“Buy this because it is extraordinarily cheap. The owner must sell right now because…”
This is the opening line of a thousand confidence games. Stories told by well-dressed, smooth-talking grifters. Like many of those sent out to sell the Paulson Plan (which is not dead, as Congress will certainly reconsider some form of it later this week).
The government can buy financial assets from the world’s leading financial firms at prices so low that substantial profits are likely.
Read those words. Confidence tricks require marks, people who believe preposterous statements about promised gains if stated authoritatively and backed with a slick story.
- “The Paulson Plan Will Make Money For Taxpayers“, Andy Kessler, Op-ed in the Wall Street Journal, 25 September 2008
- “Bailout May Be Granddaddy of All Carry Trades“, John M. Berry, Bloomberg, 26 September 2008
- “Taxpayers can still benefit from a bail-out“, Lawrence Summers, op-ed in the Financial Times, 28 September 2008
Not all advocates of the Paulson Plan are attempting to con us. Many are enablers, often economists with unjustified confidence in their ability to use the government’s power to manipulate markets. At this time they are, to borrow Lenin’s apt phrase, “useful idiots” for those who will profit from this plan.
There are a few voices stating the obvious, such as “Hold-to-Maturity is the new Mark-to-Myth“, James Saft, op-ed in Reuters, 25 September 2008 — Excerpt:
“Now what the hell is a ‘held-to-maturity’ price, and how in the world can an auction or ‘other mechanism’ be devised that gives the market a good idea of ‘hold-to-maturity’ prices — since there is no such thing?” economist Thomas Lawler, a former Fannie Mae portfolio manager and founder of Virginia-based Lawler Economic & Housing Consulting, wrote in a note to clients. “Of course, everyone knew what he meant: ‘held-to-maturity’ means ‘above market.'”
The hope, presumably, is that the subsidy given by buying up debt for more than it will fetch on the open market will be enough to prop banks and attract new investors.
Why will we probably lose money on this plan?
The historical analogies used to support this plan fall into two general types.
First, narrow problems (aka special situations). Such as our loans to Mexico and Chrysler. Chrysler was saved with the aid of some large government contracts and new management. Mexico was in trouble in 1994, but hardly a bankruptcy candidate. Neither are at all similar to the current conditions or the measures in the Paulson Plan.
Second, the loans to homes and businesses during the Great Depression (e.g., the Home Owners Loan Corporation). These measures were broadly similar to the Paulson Plan, but with one essential difference. These measures were put into effect in 1934 and thereafter. The recovery, sparked by WWII, was years away. But there were two major differences. Most of the damage had already been done, and loans were made to going concerns or on the basis of tangible assets (e.g., homes). The Paulson Plan purchases will be made on assets of uncertain value — in the early phases of the recession.
Neither of those things make it a bad plan (there are many other reasons it is a bad plan, discussed in earlier posts listed below). Just that these factors make it unlikely that the Paulson Plan will turn a profit — or even break even. The results depend on the exact terms of the final bill (yet unknown) and its implementation by Secretary Paulson and his successor.
If not the Paulson Plan, then what should we do?
That is a complex question. For a simple answer see A solution to our financial crisis.
Afterword
If you are new to this site, please glance at the archives below. You may find answers to your questions in these.
Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
Some FM posts about the current crisis
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Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
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High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
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Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
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Another voice warning about the nationalization of AIG, 18 September 2008
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A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
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A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
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Another step away from our Constitutional system, with applause, 19 September 2008
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What do we know about the financial crisis? What are the key questions?, 20 September 2008
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Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
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America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
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Legal experts discuss if the Paulson Plan is legal, 21 September 2008
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Essential steps to surviving the current crisis, 23 September 2008
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How should we respond to the crisis?, 24 September 2008
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A solution to our financial crisis, 25 September 2008
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Is the US economy in good shape, or in terrible shape?, 27 September 2008
For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.
Funny, I’m convinced the US is in deep doo doo over too much debt, yet also that it has strong enough fundamentals in many real-productive areas that this crisis is not yet THE big debt crisis.
Well, the (first?) bailout bill failed, I’m glad. The gov’t should be buying low cost houses, perhaps at 50% of their prior mortgage price, or close to their 1995 price.$400 bln. can buy 2 million avg $200 000 houses — then the gov’t can provide as much ‘low cost (loss)’ housing as the Dems push for successfully, with a clear cost.
There will be no profit on paper the gov’t buys. The paper value is gone, or will be by the time any gov’t agent buys any.
The maybe $2 trillion dollars of over-value that has disappeared was funding a huge amount of building … and finance groups. The finance groups are too big, too many employees, they need to shrink really really fast. Depression level job losses in big banks.
That’s what the bailout is supposed to save — the buggy whip makers after Ford. Bad mistake.
