10 reasons to oppose the housing bailout

The top ten reasons to oppose President Obama's $275 billion housing bailout:

1. The Bailout Encourages Bad Behavior
2. It Rewards the Wrong People
3. It Will Further Nationalize our Housing Market
4. It is a Futile Effort to Re-inflate the Housing Bubble, which Failed Miserably in Japan
5. The Bailout Keeps People in Homes They Cannot Afford
6. The Bailout Steals Billions from Hard Working Americans
7. Policy Like this Caused the Crisis
8. We Cannot Afford it
9. It Distorts the Market Economy
10. The Plan Creates Uncertainty in the Marketplace

Details of the $8,000 homebuyer tax credit

The stimulus package recently signed by President Obama has a $8,000 tax credit for "first-time" home buyers. This means taxpayers are paying for part of your house, even though they don't get to live in your house. (Sounds fair, right?)

Here are the details of the tax credit:

First-time buyers can claim a credit worth $8,000 — or 10% of the home's value, whichever is less — on their 2008 or 2009 taxes.

A big plus is that the credit is refundable, meaning tax filers see a refund of the full $8,000 even if their total tax bill — the amount of witholding they paid during the year plus anything extra they had to pony up when they filed their returns — was less than that amount. ...

To qualify for the credit, the purchase must be made between Jan. 1, 2009 and Nov. 30, 2009. Buyers may not have owned a home for the past three years to qualify as "first time" buyer. They must also live in the house for at least three years, or they will be obligated to pay back the credit.

Additionally, there are income restrictions: To qualify, buyers must make less than $75,000 for singles or $150,000 for couples. (Higher-income buyers may receive a partial credit.)

Applying for the credit will be easy - or at least as easy as doing your income taxes. Just claim it on your return. No other forms or papers have to be filed. Taxpayers who have already completed their returns can file amended returns for 2008 to claim the credit.

Home prices are still declining. By my estimate, the median U.S. home is $50,000 overpriced, so this credit will reduce the loss you experience over the next few years, but not eliminate it.

Bill Gross: American Patriot

Billionaire "bond king" Bill Gross has offered to put country before self:

One of the chief concerns about the Treasury Department’s $700 billion bailout plan is that the same Wall Street firms that helped create the crisis could make a killing cleaning it up.

William H. Gross, the manager of the country’s largest bond mutual fund, has a solution: he is offering to sort through the toxic assets — free.

“We have a large and brilliant staff that can analyze and has analyzed subprime mortgages that can help the Treasury out,” Mr. Gross, the co-chief investment officer for the Pacific Investment Management Company, said in an interview at the company’s headquarters here.

He added, “And I’d even be willing to say that if the Treasury wanted to use our help, it would come, you know, free and clear.”

Mr. Gross explained his offer as a philanthropic one. With Pimco’s $830 billion under management, “we make fees aplenty,” he said.

By the way, I change my earlier assessment. I now think Bill Gross is the odds-on favorite to run the TARP, with Buffett in second place. Since both men have said they'd like to do it (although Gross was the only one enthusiastic about doing it for free), a third option is that treasury bureaucrats run it with both Gross and Buffett assisting voluntarily.

Oh yeah, that other bailout!

In case everyone forgot, Congress already enacted one bailout months ago:

Amidst all the chaos surrounding the $700 billion Wall Street bailout plan, the federal government's other housing rescue program quietly opened for business Wednesday.

But will any mortgage servicers come knocking?

The Federal Housing Administration unveiled its $300 billion Hope for Homeowners program, which allows struggling borrowers to refinance into more affordable mortgages backed by the federal government. The legislation, which was signed into law in late July, was hotly debated for months on Capitol Hill with Democrats supporting it and Republicans opposed.

Before the so-called Wall Street bailout emerged, this FHA program was the federal government's answer to the mortgage crisis. It was seen as a primary means to stemming the foreclosure tide and stabilizing the housing market. ...

Banks, however, didn't receive the program's details from the FHA until Wednesday, and say it will likely be weeks before they can offer it to their customers.

Even then, lenders probably won't rush to participate in the program, which is voluntary, since it requires them to take a pretty significant losses on the loan principal in most cases. Instead, banks have said that they'd prefer to use their own mortgage modification programs where they can better control the terms. ...

The problem is that the Hope for Homeowners program requires banks to reduce the loan's principal to 90% of a home's current appraised value, which is likely to be much less than the owner paid for it. Lenders prefer to freeze or cut interest rates so they can at least recover the original amount of the loan, said Tom Kelly, spokesman for JPMorgan Chase...

"You lock in your loss," Kelly said, by reducing loan principal.

Banks might turn to Hope for Homeownership if they feel the loan is hopeless and just want to get rid of it, he continued.

Lenders also won't be pleased with the new home appraisals, which will show them just how underwater their borrowers are, said James Gaines, research economist at the Real Estate center at Texas A&M University.

He doesn't see a lot of lenders flocking to the program.

