Myth #1: Ordinary taxpayers would have to pay for the Troubled Asset Relief Program (TARP).
Myth #2: It would reduce the value of the dollar.
The truth:
The government probably wouldn't have to print money, raise taxes, or go into deeper debt to do it. Instead, the government would be sucking in $700 billion of mortgage bonds while spitting out $700 billion of Treasury bonds. It would simply trade one asset for another of equivalent market value.*
The government probably wouldn't be giving Treasury bonds directly to banks in exchange for mortgage bonds. Instead, it would likely pay cash for the mortgage bonds and then sell an equivalent amount of Treasury bonds onto the open market. However, there would be no significant change in the monetary base.
Warren Buffett has pointed out that current buyers of mortgage-backed securities are expecting to earn an annual rate of return of at least 15%. He said that the government should be able to earn at least 10%, as a conservative estimate.*
As of Friday, 30-year Treasury bonds were yielding about 4.4%. If Buffett is right, this means that over the long run, the government should be able to earn a net annual rate of return of 5.6-10.6%. With $700 billion invested, this translates to a gain of $39 billion–$74 billion per year.
Of course, there is risk of a loss—even a big loss. However, the odds are in the government's favor.
If this is a boon for the government, why would banks go for it? It's simple: weaker banks would be giving up higher returns in the long run for greater stability in the short run.
Update: I should have said the government won't have to go into deeper net debt. It would go into deeper debt, but it would use the debt to buy assets of the same value. This is a lot different than going deeper into debt to finance current spending, as the government usually does.
* This assumes the government buys at market prices, rather than following Bernanke's stupid idea of overpaying.
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We're all going to hurt as banks de-leverage. The bailout did not reach to the root of the problem. Instead it focused on transferring money from tax payers to the banks.
ReplyDeleteWe're already going to have problems regardless. Paulson's bill only would have made things worse, increasing inflation, the national debt, dropping the dollar and hurting this countries over all credit.
The plan specifically called for increasing the national debt.
I am not an economist James. But what if your house prices continue to decline? What if the delinquent crowd rises to 10-15 percent? Then what?
ReplyDeleteI believe there is fear to approve the plan because realists understand that house prices are not even near the bottom.
Hovanian went on CNBC to say that house prices are falling below cost of materials. Well, that has nothing to do with the economic cycle. What counts are rents and income related to housing. If Americans no longer can afford the materials, housing is dead forever.
In which case the government purchase of these loans is a REALLY BAD IDEA.
Is it worth the gamble James?
Gary's right. There's a boatload of assumptions in there. What if housing falls another 25-30%? Many of those assets will be worthless.
ReplyDeleteIn that case, we'd be giving $700B of treasuries for absolute zip.
If congress is handing out $700B for zip, I'll be second in line. I'd like my $700B bailout too, pleez.
Chuck
Just curious if you have any idea about the effect on yields if Treas tried to sell $700 billion of 30-year bonds on top of its regular borrowing?
ReplyDeletehow does this not increase the money supply? when the government sells treasury bonds, it raises money that has to be paid back. paid back using what, exactly?
ReplyDeleteneither the government, nor anybody else, knows what the market price is. that is the problem. these crappy mortgages don't trade.
This is so false it hurts. If it WAS an even trade, then why do it in the first place? They could just sell them on the open market and be fine. It's called a bailout for a reason. They're not getting what they had, and we're getting stuck with the bill. The money's gotta come from somewhere.
ReplyDeleteI don't see how this plan would have helped deal with the central issue that has caused this problem: the decline in house prices. What is worse is the Paulson plan could have made things worse. It would have made the government pay 65 cents on the dollar for securities today worth 10 cents on the dollar. Sure, if the securities go back to being worth a dollar, the taxpayer wins. But look around at the housing problem and there is no recovery in sight. So the market continues to decline while Wall Street gets its bailout? No way. How about including a program as part of this that buys up part of the excess housing inventory and either sits on the excess, or destroys it with bulldozers. That is what happened in Texas after the S&L collapse.
ReplyDeleteCaleb Mardini said...
ReplyDelete"We're already going to have problems regardless. Paulson's bill only would have made things worse, increasing inflation, the national debt, dropping the dollar and hurting this countries over all credit."
Under Buffett's projections, it would have done none of those. Whether it increases the national debt depends on how you define the term. It would increase the gross debt, but not the net debt (because you are adding assets to the balance sheet at the same time you are adding liabilities).
Gary Anderson said...
"I am not an economist James. But what if your house prices continue to decline? What if the delinquent crowd rises to 10-15 percent? Then what?"