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Fabius Maximus replies: Since you never respond to my evidence that this analysis is nonsense, there is no point to repeating my objections.
Another possible solution to excess housing:
Increase immigration. Why not advertise to foreigners? Eliminate those silly English only rules. Make our country hospitable. Try to convince the American public that it’s for our own good.
It might happen anyway, as the foreigners switch from T-Bills to hard assets, and gain a controlling stake in the economy.
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Fabius Maximus replies: How sad that almost 2 years into this crisis most Americans still believe it is a mortgage or real estate crisis. Time will bring greater insight into the broader roots of the problem.
This Crisis have eliminated any chance of any focus on REAL economic weaknesses , structural weaknesses , for example the Decaying industrial base, the lost competitvness, and the service-ONLY economy that you grandchildren will inherit.
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Fabius Maximus replies: I do not understand the basis for your comment.
(1) The US in not a centrally planned econmoy, and so the government does not plan or direct such things.
(2) The lost competitiveness is largely a function of the US dollar’s overvaluation. Even so exports have been rising for 35 years as a % of US GDP — esp. strongly in the past few years. See the second graph in Can you see the signs of spring in the coming of winter? A note about the recession. A substantial devaluation of the US dollar will restrore the competitiveness of our goods and services and eliminate the trade deficit.
(3) What evidence is there of a “Decaying industrial base”? Why is manufacturing better than services? Manufacturing was 28% of GDP in 1953, 15% in 1993, and 12% in 2006. But services, such as software and entertainment, have increased — producing total export growth.
Samer, so petition your local government representatives. The Crisis that you speak of has been 30 years in the making. In that time, what focus has there been on the ‘REAL’ economic weaknesses that you bring to our attention, and what have you been doing about it all this time?
You know, we may have a sense of disdain for the French in regards to some things, but the Frogs sure could teach the English speaking world a thing or two about public outrage and organised protest.
If only we could tap Apathy as a power source, we would have an unlimited supply of green, renewable energy for the rest of eternity…
I don’t exactly mean to talk past your posts, but we’ll continue to disagree on the depth and scope of this crisis at this time.
Here’s a WSJ note: “The Depression of 2008? Don’t Count on It“, Jason Zweig, columnist for the Wall Street Journal, 30 September 2008.
Besides noting that the Fed is ready to provide a lot of cash/liquidity (unlike 1929 or 1873), it tellingly states: U.S. nonfinancial companies have just under $1 trillion in cash on their books. Even though Wall Street is dead, innovation is not: In the months to come, clever new financial go-betweens will spring up and find a way to get that cash flowing again.
I’m pretty sure $1 trillion in cash means the non-financial, non-building US companies are not about to go into depression. Challenge question: how much cash do the non-finance companies have to have before you’d agree their level of cash makes them ‘fundamentally’ sound? Or, where is your evidence that cash on hand is not relevant?
My understanding is that your blog and evidence is to show this current crisis is MORE than the huge housing / finance meltdown. My own current view is that the crisis is mostly in housing and Big Bank finance; and that some meltdown in finance, an intermediation role, was inevitable as the MBS ‘product’ became unwanted by investor buyers. OK, with the further complication of a big energy price shock.
My speculative proposal of the gov’t buying houses seems ‘an act of faith’. Evidence that this is nonsense: if you know of a case where there was overbuilding and overpriced houses, which a gov’t then bought the houses and that didn’t significantly reduce the crisis. (I don’t know of such a case. Nor does your evidence so far show one.) Certainly speculative, but at least it seems like an alternative a lot of Reps could push instead of the more speculative Paulson plan.
Your solution depends on stabilizing the financial sector. I claim that can’t happen until after the house prices have stable values — because only with much less uncertainty in house prices can the MBO financial instruments be valued and thus allow banks with MBOs on their books to have stable values.
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Fabius Maximus replies: You are not talking past my posts, you are ignoring my objections, hence my increasingly blunt references to your quack nostrums. They are significant, as I suspect the American people are in general equally unaware of our actual situation.
House prices are not the causes of this crisis, they are a symptom (or effect) of the underlying problem (excessive debt accumulation). Efforts to stabilize asset prices at above market levels are a traditional method of responding to deflation, with a uniformly poor record.
“Besides noting that the Fed is ready to provide a lot of cash/liquidity”
How bizarre to consider this significant. The Fed has already supplied vast amounts of liquidity (see this chart of the US Adjusted Monetary Base. To know visible effect. Why think that providing more will have a greater effect?
“Or, where is your evidence that cash on hand is not relevant?”
That many economic actors have large cash reserves is irrelevant. US households have vast reserves of cash, as seen in the Fed’s Flow of Funds reports. But bankruptcies and foreclosures are skyrocketing nonetheless. The reason is obvious and fundamental. Economic actors are not a unitary entity, so their aggregate condition means little. The distribution is more important that the average.
