Saturday, September 27, 2008

What is to be done?

UPDATE: The post below was composed on Friday and Saturday, so the news is a little outdated.

The distinction I made is parallel to the distinction Virginia Postrel makes in her recent post between the "illiquid" (the immediate credit crunch, the unwillingness of lenders to lend) and the "insolvent" (the narrower and longer-term problem of serious restructuring or bankruptcy, caused by mortgage loans not performing or in default). She also makes the wonderful suggestion that any net profit Treasury makes on federal intervention should be rebated directly to taxpayers.
The Paulson-Bernanke proposal for a financial sector bailout still seems to be floundering in Washington. The House Republicans, at last report, are still split on the idea, and without a united front from them, the Democrats are not willing to jump in alone.

For a moment, set aside the economics of the proposal and focus on the politics. The Congressional Republicans suffered in the 2006 elections from the perception that they had completely lost it on restraining federal spending. They had also spent six years in partisan lockstep with Bush on spending, expanding government, and the Iraq war. Enough conservative and independent voters got pissed off by the Republican abandonment of anything resembling conservative policies that many just stayed home or, in some cases, voted Democratic. The Republicans lost control of Congress.

That painful lesson floats in the background now as the House Republicans struggle with the question of whether to support the plan. Some support it because they think it's a good idea, and others oppose because they think it's bad. What hangs in the balance is how much Bush can call on simple partisan and personal loyalty. He lacks the automatic Republican support he enjoyed in his first term, and thus we see a political cliffhanger.

Now turn back to the economics of the plan. Paulson and Bernanke got themselves in some trouble because they failed to explain the situation and their proposal completely enough.

Some of the problem is everyone's ignorance about when and where the housing market will bottom. That event will be crucial in determining the final, diminished values of the assets that back the financial paper (bonds and other credit instruments) that many now suddenly mistrust. Those values in turn will determine the ultimate losses that lending institutions, depositors, and bondholders will face. Many will just have a bad day; a subset will suffer large losses; a subset of that subset will go bankrupt. No one knows the full scope yet. Yesterday's Washington Mutual failure threw some more paint on the canvas and filled in another part of the still-incomplete picture.

Paulson and Bernanke are also wrestling with a crisis that has two very distinct parts, subcrises with different origins, time horizons, and consequences. Their plan addresses both at once, which was probably a mistake, and thus evokes a lot of skepticism.

There's a large advantage to separating these two parts. Part two will take a few years to fully work out and make sure that the government is not overpaying for distressed assets. No one can make those judgments now -- it's too early. At the same time, part one can address the credit crisis right away, but through short-term loans, not buying up assets.

Part one, the credit market crisis, is immediate and needs to be confronted quickly. Failure here would cause severe economic problems, as short-term credit acts as quasi-money for businesses, government, and individuals. If banks and other lenders suddenly decide all at once to stop lending, we will have something like the Great Depression on our hands. The Fed is already acting as it should to prevent this, keeping low the interest rates it controls (federal discount and interbank overnight). It also injects cash by buying up Treasury and government agency bonds and exchanges longer-term bonds for shorter-term. All act to keep the money supply flowing, or "liquid," as economists say.*

But it might prove necessary to do more with the credit crisis than the Fed, under its normal rules, can do. The New York Federal Reserve's AIG loan is the model to follow. It's a relatively short loan (twenty-four months) and, during its term, gives the Treasury some say in how AIG is run. The Treasury, by charging AIG interest, is also forcing AIG to pay for the privilege of rescue.** Such an approach is about preventing a short-term credit crisis, nothing else. It should be ad hoc and address serious dangers quickly as they arise with time-limited rescues. It's not about the collapse of underlying asset values (houses, mainly).

Dealing with that collapse is part two of the crisis, where we have to think in terms of a few years or even a decade, not weeks or months. The model should be the Resolution Trust Corporation that dealt with the savings and loan bust of the early 90s. Here's where the RTC-like agency collects distressed assets in a kind of giant fire sale.† It then resells them, not immediately, but over a period of time, to get better prices and not glut the market for those assets all at once. The RTC worked well in the end, costing taxpayers only about $100 billion.†† The initial cost seemed much higher, because the RTC was in buying mode at first. But in resale mode later on, it recouped most of its gross costs. It worked because it spread out the impact of the S&L bust over a number of years, preventing the cost from being felt all at once.
* Bernanke has a strong interest in the Great Depression, when banks failed in large numbers, as the Fed kept pursuing the exactly wrong policy. In effect, it hoarded gold (the dollar was backed by gold in those days) and starved its member banks.

The Federal Reserve is actually not part of the government. It's a publicly chartered, non-commercial private entity that regulates the money supply, which includes not just cash, but various forms of credit and foreign exchange. It's a "bank of banks," which federally chartered banks are required to join and contribute to. Other banks can join too, if they want.

Recently, proposals have been floated to allow non-bank entities (insurance companies like AIG, for example) to join. They would get the help the Fed can provide in a crisis, but they would also have to pony up some of their assets in exchange and accept a higher level of regulation.

** From the government and taxpayer point of view, a loan is better than a guarantee. It makes AIG's assets collateral in case of default. The conditions are more spelled out than a guarantee usually is, and the term is limited in time. Someday, people will thank Paulson and Bernanke for this.

† By themselves, assets are not "distressed." They become so when a loan or some other financial obligation is attached to them that assumes a value well above what they can actually be sold for. Selling the asset raises some cash, but not enough to fully cover the attached obligations.

†† I know, I know - "only" :)

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