Asset prices are said to be forward-looking. The price is based upon future return projections. As long as those future projections are accurate, there is no problem. If they are inaccurate, they are just as likely to overestimate future returns than underestimate them.
Gary Anderson said...
"Hovanian went on CNBC to say that house prices are falling below cost of materials. Well, that has nothing to do with the economic cycle. What counts are rents and income related to housing. If Americans no longer can afford the materials, housing is dead forever."
I did not see the interview, but what appears to be missing in the analysis is land prices. I'd say that if a builder can't afford to build, it may be because building prices are falling faster than prices for vacant land.
Another option is that builders usually make some of their money on the increase in land prices during the time they are constructing the building. When land prices are decreasing, they are losing money on the land during the time it takes to build the building.
You are right about rents and incomes related to housing.
Anonymous said...
"Just curious if you have any idea about the effect on yields if Treas tried to sell $700 billion of 30-year bonds on top of its regular borrowing?"
As the government issues more treasury bonds, the yield would go up, all else being equal. This would reduce the projected rate of return in my example. However, there is a countervailing force right now. Investors are so fearful of a financial collapse right now that they are flocking to riskless assets like Treasuries. The government can use this fear to its advantage by increasing purchases when the TED spread increases, and slowing purchases when the TED spread decreases. This way, the government can increase taxpayer returns and stem financial panics at the same time.
mrowens said...
"how does this not increase the money supply? when the government sells treasury bonds, it raises money that has to be paid back. paid back using what, exactly?"
That was already answered in the original post. It pays back the Treasury bonds with the returns from the mortgage bonds. I am basing the projected returns on mortgage bonds on Buffett's comments. I assume Buffett knows a thing or two about investing.
Infinity8Ball said...
"This is so false it hurts. If it WAS an even trade, then why do it in the first place? They could just sell them on the open market and be fine."
I already stated my hypothesis on this in an earlier post.
Anonymous said...
"I don't see how this plan would have helped deal with the central issue that has caused this problem: the decline in house prices."
You're right, that is the central issue. However, prices are declining because houses are overvalued. The best thing to do is let them fall to reasonable levels. Rather than trying to prevent a needed fall in housing prices, we need to stop the fall in housing prices from taking down the entire economy.
Anonymous said...
"How about including a program as part of this that buys up part of the excess housing inventory and either sits on the excess, or destroys it with bulldozers."
That's a terrible idea. People could be living in those homes.
If you believe that the purpose of houses is to help the haves become wealthy at the expense of the have nots, then your idea makes sense. If you believe that the purpose of homes is for people to live in, then that is the dumbest idea ever.
The problem is not that there are too many homes. The problem is that they are unaffordable. To make them more affordable, the prices need to fall.
6,400 jobs moving to Alexandria.
ReplyDeleteBuy here.
James said: "The government probably wouldn't have to print money, raise taxes, or go into deeper debt to do it. Instead, the government would be sucking in $700 billion of mortgage bonds while spitting out $700 billion of Treasury bonds. It would simply trade one asset for another of equivalent market value."
ReplyDeleteTreasury bonds are not ASSETS of the Federal government, they are OBLIGATIONS of the Federal government. Treasury bonds are debt. By issuing treasury bonds in exchange for bad assets, the government would, in fact, be going deeper into debt.
Hi James,
ReplyDeleteDid you see today's post by Krugman? It confirms, in part, your myths.
http://krugman.blogs.nytimes.com/2008/09/30/where-will-the-money-come-from/
Rebecca
Wait a minute!!!!
ReplyDeletePlease explain. If the FED is buying the bonds, it only has but so many T-bills that it has accrued over time.
If the Treasury is issuing new bonds, that is creating new debt, and new money. That devalues the currency and creates inflation, ceteris paribus.
I believe you are wrong that the two items are myths, but please explain.
" . . . The government would be sucking in $700 billion of mortgage bonds while spitting out $700 billion of Treasury bonds. It would simply trade one asset for another of equivalent market value.*"
ReplyDeleteOkaaay. Tell you what, I'll take the Treasury bonds, you take the mortgage bonds.
"... weaker banks would be giving up higher returns in the long run for greater stability in the short run."
And the government gets what? The inverse? Or just two short ends of one stick?
John Fontain said...
ReplyDelete"Treasury bonds are not ASSETS of the Federal government, they are OBLIGATIONS of the Federal government. Treasury bonds are debt."
