September 30, 2008

The Pearlstein Option Reconsidered

Clearly, we need a new proposal for the credit catastrophe... a proposal that is both workable and passable in the current 110th Congress (the 111th will almost certainly be worse). But allow me to start by looking at one that is obviously un-workable and un-passable.

Read this war statement by Rep. Michelle Bachmann (R-MN, 100%) "explaining" her Nay vote on the Paulson rescue plan; she first exults in her triumph, then enunciates her putatively new proposal. The statement was quoted rather approvingly by John Hinderaker as a good example of the "conservative case" that could be made against the plan:

Today marks an historic moment for America as a solid bipartisan majority of Congress rejected the fatally flawed Paulson Plan. Standing shoulder to shoulder with taxpayers, we declared that we can do better.

As I’ve stated previously, this plan was rushed, unworkable, and short-sighted. A majority of House Republicans have parted ways with President Bush on this plan and we demand that alternative proposals be put on the table. There is universal agreement that this plan was bad, but its supporters claimed it was the only option. There were alternatives available, but Speaker Pelosi and the Administration chose to ignore them and used every parliamentary trick in the book to stifle debate. Now, they will have to listen to the voices of American taxpayers who refuse to open their checkbooks to Wall Street to write a $700 billion check with no strings attached.

I support a plan that would have Wall Street bail itself out, not hardworking taxpayers, by requiring institutions to insure troublesome assets that are causing today’s credit crunch. It would suspend mark-to-market accounting, which forces companies to take losses on artificially devalued assets on an artificial timetable, to give investors more confidence.

The plan I support would break up Fannie Mae and Freddie Mac -- government sponsored enterprises that are at the heart of this crisis -- so that the encumbered taxpayer no longer backs them -- implicitly or explicitly -- and so that they do not artificially grow larger than the market will allow. We cannot pass legislation that sets America up for a Groundhog Day reprise of this mess and that means changing the problem at its core - the GSEs.

Furthermore, the plan I support suspends capital-punishing tax rates to bring more capital into the U.S. markets rather than our foreign competitors. And, the plan ensures the Federal Reserve’s attention is focused on long-term price stability rather than short term economic growth. Finally, it requires the US Treasury to write rules keeping executives who made the risky decisions from personally profiting from them with excessive compensation or golden parachutes all at the expense of taxpayers. We can't have a market that only condones risky behavior. The balance between risk and reward is an important part of the free market.

My colleagues and I stand ready and willing to negotiate with any parties on a plan that will help stabilize our financial markets and relieve the liquidity crisis without exposing taxpayers to a $700 billion bailout debacle.

What is wrong with this picture? Two things:

First of all, in the first blue-highlighted passage, she falsely -- even mendaciously -- caracatures the Paulson plan as a bid to "open [taxpayer] checkbooks to Wall Street to write a $700 billion check with no strings attached."

This is demagogy, pure and simple; it's as bad as Squeaker of the House Nancy Pelosi's (D-Haight-Ashbury, 93%) "history lesson" on the Bizarro-world origins of the crisis in the "unregulated, anything goes" economic policy of the Bush-McCain administration.

Bachmann knows better; she knows that nobody is writing a check to "Wall Street" (is that what Paulson scribbles on the "pay to the order of" line?); that we would in fact be buying securities that are underpinned, at their core, by real property; that the initial cost would be much less than $700 billion; and that the most likely outcome is that those securities would rise in value, so we would make back much of what we spent... and maybe even make a profit.

(We know that House Republicans understand this, else why would they have fought so hard to get a provision ensuring that all "profits" would go to pay down the federal debt?)

But apart from the libelous description of the rejected plan, there is another problem with Bachmann's statement: The centerpiece of Bachmann's own alternative is the same insurance-only option Democrats already rejected.

Why would the Democrats make an abrupt about-face and support it now? After deliberately (most now agree) killing the plan in the first place, does anybody honestly believe that they will now do everything in their power to give the Republicans a huge, huge victory -- right before the election?

