Is Paulson’s plan the cause of the current financial gridlock?

“I am concerned that the bailout might be the cause of the problem that it purports to solve.

Treasury Secretary Henry Paulson described the problem as follows:

“The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy. When the financial system works as it should, money and capital flow to and from households and businesses to pay for home loans, school loans and investments that create jobs. As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.”

The heavy use of the plumbing metaphor almost makes one picture Paulson with his pants riding down a couple inches, leaning over a financial toilet bowl. It is clogged with unwanted securities backed by mortgages, supposedly because the sellers cannot find any buyers.

However, the market could be clogged because the prospects for a bailout are destroying the motivation to sell mortgage securities. If you sell this week and take a big loss, you will look pretty stupid if there is a bailout next week where comparable securities fetch much higher prices.

It could be that a Congressional rejection of the bailout proposal, rather than clogging the markets, will unclog them. If Congress goes home having sent financial institutions a clear signal that there will be no bailout of any kind, then sellers will bring their securities to market, and we will find out what the market thinks they are worth.

In the worst case scenario, the market will assign low values to the securities. Firms that are sufficiently capitalized to hold mortgage securities will earn profits at the expense of weaker companies that have to sell securities or go bankrupt. In the end, it may turn out that the winners really took advantage of the losers. That is capitalism at work in financial markets.”

Arnold Kling, “An Alternative to the Wall Street Bailout”, Pajamas Media (24 September 2008).

http://pajamasmedia.com/blog/an-alternative-to-the-wall-street-bailout/


Arnold Kling is an economist who worked at the Federal Reserve Board in the 1980s and at Freddie Mac in the 1980s and 1990s. He blogs at Econolog.

Dr. Kling could well be right. What has paralyzed financial markets are not toxic securities but the uncertainties surrounding any action the government might take. Anyway, why would the average American want the Treasury (or some agency linked to the Treasury) to buy these securities at a high price when the private sector might buy them at a low price? Why should I care if the assets of some financial institution are sold at a low price? I’m not affected by the transaction? On the other hand, I would be negatively affected if the Treasury bought the securities at a high price and later sold them for much less. Now I’ve lost, because the difference will have to be made up by my taxes.

The government (both the Administration and the Congress are backing this plan, with only the most minor of differences in positions) argues that by buying the securities they will be providing the banking system with the capital they need to function as a financial intermediary and the banks will once again be able to extend the loans non-financial firms and other users of credit need. But even if the presently illiquid securities were sold at a low price, the funds they brought into the banks would help make them make financial viable, and the banks could be further recapitalized by eliminating their dividends for a few years and if necessary floating more stock for additional capital. If the newly issued stock of the banks were considered unattractive investments, Congress might consider waiving taxes on bank profits for a few years if the profits were reinvested in the bank. There are many things that could be done to re-capitalize the banks without dipping into the government’s coffers.

The government has moved to hastily on this matter. Nowhere near enough pressure has been applied to all these financial institutions to fix their problems themselves. As Dr. Kling implies, let the market sort it out. In the end, the market will restore normality to the financial sector as fast as it takes Congress to act and it will do it without a drain on the public purse.