The Paulson doctrine(s): Part 1, prevent the Second Great Depression
By their works ye shall know them, as the saying goes, and over the last few weeks, we have found the world’s financial markets gyrating hysterically as they seek to decipher what the new ruling troika of Paulson, Bernanke, and Geithner will do next.
New York Times: Ben Bernanke, far left; Tim Geithner, far right
With SEC Chairman Chris Cox and Treasury Undersecretary Bob Steel caught in the middle
Surprise an animal and its first instinct is to freeze. As I wrote last week, with the passage of new legislation, Treasury/ Fed gained ‘too many powers,’ with so much financial clout, and precision to wield it, that they could just about dictate the value of quite specific classes of securities. Although the powers were first revealed in March, when by banking on value, Treasury/ Fed arranged the shotgun marriage of Bear Stearns to JPMorgan Chase, that was seen as an isolated event.
What really spooked capital was reading the litany of new authorities granted to Treasury/ Fed in July by HERA, powers to control the GSEs, the world’s liquidity facility.
I promise to use my omnipotence for good
Realizing that virtually any GSE currency could be appreciated or depreciated at whim, global capital markets slowly seized up, and the GSEs’ downward spiral into conservatorship became a self-fulfilling fear. By sitting on the sidelines, capital was demanding that Treasury establish a set of rules governing deployment of these powers.
“Provide stability, support availability, protect taxpayers,” was the mantra Secretary Paulson repeated to his troops and to the markets, but that fine phrase doesn’t define or limit behavior. Those aren’t rules or operating principles, they’re observable conditions by which to judge actions.
Yep, it’s working
The markets wanted rules – it’s been getting cases. By their decisions ye shall know them, and stake by multi-billion-dollar stake, Treasury is defining the boundaries of what economic historians will come to call the Paulson Doctrines.
Based on what we’ve seen, here they are, in descending order of priority
1. Prevent the Second Great Depression. This is Job 1, and it’s always been Job 1.
That’s the lesson of the AIG loan. Saving AIG had no explicit statutory basis – AIG is not a counterparty of the Federal government, not a regulated entity, nothing more than a gargantuan reinsurer of a myriad of risks scattered around the globe. Treasury found some existing authority for its action – because Treasury went looking for it.
We live our lives in morbid preoccupation over some remote risks and in happy ignorance of other much more severe risks all around us. Just as we never think twice about the miracle of a cell phone call or how an email finds our Blackberry, we have faith in the pieces of paper in our wallets called money.
You have to believe my signature is worth it
We accept that figures on a computer printout equal wealth. We take for granted that money in the bank will be there for us when we want it – even if millions of us all want that same money at the same moment.
These beliefs can be shaken, and when they do, people panic.
Not so wonderful life
The herd being observant, panic is contagious – in
It didn’t happen here: Northern Rock
As used to be said of the Devil, naming calls. Although the phrase is never voiced, I am sure prevention of the Second Great Depression is uppermost in Chairman Bernanke’s mind, for whether by accident or serendipity, we have exactly the right Federal Reserve chairman for this moment, who’s been studying the Great Depression his whole life:
Having devoted much of his career to studying the causes of the Great Depression, Bernanke was the academic expert on how to prevent financial crises from spinning out of control and threatening the general economy.
Several times the capital markets have been in danger of cramping up. Each time Treasury/ Fed has acted, with enormous bets.
One line from his “Essays on the Great Depression” sounds especially prescient today: “To the extent that bank panics interfere with normal flows of credit, they may affect the performance of the real economy.”
That’s the only lesson I’ve taken away from Black Tuesday and the 1929 crash – at precisely the moment when fortitude would win the day, capital fled.
Take up the flag, and charge!
Personally, I have no qualification to opine on whether backstopping AIG was the right thing to do – and frankly, 99.999% of the people who claim an opinion on this subject have even less qualification than I have. I can guarantee you that Messrs. Paulson, Bernanke, and Geithner think it was the right thing to do, and among the three of them they’re far more thoroughly qualified than any other three people in the world. Comes the moment, comes the men.
“God protects fools, drunks, and the
“We have not journeyed across the centuries, across the oceans, across the mountains, across the priaires, because we are made of sugar candy.”
2. Keep the GSE(s) in the loan-buying business. That’s the lesson of the dual conservatorship – not just Freddie Mac but also Fannie Mae. As I’ve documented elsewhere, Fannie Mae has been clearly stronger than Freddie Mac – in market share, and most particularly in its recent recapitalization. When Treasury made its moves that fateful weekend, Fannie’s now-former CEO Dan Mudd argued passionately that Fannie need not go into conservatorship, but his objection was briskly overruled – and the only plausible reason is the necessity to make crystal clear that both GSEs would be in the loan-buying business.
Had Freddie Mac been under conservatorship and Fannie Mae not, a gap would have opened up in their loan pricing, as investors flocked to Freddie securities and away from Fannie’s. That kind of differentiation had already been taking place in the weeks before conservatorship, as investors were buying Treasuries and selling Fannie/ Freddie.
“Too big to fail” is a cliche too casually bandied about. This time it was real:
Secretary Paulson, September 7: Clear enough for you?
Keeping the GSEs in the loan-buying business is also the message behind the specific actions taken on the securities, such as underscoring that both GSEs may continue to enter into valid and binding contracts.
Now that both GSEs have been taken into conservatorship, the next question to be asked is this: Do we still need two of them?
Two GSEs enter. One GSE leaves?
3. Do as little as possible, if that. Paraphrasing Chili Palmer, this is Job 3. That’s the lesson of Lehman.
Be cool, okay?
If the government always rides to the rescue, people take silly risks – that’s moral hazard, whether it applies to extreme skiers wanting the National Guard to airlift them off frozen mountains, or traders making huge option bets they can’t cover. While editorialists wail about moral hazard, Messrs. Paulson, Bernanke, and Geithner have forgotten more about it than most of us will ever know.
Doing as little as possible is also the lesson of the AIG capital injection: a loan. A loan is less intrusive
than a direct takeover, and more akin to emergency financing, less like a private-equity raid.
We’re private equity and we’re here to kill all the women and rape all the cows
[Continued tomorrow in Part 2.]
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