The insurance option was never very well explained, and I for one cannot fathom how anyone could think that it, all by itself, would inject enough liquidity to unfreeze the credit market. For one reason, it requires massive insurance premiums to be paid on very, very insecure securities by the same firms that have no capital to pay anything. That's the whole problem... they have no liquidity, and they cannot borrow any money.

What are we supposed to do -- lend them the money to pay for the insurance premiums we charge them? Isn't that a lot closer to "opening taxpayer checkbooks to Wall Street" than the plan they rejected?

It is surreal to offer as a "plan" for resolving a congressional impasse the very provision the other side has already declared a deal-killer. It is absurdist to pretend that this time, everything will be different. Why -- does she think Democrats are now contrite? And it is breathtakingly hypocritical to reject a plan on the grounds that it constitutes writing a check to Wall Street... and then offer in its place a plan that constitutes writing a check to Wall Street.

If there were other new ideas in her "plan" besides the insurance option, something that Democrats had not already emphatically rejected, it might be a good basis to begin negotiation on a compromise. Here are the other ideas she proposes; see if any strikes you as either original or able to resolve the current crisis in any reasonable period of time (that is, before the axe rolls):

• Suspend (why not eliminate entirely?) "mark to market" accounting, which forces even those firms that have no intention of selling a security nevertheless to revalue it everytime some other panicked or desperate institution dumps it below the current price -- thus devaluing the reserves of even healthy financial institutions, holding them hostage to the sickest.

This is a good idea -- but not only was it already in the previous bill she voted against, it can only help somewhat... and almost by definition, only helps those institutions that are the healthiest anyway. We need a way to prevent hundreds of unhealthy firms from going belly-up right now.

• "Break up" Fannie and Freddie "so that the encumbered taxpayer no longer backs them -- implicitly or explicitly."

I have no idea what she means here: just remove their status as government sponsored enterprises (GSEs), so they become private institutions instead? Or forcibly dismantle them?

While that takes the taxpayer off the hook for propping them up, which is a worthy long-term reform, how does that make either more solvent right now? Wouldn't both Fannie Mae and Freddie Mac then immediately collapse, forcing them to flood the market with more than a trillion dollars (!) of currently toxic, illiquid instruments?

• Temporarily suspend the capital-gains tax.

Again, a wonderful idea for the long-term (but let's make it a permanent elimination)... but how does this help now? Does Rep. Bachmann actually think that those firms currently in danger of sinking under the waves are worried about being taxed on some huge capital gain? In fact, as we discussed earlier, suspending the tax removes the incentive for firms to write off bad debts for tax purposes, pushing them towards bankruptcy instead.

• Prevent "executives who made the risky decisions from personally profiting from them with excessive compensation or golden parachutes all at the expense of taxpayers."

An interesting argument to make from a congresswoman who goes on, two sentences later, to extol the "free market!" But again, the Democrats are foresquare behind this -- and it would have no short-term impact whatsoever on frozen credit.

• [Ensuring] the Federal Reserve’s attention is focused on long-term price stability rather than short term economic growth.

This isn't a proposal; it's a description of the result that Bachmann hopes will accrue from the other elements of the plan. Congress cannot order the Fed to focus on one thing or another and expect to be obeyed:

What we need is a plan that is both workable -- that is, it would actually help resolve the present credit crisis, not simply a grab-bag of great ideas for making the system better far in the future -- and also passable... something both conservatives and liberals can back. To propose something that is neither is the pinacle of irresponsibility (and electoral stupidity).

I believe several points are imperative; for workability:

1. Such a compromise plan must give a gigantic incentive for somebody with enough liquidity to take the toxics off the backs of the struggling financial institutions before they all collapse, taking the larger economy with them.
2. This "somebody" must be able to make them thoroughly transparent, to give the market a chance to revalue them, allowing subsequent sale.
3. Thus, Mr. Somebody must be able to compel compliance by the former owners in investigating the history of the security.

These three requirements narrow that "whoever" down to some branch of the administration or a proxy that holds the same powers, in my opinion; in other words, this program must be administered by the Treasury, FDIC, the SEC, some other regulatory body, or a corporation administered by one of the above and granted pass-through authority by Congress. Nobody else has the trust, the ready capital, and the regulatory power to make it work.