In plan language, Bill Gates might have a billion in cash. But he will not share it with the millions of people unable to make their mortgage payments. Ditto for businesses, which at the same time have 50-year low average bond ratings AND record high levels of cash. The ones with cash will not bailout the ones going under.
This logical fallacy results from a misunderstanding of simple statistics. As in the old story “if your feet are in the oven and your head in the freezer, your average temperature is just fine.”
Credit markets are not working now (look at the TED spread, the near-zero yield on T-Bills, spreads to Treasuries on corporates, cds levels). Why is this happening? Investors have become super risk averse.
There will be large negative consequences from credit markets not working (economic growth requires ongoing expansion of credit, companies have short term debt that needs to be refinanced).
A major goal of any plan to fix things needs to be causing investors to become less risk averse (so that they will once again start buying things from commercial paper, to corporates, to mortgage-backed paper). So long as investors remain amazingly risk averse, things will be bad.
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Fabius Maximus replies: Like most financial analysis today, this confuses causes and effects. The risk aversion is an effect of deeper causes in the real economy, and cannot be directly treated. Folks in the financial industry often forget that there is a real economy, and they are only a tiny part of it. This is the “What’s good for {us} is good for America” fallacy (this is a misquotation of Charles E. “Engine Charlie” Wilson, at his confirmation hearings to become Ike’s Secretary of Defense).
(FM) “The Paulson Plan Will Buy Assets Cheap. . .”
Worse than that, the financial firms will be able to shift their illiquid assets around to make sure the Treasury buys the worst of them.
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Fabius Maximus replies: That’s the role of marks in the finanical ecosystem, to believe when they are told “these assets are cheap; easy profits for you”.
I once asked a con man how he justified what he did (everybody has words to live by). His reply: “Stupid people do not deserve to have money.” He saw himself as a Darwinian agent in the world, increasing its efficiency by moving resources from the stupid to the smart.
FM: who are you to say what are the causes of super-high risk aversion or that this cannot be addressed directly? Bill Gross was on CNBC yesterday, basically saying that so long as congress fails to act on something systematic, he will continue to put his assets under the mattress. Given that he manages more than $500 billion, my guess is that his not changing his risk averse stance means the credit crunch persists. Actions causing him to change his view strike me as addressing investor risk aversion rather directly.
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Fabius Maximus replies: Risk aversion is a psychological condition. If you have telepathic powers, then you can directly affect people’s thinking. Government efforts to do so have a near-perfect record of failure. How many people even remember the Treasury’s Hope Now alliance, in October 2007? Or President’s Ford’s Whip Inflation Now program?
Risk aversion is being caused by systemic events. We can directly affect the system, but not the psychology of investors.
Inadequate analysis is IMO a major reason why after 22 months — and repeated government programs — both markets and the economy continue deteriorating. Our leaders prefer fiddling with the controls hoping to produce some psychological reaction in the masses, rather than addressing fundamental problems.
Correct diagnosis is necessary for effective treatment. When we finally do the former we can consider ways to do the latter.
FM: the various markets’ strong reactions immediately following political events related to the credit crisis are evidence as to changes in investor risk aversion which can be caused by political events.
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Fabius Maximus replies: Yes, the market responds to real world events. Does anyone disagree? Changes in the risk premium are a quantitative measure of changes in people’s risk aversion.
And your point is?
FM: I thought you were arguing that we can’t do things to cause risk aversion to change in predictable ways. I’m saying that the market reaction following the no vote on Monday points to our ability to change investor risk aversion in predictable ways, at least in certain cases. Doing something perceived by investors as a systematic attempt to shore up the credit markets will there fore likely result in some moderation of risk aversion and, as a result, generally higher prices and a huge increase in liquidity for various securities.
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Fabius Maximus replies: This seems a bit confused.
“I’m saying that the market reaction following the no vote on Monday points to our ability to change investor risk aversion in predictable ways.”
You believe that Congress voted against the Paulson Plan, deliberatly intending to increase risk aversion and crash the market? As a naif, my interpretation is that the crash was an unanticipated result and illustrates the unpredictability of changes in investor psychology.
I have explained the theory, why we should direct our corrective measures to the fundamental problems — not investory psychology. I have given historical examples of how such measures have failed in the past (do you have examples of successes?). There is nothing more to say. If you respond to my points, I can reply.
FM: Point was just that on Monday, it was pretty clear that markets were discounting with some probability a yes vote from the house, and that investors tended to think the plan was a step in the right direction. As a result, it was clear before that vote that a no vote would result in increasing risk aversion, and the result of that would be markets tanking. Just how negative would be the market reaction to a no vote was not clear, but certainly the direction was predictable. Thus, I’m arguing that investor risk aversion can be affected, at least directionally, but either implementing or not implementing some kind of systematic attempt to fix things. I hope it’s not yet too late.