More on the "Bailout"

Greg Mankiw's friend provides a nice follow up to my previous posting that the bailout is not about Wall Street Fat Cats. This friend was responding to the letter signed by many academic economists that expressed concern about the $700 billion bailout package. The friend writes,

A LOT of payrolls get paid at the end of the month. The next for many companies is September 30. Three different people with hugely relevant knowledge said to me today words to the effect of: "Why don't your economist buddies want [insert fortune 100 company/companies here] to be able to pay their employees on Tuesday. If Washington doesn't do something now, they won't be able to". That just scared the hell out of me. I can go into more details if you like, but all of them involve the four horsemen of the apocalypse.

Greg Mankiw responds to this friend that he too has reservation about the details of the plan. However, given the urgency of the situation, he believes we should ultimately follow Bernanke's lead:

I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Greg is correct here in terms of acting soon. However, I am on board with Paul Krugman and other economists who see the original Paulson plan failing to address the capital shortage problem. In case you missed this part of the debate, Sebastian Mallaby sums it up nicely:

How can the Treasury encourage private players to back up its purchases? The short answer is: Buy cheaply. If the government pays, say, 30 percent of what the loans were originally worth, any hedge fund that thinks they are really worth 40 percent will dive into the market. If the government pays 50 percent of what the loans were originally worth, that same hedge fund will stay on the sidelines -- or may even figure out a way of betting against the government.

[...]

[However,]Paulson and Bernanke... shrink from buying loans cheaply because doing so would force banks that currently value loans at high prices to recognize big losses, leaving them with too little capital. Buying loans cheaply would solve the liquidity problem in the loan market, but it would also reveal banks' capital shortage.

The way around this problem is for the Treasury to buy equity in the distressed institutions directly. Lucian Bebchuk explains it like this:

[Treasury buying troubled assets at fair market value--buying cheaply--] may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today's fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.

But the best way to infuse additional capital where needed is not by giving gifts to the firms' shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.

Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won't necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.

Note that this approach makes existing shareholders "bail in" some of the losses--since their existing equity shares will be diluted in value--as opposed to having taxpayers completely bail them out. I find this approach to be a more equitable one for the taxpayers.