Tuesday, September 23, 2008

Skepticism Over The Treasury Plan

I don't want to pretend I know what you're thinking when it comes to the government's plan to address the mess in the financial system. It may be something like this though:
Thank goodness someone has a plan. Don't bother me with the details, just do what it takes to fix it and let's get on with our busy daily lives.
That's pretty much how I reacted when I learned we had termites in our walls.

When the bill ranges in the billions of dollars, though, we probably should bother to stop, learn a little bit more, and ask a few questions before plunging ahead.

First, a summary of the problem via Paul Krugman:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

Next, a summary of the Treasury's proposal to address it. The Treasury would be legally empowered by an Act of Congress to purchase troubled assets to promote market stability and "unclog" our financial markets. The limit on this authority would be set at $700 billion. The assets are "intended to be residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans." The government would sell off the assets once they regained some value.

One big question will be "how much will the government pay?" As law professor Hal Scott notes, pay too much and the public will be outraged. Pay too little, though, and we'll fail to accomplish our objective. Another is whether this is even the right model. Some, such as Krugman, have suggested that the Fannie Mae bailout from a few weeks ago is a better model, with the government actually taking ownership.

I'd like to think that there's a little time for rationale discussion and that the markets, knowing that help is on the way in one form or another remain calm. Otherwise, we'll just need to buckle in.

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