What the financial crisis isn’t: Part 3, the way forward
[Continued from yesterday’s Part 2 and the previous Part 1.]
So far we’ve seen that almost everybody is wrong about what the financial crisis is …
1. Not an asset bubble … a systematic under-pricing of risk.
2. Not caused by subprime lending … although that was the miner’s canary.
3. Not principally about the GSEs … because other financial institutions are in much worse shape
4. Not just about housing … although that is the biggest asset class
5. Not specific to the
… and who’s to blame …
We’re just the unum in the pluribus
6. It’s not proof of ‘under-regulation’ … provided we have a reasonable definition of ‘regulation’.
7. It’s not the [
8. There’s no single culprit … plenty of blame to go around, step right up and claim your share.
9. It’s not really rational … but as John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.”
Can we equally debunk possible solutions?
C. What’s the answer?
1. It’s not a bailout
Bailout means charity. Bailout means giving without expectation of recovery. Bailout means letting sympathy trump judgment.
Questionable judgment?
None of these apply to Paulson’s prescription – or Paulson’s patent medicine – whatever will become the common name for the Troubled Assets Recovery Program (TARP) contained within the Emergency Economic Stabilization Act (EESA), yet it’s known as the bailout bill even though, as I previously posted, it may well be a bonanza:
The Paulson premises. Beyond the Paulson doctrines, the TARP proposed by Secretary Paulson is predicated on several premises:
* These assets have an ‘intrinsic value’ – say, what a good evaluator would come up with provided there was plenty of rational money in the market. (That is, they’re probably real paintings – if not Vermeers, then Jan Steens.)
Trash on the floor – yes, that’s Jan Steen
* They have an ‘immediate trading price’ – what you’d get if you sold them tomorrow – which is grossly below intrinsic value, because the market’s acting irrationally.
If Paulson’s premises are right, then Treasury can buy the assets for more than ‘fair market value’ and less than ‘intrinsic value.’
Fair market value, fair value, or some other value? Most definitions of ‘fair market value’ use ‘immediate trading price’ as their measure, except for ‘distressed sales,’ which mean situations where the seller has a financial gun to his or her head. The problem is the entire country is a distressed seller, which screws up the market, so it’s entirely possible to have immediate trading price (the usual best evidence for ‘fair market value’) much, much less than intrinsic value (which is what people use for ‘fair value’).
2. It’s not about giving corporate welfare
TARP isn’t about charity for banks, it’s about selling them their lifeblood – cash – at what treasury expects will be good prices. Indeed, the final legislation includes all sorts of executive stingers, including (excerpts taken from Bingham McCutcheon’s excellent summary):
Warrants and Debt Instruments
Any financial institution that sells troubled assets to the Secretary must, depending on the situation, give the Secretary either a warrant to receive common or preferred stock or a debt instrument. The Act provides the Secretary with broad discretion to determine the percentage of equity the warrants will represent and the Secretary has the right to sell, exercise, or surrender warrants, at any time that it is in the interest of taxpayers to do so.
The warrants will act like an equity kicker in the asset pricing – basically, getting a pieces of the profits likely to be obtained by institutions that offload that illiquid positions.
Equity kickers: boosting returns since Eisenhower played football
Executive Compensation and Corporate Governance
Any financial institution that directly sells any of its troubled assets to the Secretary under the terms of the Act must satisfy certain new executive officer compensation requirements. These include limits on executive officer compensation, the recovery of any bonus or incentive-based compensation paid to a senior executive officer based on a statement of earnings [what we might call the Frank Raines provision – Ed.], gains or other criteria that later proved to be materially inaccurate, and the prohibition of golden parachute payments to senior executive officers. These requirements will bind the financial institution for as long as the Secretary holds an equity or debt position in the financial institution.
From the New York Times: I haven’t given my bonus back – have you?
In situations where the Secretary purchases troubled assets from a financial institution through an auction purchase, the financial institution shall be prohibited from entering into any new employment contract that provides a golden parachute in the event of an involuntary termination, bankruptcy filing, insolvency or receivership.
3. It’s not about protecting Wall Street per se
Paraphrasing James Carville, it’s about the economy, stupid.
And the economy ain’t getting better by itself
If there’s a single lesson from the Great Depression, it’s this – when credit contracts, so does the economy.
No credit, no capital for business expansion. No business expansion, no job creation. No job creation, a massive recession.
NIMBYism, 1930s style
The second Depression lesson is: in a Depression, the rich increase their relative share of wealth,
He wasn’t called ‘Daddy Warbucks’ for nothing
and the poor suffer worst.
Self-built housing in the Depression
4. It’s not ‘a failure’
With the 24-hour global news cycle, we’ve become conditioned to immediate action, immediate responses, immediate impact (what
In the original article, Kaus describes two trends: the speeding up of the news cycle and the compression of the schedule of primaries for the 2000 U.S. general election. Kaus wrote: “Feiler’s point is that we should put these two trends together–and that when we do, Trend 1 considerably softens the impact of Trend 2.” Kaus uses the observation to reassess the concept of momentum in politics, suggesting that there are now simply more opportunities for turns of fortune and that voters are able, for the most part, to keep up.
As a corollary, when Congress takes an action – like TARP – we look for the immediate response and judge everything by that. We are unwilling to accept that some events take a while to work. TARP passes, stock market drops – my gosh, it’s a failure! Try something else!
We don’t want to understand that some events take a while to work their effect. As I wrote in The Pile-up in Slow Motion:
We’ve all seen pictures of pileups, where an initial crackup so disrupts the flow of traffic that everybody behind it also skids into the expanding snarl. The disruption – and the danger – move back up the highway, and even as the first cars are being hauled away, one can sometimes hear the sound of rending metal and burning rubber.
Nobody’s moving now …
If you recall, things started to unravel last August (2007), more than a year ago. Since then we’ve had the Bear Stearns banking on value, the GSE conservatorship, HERA, and now EESA/ TARP. Each of these is a big move:
With people and companies as pieces
Together they make a strategy.
Will the moves work? I think so — and lots of people think panic selling is the classic tipoff of a bear market ending – but it’ll take us a while to find out. Anyone who claims certainty is either clairvoyant, lying, or mad.
D. So what the heck is it?
The Panic of 2008 is a global repricing of risk, the hangover from a decade of binge financial risk-taking by just about everybody who could do so.
As such, it’s the greatest economic challenge the world has faced in half a century.
Which means we all have to figure it out for ourselves.
How far we’ve come in half a century: a 1958 modem
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