Toxic Sludge

The Economy


In my last post I attempted to make sense of the origins of the current economic crisis in the subprime mortgage debacle. In this post I look at the solutions being offered and ask: Why do we need a bailout?

As explained in the last post (make sure to view the cartoon slideshow on the subprime lending crisis) the current scandal is the product of banks packaging bad loans as AAA quality securities which could be resold in a deregulated financial marketplace. As a result, the entire financial system is now based on a lot of bad paper. The technical term for this is toxic sludge.”

The problem is that nobody, not the banks, not the government, knows how much of this toxic sludge they own. And they don’t know how much the other banks own either. So nobody can trust anyone else. As a result banks are unwilling to lend money to each other. That’s why the government needs to step in and buy up this toxic sludge.

That’s why having the Treasury Department buy up all those toxic assets is probably a good idea. Recapitalization isn’t enough if it leaves banks still owning securities with values so variable that it’s too risky to lend to them anyway. We need to get that stuff off their balance sheets in order to make their financial position more transparent and we need to increase their capital base (which the Paulson plan accomplishes by paying above-market prices for the toxic sludge in return for a guarantee of equity down the road if the sludge eventually has to be sold at a loss). That combination has a better chance of working than either one alone.

And why is the toxic sludge so hard to value? Can’t we just make banks open their books and provide detailed information on all this stuff? Sure. But you’ve still got two problems. First, in the later days of the mortgage free-for-all, mortgages were packaged up with no documentation at all. So no one, not even the banks, knows for sure just how good or bad their mortgage portfolios are. Second, even if we knew that, their value would still depend on how much farther down home prices have to go. And that’s anyone’s guess.

Where will the money come from?

Paul Krugman put it best: it doesn’t have to come from anywhere. Ultimately, the Paulson Plan will move money in a circle.”


James Gailbraith elaborates:

Despite the common use of language, the capital cost of this bill does not involve taxpayer dollars.” It authorizes a financial transaction, exchanging good debt (U.S. Treasury bills and bonds) for bad debt (the troubled assets”). Many of those troubled assets will continue to earn income for some time, perhaps a long time. The U.S. Treasury commits itself to paying the interest on the debts it issues. The net fiscal cost — which is also the net fiscal stimulus — of this bill is the difference between those two revenue streams.

In a more recent post Krugman explained further:

The effect would be that if the financial firms did well, taxpayers would share in their good fortune via those stock holdings; if firms did badly, they could meet their obligations by selling some of those bonds, which would cut into the value of all their stock, including the stuff Uncle Sam owns. So as in the case of Wachovia, what’s really happening is that the taxpayers are taking on some of the risk.

How much risk?

The answer is that we really don’t know. James Gailbraith suggests that it will cost about $50 billion a month, and so $700 billion just buys us about a year’s worth of time.

But it isn’t going to be enough, not even by a long shot. Structural changes are needed and everyone’s best hope is that we can simply keep the system going until we elect someone competent who can restore trust in the system.

That person is not John McCain whose main economic policy advisor is Phil Gramm, the arch-deregulator, who took special care in his Senate days to prevent oversight of financial derivatives — the very instruments that sank Lehman and A.I.G., and brought the credit markets to the edge of collapse.” Just take a look at McCain’s economic policies and you’ll see how beholden he is to the whole conservative orthodoxy which got us into this mess.

The original bailout plan was based on the idea that the toxic sludge is undervalued and that, in the long run, it will be worth what it was originally worth. But almost every leading economist said this was simply not the case — that invariably some of it will be undervalued and we will loose money.

the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

In other words, its not exactly a full circle as the above diagram suggests — but we simply don’t know what the difference between the two revenue streams will be. Its possible the government/taxpayers will even make some money in the deal — if its written correctly. That’s why there was a call to redo the plan with some protections for the tax payers. The Dodd-Frank bailout offers some of those protections. Here is James Gailbraith on the strengths and weaknesses of the plan.

There is no question that the current bailout bill represents an enormous improvement over the original Treasury proposal. Unlike the original proposal, this bill protects the public interest with requirements for disclosure and audit, for reporting to Congress both on procedures and results, and with protections against arbitrage, conflict of interest, and fraud, with provisions requiring the secretary of the treasury to try to minimize foreclosures, to acquire warrants, and with limitations on executive compensation, especially golden parachutes.

In several respects, the language could still be improved. …

So that’s where we are now. It isn’t the plan most people think would be ideal, but it is much better than nothing and it seems most (sane) people agree it is sorely needed. I strongly recommend you look at this chart to see how your representative voted. If they voted No” on the Dodd-Frank plan, give them a call and ask them to change their minds. I did.