Buffett suggests improvement to TARP

From Fortune Magazine:

Warren Buffett suggested Thursday that the U.S. Treasury team with private investors to buy the distressed mortgage assets at the center of the controversial $700 billion Wall Street bailout, and said the price tag of the rescue plan may have to rise.

Buffett, the chairman and CEO of Berkshire Hathaway, called the problems facing world markets "unprecedented" and warned of a "disaster" if Congress does not move faster to shore up the economy.

"We had an economic Pearl Harbor hit," he said ... "For a couple of weeks we've been arguing about who's at fault [and] fooling around while things have gotten a lot worse." ...

"It will cost more to solve this problem today than it did two weeks ago," said Buffett...

But he described a plan he thought of Thursday morning on the way to the Summit that would allow Treasury and private investors to buy assets together. He said his proposal would kickstart demand for mortgage-backed securities, help find a market price for these troubled assets and make it more likely that taxpayers would be made whole or even come out ahead in the bailout.

Under Buffett's plan, Treasury would lend hedge funds, Wall Street firms or any other investors 80% of the price for distressed assets. Investors would benefit from borrowing at lower rates available to the Treasury. But the government would get first claim on the sale of those assets, which means it would get its loan back plus interest and possibly turn a profit. Only then would investors see a penny.

"Now you have someone with 20% skin in the game," explained Buffett. "Believe me, I won't be overpaying if I'm buying with that kind of leverage. And you have someone [the investors] to manage the assets to the extent they need to be managed."

Buffett also noted that the presence of the government in the transactions would raise the price of assets above the absolute firesale levels for which they could now be sold. That would benefit the banks trying to unload them. ...

He said the [financial] problem boils down to widely-held assumption during the housing boom that prices could only go up.

Under this scenario, the private investors would benefit by being able to borrow at ultra-low interest rates that normally only the government can get. They could also get higher potential returns by having higher leverage. Meanwhile, taxpayers are protected because the private investors would take a 100% loss before the government lost a penny. This gives the private investors a very strong incentive to protect taxpayers from a loss.

The Economist: Bailout "deserves support"

The Economist endorses the bailout:

No government bail-out of the banking system was ever going to be pretty. This one deserves support.

Saving the world is a thankless task. The only thing beyond dispute in the $700 billion plan of Hank Paulson, the treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, to stem the financial crisis is that everyone can find something in it to dislike. The left accuses it of ripping off taxpayers to save Wall Street, the right damns it as socialism; economists disparage its technicalities, political scientists its sweeping powers. ...

Spending a sum of money that could buy you a war in Iraq should not come easily; and the notion of any bail-out is deeply troubling to any self-respecting capitalist. Against that stand two overriding arguments. First this is a plan that could work (see article). And, second, the potential costs of producing nothing, or too little too slowly, include a financial collapse and a deep recession spilling across the world: those far outweigh any plausible estimate of the bail-out’s cost. ...

Mr Paulson’s plan relies on buying vast amounts of toxic securities. The theory is that in any auction a huge buyer like the federal government would end up paying more than today’s prices, temporarily depressed by the scarcity of buyers, and still buy the loans cheaply enough to reflect the high chance of a default. That would help recapitalise some banks—which could also set less capital aside against a cleaner balance sheet. And by creating credible, transparent prices, it would at last encourage investors to come in and repair the financial system...

The economics behind this is sound. Government support to the banking system can break the cycle of panic and pessimism that threatens to suck the economy into deep recession. Intervention may help taxpayers, because they are also employees and consumers. Although $700 billion is a lot—about 6% of GDP—some of it will be earned back and it is small compared with the 16% of GDP that banking crises typically swallow...

Mr Paulson’s plan is not perfect. But it is good enough and it is the plan on offer. The prospect of its failure sent credit markets once again veering towards the abyss. Congress should pass it—and soon.

Larry Summers on TARP

Larry Summers, Harvard economist and former U.S. Treasury Secretary under Bill Clinton, gives his thoughts on the proposed bailout:

It is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

The American experience with financial support programmes is somewhat encouraging. The Chrysler bail-out, President Bill Clinton’s emergency loans to Mexico, and the Depression-era support programmes for housing and financial sectors all ultimately made profits for taxpayers. ...

Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. ...

Indeed, in the current circumstances the case for fiscal stimulus — policy actions that increase short-term deficits — is stronger than at any time in my professional lifetime.

What led to the bailout's defeat...

CNBC discusses the backlash:

In the end, the financial markets did not stand a chance against voter antipathy, partisanship and election year politics.

The defeat of the extraordinary $700 billion financial rescue package represented a perfect collision of the forces of modern politics — a fast-moving Internet campaign, vulnerable incumbents, a weakened and unpopular president, and a roiling presidential campaign — all working against the so-called Masters of the Universe.

Polls showed widespread public opposition to the plan — the biggest federal intervention in financial markets since the Great Depression of the 1930s — and many Republicans saw such an enormous set-aside of taxpayer money as an unnecessary intrusion into free markets. Of the 19 most-endangered House incumbents, 13 voted no. ...