This doesn't mean that private capital cannot compete with the government for those securities... so long as, in the end, financial institutions are compelled to cooperate with some entity to detoxify their frozen assets and get the credit market moving again.

And for passability through Congress:

4. The plan cannot be something already rejected by one or the other side as a "deal killer." (Liberal Democrats cannot ram through a Pelosi dream-list -- at least not for four months -- because (a) the Senate would filibuster it, and (b) the president would veto it.)
5. Yet it must resolve the central problem stopping House conservatives like Michelle Bachmann from supporting it: putting taxpayers at risk for the huge price tag of what they have dubbed a giveaway to Wall Street.

In an earlier post here, we briefly mentioned an intriguing suggestion, the "Pearlstein Option":

There are some other proposals floating about. Steven Pearlstein in the Washington Post has a very interesting one... Treasury sets up a resolution corporation (as per Paulson-Bernanke); but then instead of buying the illiquid securities with cash, they swap them for preferred stock in the new resolution corporation itself:

My own suggestion would be to structure the rescue around a new government-owned corporation that would be capitalized, initially, with $100 billion in taxpayer funds. The company would use auctions or other mechanisms to buy the troubled securities from banks and other regulated institutions, but instead of paying for them in cash, the government would swap them for an equal number of preferred shares in the new company. (Preferred shares are something of a cross between a bond and common stock.) Those preferred shares would pay a government-guaranteed dividend and could be redeemed by the government at any time. But they could also be used by banks to augment the capital they are required to maintain by regulators.

The beauty of this arrangement is that, rather than protecting taxpayers by having the government take an ownership stake in hundreds of privately owned banks, it would be the banks that would own a stake of the government's rescue vehicle. The government would suffer the first $100 billion in losses from buying and selling the asset-backed securities, but any further losses would be borne by the other shareholders. And should the rescue effort actually wind up making a profit, then the banks would share in that as well.

I believe this could be the basis of a new compromise (sorry, more bullets incoming):

• It would remove the risk from taxpayers and put it back on Wall Street institutions who accept the preferred stock; the only money spent would be the initial capitalization of the resolution corporation, and perhaps some later recapitalization in the early phases (probably less than the $85 billion required by the takeover of AIG... let alone if, say, Bank of Amerca were to go under).
• Nevertheless, by allowing those institutions to count such preferred stock as reserves against whatever they have leveraged, it removes the pressure to sell, sell, sell to get their reserve-to-debt ratio down below the legal minimum.
• Since no significant taxpayer money would be going directly to failed financial institutions, there is no way that any rational voter could consider this a "bailout" of Wall Street.
• The resolution corporation (fully government-owned, not one of those pesky GSEs) would have the legal authority to compel cooperation by former security owners, thus allowing them to create a paper trail of each security. This will make it possible for the market to "reset" those securities by auctioning them off -- generally for much more than they paid for them.
• But because even a government-owned corporation is still a corporation, not the U.S. Treasury itself, other institutions should be allowed to bid against it to buy securities. This creates market forces at both ends, buying the illiquid asset and reselling it.
• Assuming all goes more or less as planned, the resolution corporation will make a profit... thus giving a big incentive to institutions to participate, since the value of their preferred shares in the resolution corporation will rise, giving them even more reserves.
• The Democrats evidently had no problem with allowing the federal insurance idea as an option, not the entire plan, since it was an option in the last bill; I presume this means they'll allow it as an option again.

I hope this idea is at least brought up; I'm sure that a sizeable minority of Republicans now regrets its Nay vote and are looking for an excuse to change it; and I further suspect the majority of conservative Naysayers is quite willing to consider voting Aye -- for a less statist, more free-market proposal such as the Pearlstein Option.

But whatever we do, we need to do something quick. This isn't just the "do something!" disease; we really are on the brink of catastrophe. You know I'm not given to Cassandra-like dire warnings of pending doom... but let's all remember that Cassandra was right, and Troy did indeed fall.

Like a blinking VCR clock, even a prophet of doom can be right once a day.

Hatched by Dafydd on this day, September 30, 2008, at the time of 3:24 PM

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