“What ... is the challenge [the US financial system faces]? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his "troubled asset relief programme", is that "the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. .... By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies. ....
Given the recent explosion in leverage [borrowing], the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly. ....
[T]he Paulson scheme ... can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.
... [A] scheme for dealing with the crisis must be able to remedy the looming decapitalisation of the financial system in as targeted a manner as possible. ....
The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system [, and] ... they would require not a penny of public money.”
Martin Wolf, "Paulson's plan was not a true solution to the crisis", Financial Times (24 September 2008).
http://www.ft.com/cms/s/0/a09b317e-898d-11dd-8371-0000779fd18c.html.
Martin Wolf is associate editor and chief economics commentator at the Financial Times. Luigi Zingales' proposal discussed by Martin Wolf here is the subject of the Tdj “One professor says Paulson's bailout of financial institutions follows the wrong approach”. It can be found at: http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf.
Two developments in the ongoing financial crisis over the past few days are of interest: First, opposition to the Paulson Plan seems to be increasing and for the reasons outlined by Zingales. Second, the FBI and SEC have begun an investigate of Fannie and Freddie, Lehman Brothers and AIG looking into misconduct by their executives.
It is by no means clear how this will all work out, either on Wall Street, Main Street, or Pennsylvania Avenue.
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