge bet on the economy

We saw today Hank Paulson’s true feathers as a former Wall Streeter. Currently the US Treasury Secretary , he was for a very long time a member of the financial markets, as a former financier from Goldman Sachs. His outline for helping Fannie Mae and Freddie Mac, in keeping with his trader mindset, illustrates that he is comfortable with making unhedged positions based on his readings of the market. Because now, he is making a massive bet with tax payers’ money.

His plan for Treasury to act as backstop to Fannie Mae and Freddie Mac, and his proposal from Congress to give him the authority to do so, but without any specification as to amount or limit, makes this a massive bet in the tradition of what he might have done or approved of when he was still at Goldman Sachs.

In my opinion, the options as Paulson outlines them, look very much like a modification of “prisoner’s dilemma”, as Game Theory economists would call it. In essence, Paulson is trying to avoid having to indicate a real and specified amount for government bailout right now, because he believes that he runs the risk of indicating an amount which may be construed as too small by the market. This would result in a greater run on confidence in the market, which would only make the specified bailout amount futile. However, by keeping the amount unspecified for now, but nonetheless the commitment clear, he is in effect asking for a “blank check”, as many Senators termed it, from the government to support the beleaguered institutions.

In other words, he is trying to avoid committing an expensive but specific amount now, which may turn out useless if deemed unacceptable by the market, in return for an unspecified amount, which might – MIGHT – be deemed acceptable by the market, and hence, diffuse the market panic, and possibly result in the bailout becoming unnecessary.

In a Goldman context, this is an elegant solution. It is a solution based on the reading that much of the turmoil at Fannie and Freddie are also effects of market psychology. Taking away that fear, and instilling confidence back, brings capital back to these institutions, and thereby takes away the need for use of government funds.

In a Goldman context, if this thesis proves incorrect, the risk will be a significant blow to the Goldman capital exposed in this position. Since he is now Treasury Secretary, Paulson’s bet puts the entire US economy exposed. If he loses, it’ s not the capital of otherwise-rich Goldman Sachs partners that will take a hit. It will be the US taxpayer.

If his bet is unsuccessful, this could result in further fiscal problems for the US, which will be felt world-wide. l put forth my own thesis that that kind of hit to the US economy will result in a global recession.

During his testimony, many Senators asked why the Fed’s discount window is not enough to support the 2 Fs. As pointed out by both Bernanke and Paulson, the decision of how much and in what manner any bailout to these institutions is better made at the Treasury rather than at the Fed. They both say that this is more a fiscal matter than a monetary one.

It took a lot of turns for this question, and still the same answer was provided. In my opinion, a bailout is a bailout is a bailout. The main difference between getting bailout funding from the Fed, as opposed to Treasury, is that if the Fed provides the funding, the Fed will just print out more money to fund it. That makes the move inflationary. If they get the funding from Treasury, that will be real money that comes from taxpayers. This will be depressionary.

So in effect, the decision to transfer the decision of whether to help Fannie and Freddie, and by how much, to Treasury is an acknowledgement that inflation is a real threat, and more moves that could exacerbate it will only worsen the economic situation.

So we all arrive at this Paulson proposal, the bet on the market psychology proposal. A blank check, meant to be a strong signal to the market, of government’s commitment to Fannie and Freddie. A blank check, nonetheless, that comes with real commitment, which will likely be cashed in some amount, one way or the other.

Just by how much, nobody knows. Paulson says that he will ensure any funding provided by Treasury will be negotiated to ensure that the taxpayer’s interest is preserved.

But I’d like to know, and for sure, no one can answer this with any specificity. What is the limit that the government can afford to provide, before it becomes an even bigger problem for everyone? At what point do we conclude that Fannie and Freddie’s liquidity problems have just been transferred to the national government?

Then again, maybe the signal alone could be enough to placate the market, and Paulson will come out looking like a genius. Maybe Game Theory needs to come up with a name for this. How about Paulson’s dilemma?

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