What Is To Be Done?

Throw money at it, apparently. The Times reports on the bailout plan. The proposed text of the legislation says:

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.

Sure sounds like blank check.

Ever-snarky Willem Buiter dubs it the TAD (Toxic Asset Dump), but he does have some constructive suggestions on making it work, including:

The price at which the illiquid assets will be acquired by the TAD will be crucial for its effect on future bank behaviour. Prices should be higher than what the banks that own these assets now can obtain in the market, but as far below their fundamental value as is consistent with the survival of these banks. This is both to protect the tax payer and to create the right incentives for future risk taking by the banks. Punitive pricing is therefore essential. If the banks and their shareholders don’t complain loudly about expropriation through under-pricing, then prices are too high.

Since those managing the agency are unlikely to have much of a clue about the fundamental value of these illiquid assets, the TAD should arrange reverse auctions as price discovery mechanism. I recommend a reverse Dutch auction as a particularly effective mechanism to transfer value from the banks to the tax payers.

Paul Krugman, who has generally been a Bernanke-booster, is dubious:

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

Some are floating an alternative aproach, which would involve the government making equity investments in banks. The Washington Post's Sebastian Mallaby writes:

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Krugman comes to a similar conclusion. Here is Calomiris' FT piece.

Also, Peter Baker profiles Paulson and Bernanke: could the "'The Hammer' and 'Helicopter Ben'" be buddy movie?