You are, of course, correct from the federal government's point of view. However, they ARE assets of whoever buys them. I was using the term loosely. Perhaps I should use the term "financial instruments."
John Fontain said...
"By issuing treasury bonds in exchange for bad assets, the government would, in fact, be going deeper into debt."
Now it's my turn for precision. They are not necessarily bad assets. They are higher-risk assets. Nobody is suggesting that the government buy bad assets from banks. They are suggesting it buy higher-risk assets. In exchange for higher risk, it gets a risk premium.
I specifically said in my post that the government should buy at market value, rather than overpay. The market value of a financial instrument is determined by the expected risk-free rate of return plus the risk premium.
Rebecca Wilder said...
"Hi James, Did you see today's post by Krugman? It confirms, in part, your myths."
Hi, thanks Rebecca. I think you mean is confirms my response to the myths, right? Did you notice that Economist's View linked to one of your blog posts?
Here's Krugman's summary: "For now, however, none of the rescue schemes we’re talking about involve large-scale net borrowing from abroad."
Anonymous said...
"Wait a minute!!!! ... If the Treasury is issuing new bonds, that is creating new debt, and new money."
Wrong. Treasury bonds are not money. While the government issues new debt, it is using the debt to buy assets, so there is no increase in net debt.
genovina said...
"Okaaay. Tell you what, I'll take the Treasury bonds, you take the mortgage bonds."
As long as we get them at fair market value, then it's a deal. You do understand that higher risk assets (financial instruments) get a risk premium, don't you?
genovina said...
"And the government gets what? The inverse? Or just two short ends of one stick?"
The inverse. Except, of course, that the government's income comes from tax revenues. It gets higher tax revenues when the economy is strong. So, it has a vested interest in strengthening the economy when the economy is weak. Did you ever study Keynes in school?
Yes, confirms! I did see the link - still plugging away! Thanks again.
ReplyDeleteBy the way, why didn't you explain myth 2: the value of the dollar? Look at the value of the dollar under two alternative scenarios:
1. The dollar appreciates - the government just sells the $700 billion in bonds on the open market. This will lead to an appreciation of the dollar if foreigners buy some of the bonds, since demand for USD rises.
2. The dollar depreciates - the government sells the bonds on the open market, but at the same time, the expected economic impacts of rising deficit spending gets priced into behavior. Foreign demand for US assets falls in net, flooding the fx market with USD, and the USD depreciates.
There are clearly more scenarios, as the FX market is impossible to predict, but this illustrates your myth.
Rebecca
james, isn't it more fun to use the term "bad assets" though? Come on now!!
ReplyDeleteAnonymous said...
ReplyDelete""Wait a minute!!!! ... If the Treasury is issuing new bonds, that is creating new debt, and new money."
Wrong. Treasury bonds are not money. While the government issues new debt, it is using the debt to buy assets, so there is no increase in net debt."
Wait a minute, again!!!
Your caveat, that the FED/Treasury pays market value is the issue. The point here is to recapitalize undercapitalized banks. Banks with assets that when marked to market show that the banks have little, if no cushion and are insolvent, or that they are highly leveraged. In that case, the taxpayers are only being custodians of the mortgage backed securities.
The plan on the table, is not the one you describe. The government, the taxpayers, are issuing new debt to transfer that money to the banks to recapitalize them. From the government's viewpoint, it is a net increase in debt since the capitalization has to be paid for. The hope is that these mortgage backed securities can actually be sold for something so that the losses absorbed by the taxpayer are not equal to 100% of the amount advanced in bonds, which are liquid. Issuing new bonds increased the US government debt. Whether the asset collateralizing that debt is worth anything is another issue.
Inflation is an integral part of this since there will be an increase of money in circulation and the retirment of the obligations will create an untenable need to increase taxes or, alternatively, watch the dollar fall.
Of this I am certain in the medium term, whether I correctly recall my economic devices or not.
John Fontain said...
ReplyDeletejames, isn't it more fun to use the term "bad assets" though? Come on now!!
Oh, definitely. Actually, I think those mortgage bonds are walking around right now saying, "Don't mess with me, people! I'm a Bad Ass-et."
Rebecca and Anonymous, I'll try to get back to you with detailed responses, but I don't have time right now.
This is incredibly stupid. The government is not going to buy anywhere close to market value. There is no point in it. Market value is near zero.
ReplyDeleteThe government will buy at face value and sell for near zero. Where does the money come from? Working-class taxpayers. Where does it go? To rich investors and big corporations.
They just have to pass it quick before everyone realizes the "crisis" is as fake as the buildup for the Iraq war.