Saturday, September 20, 2008

Who should we be bailing out?

Paul Krugman posts an interesting question

There’s something I don’t quite understand about how the big rescue plan is supposed to work. Maybe this is naive; but let me put it out there.

So, here’s my problem: what we have now are a bunch of financial institutions in trouble, because they’re highly leveraged, and have mortgage-related assets on their books. And they can’t raise cash because nobody wants to buy those assets. The Paulson plan will in effect create a market for toxic paper, thereby supposedly unfreezing the markets.

But what if the institutions are fundamentally broke, even if the liquidity squeeze is relieved? I think of a hypothetical institution, which tradition says we should call Capital Decimation Partners. CDP’s balance sheet looks like this:

Decimation doubtsNow, obviously CDP is in trouble if it can’t sell the toxic waste at all. But suppose that Hank Paulson does his reverse auction, and it turns out that the Treasury’s price for toxic waste is 40 cents on the dollar. Even so, CDP is still underwater. So what does Treasury do then?

One answer, I suppose, is that we think that there aren’t too many firms in that position — and that those that will still fail, even with the Paulson Plan, aren’t going to disrupt the markets too much when they go down. But do we know that?

What I haven’t heard anything about is how Treasury might recapitalize firms that will be bankrupt even with the purchase facility, yet need to be kept in being. So I’m starting to worry. Is this the son of MLEC, another

My take is that the institutions that resemble this example, with this level of leverage, are likely hedge funds and investment banks. The Fed should allow them to fail.

Commercial banks and insurance firms, the ones who provide the real liquidity to the market, should be the focus of the bailout plan. They should be the ones first in line for any RTC-type program.

But particular focus should also be on the likelihood that many commercial banks are likely to end up writing off large amounts of loans to the failing investment banks and hedge funds. Too big a write-off could result in a run on the commercial bank.

My guess is that those highly leveraged investment banks who are trapped with too much toxic assets will be folded into their largest lender. This will be tricky though if these funds have a lot of different lenders. Implementing a solution will be like LTCM to the nth degree.

Update: Paul Krugman's new post links to a draft of the Paulson plan. The first two sections of the plan:

(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

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