Such a roaring confluence of opposition could only have been overcome with strong party discipline and presidential power. But a weakened and unpopular President George W. Bush and lawmakers forced to weigh the vote against their political careers conspired against success.

Outside Congress, however, furious pressure built up against the bill in e-mail campaigns and on Internet Web sites. The Club for Growth, a conservative free-market oriented group, warned lawmakers that it would count a vote in favor of the legislation against lawmakers seeking the group's support. The Club for Growth is viewed with apprehension by many Republicans because it has been known to support challengers running against party incumbents in primary contests.

Longtime conservative activist Richard Viguerie warned that lawmakers who voted for the rescue package would be targeted for defeat. "Republicans and Democrats alike who support this monstrosity will face the wrath of the voters if they stand side-by-side with predatory politicians and bureaucrats and their greedy friends who got us in this mess," he said.

The opposition on the House floor came from an unlikely coalition of conservatives and liberals. The progressive grassroots group MoveOn.org aired an ad blaming the financial crisis on John McCain and his allies.

All those forces worked against powerful special interests. The U.S. Chamber of Commerce and a diverse group of industry lobbying organizations ranging from the National Association of Realtors to the American Hotel and Lodging Association pressed Congress to back the bill, pointedly noting that they too would consider this a key vote when ranking members.

The vote also represented an extraordinary rejection of Bush, who personally called wavering lawmakers and delivered a last-ditch public appeal Monday morning, as well as Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.

"Despite days of negotiating, this is still the same bailout bill, written by a Wall Street guy with a Wall Street solution to a problem created on Wall Street," said Rep. Mike Rogers, a Michigan Republican. "This bill was still a blank check to Henry Paulson."

I saw Chris Matthews on MSNBC last night berating a Republican congressman who voted against the bailout. Matthews asked the congressman if he was just doing what was politically easy, since he voted the way his constituents wanted instead of the way President Bush wanted. Matthews behaved as if America is a dictatorship rather than a representative democracy.

Congressmen have an ethical responsibility to listen to their constituents. Their loyalty should be to the people, not to the President. If our founding fathers had intended for congressmen to obey the President, Congress and the Presidency would not have been made separate branches of government.

Myths about the bailout

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.

Congress rejects bailout; Worst DJIA point drop ever!

The Dow Jones Industrial Average fell 777.68 points today, mostly due to the House of Representatives rejecting the bailout:

Stocks skidded Monday afternoon, with the Dow's nearly 778-point drop being the worst single-day point loss ever, after the House rejected the government's $700 billion bank bailout plan.

Stocks tumbled ahead of the vote and the selling accelerated on fears that Congress would not be able come up with a fix for nearly frozen credit markets. The frozen markets mean banks are hoarding cash, making it difficult for businesses and individuals to get much-needed loans.

According to preliminary tallies, the Dow Jones industrial average lost 777.68, surpassing the 684.81 loss on Sept. 17, 2001 - the first trading day after the September 11 attacks. However the 7% decline does not rank among the top 10 percentage declines.

The Standard & Poor's 500 index was down 8.7% and the Nasdaq composite 9.1%.

Buffett warned Congress of "biggest financial meltdown"

Buffett urged Congress to pass the Troubled Asset Relief Program:

Legendary investor Warren Buffett warned Congressional leaders Saturday night of "the biggest financial meltdown in American history" if they did not act to secure the financial system.

Buffett, by telephone, was consulted by lawmakers who were in marathon talks on Capitol Hill to forge a deal on the administration's $700 billion economic bailout plan, according to two sources.

One lawmaker in the negotiations said that the participants called Warren Buffett to get his help in gauging potential market reaction. ...

Earlier in the week, Buffett also warned that the financial crisis is "everybody's problem," not just Wall Street's. The potential collapse of financial institutions would cause industry to grind to a halt, he told CNBC Wednesday, and could have "gummed up the economy."

Paul Krugman critiques the draft version of TARP

Krugman's critique:

So there’s a draft version of the bailout out there. Pretty much as expected. Section 113, MINIMIZATION OF LONG-TERM COSTS AND MAXIMIZATION OF BENEFITS FOR TAXPAYERS, is where the rubber meets the road — it’s where the plan says something about how the deals will be done.

As I read it, Treasury can
(1) conduct reverse auctions and suchlike
(2) buy directly — but only if it gets equity warrants or, in companies that don’t issue stock, senior debt

My view is that (1) will be ineffective but also not a bad deal for taxpayers — firms that can afford to will dump their toxic waste at low prices, the way some already have on the private market, and taxpayers may end up making money in the end. Firms in big trouble will probably stay away from the auctions. The plan’s real traction, if any, is in (2), which is a backdoor way to provide troubled firms with equity — and the bill seems to say that taxpayers have to own this equity, although I wish it was clearer how much equity will be judged sufficient.

Not a good plan. But sufficiently not-awful, I think, to be above the line; and hopefully the whole thing can be fixed next year.

Add: House staff tells me that there are significant changes from this draft. More info when I get it.

My Stance on the Bailout

For the record, I support a bailout, but with $700 billion on the line I think it is extremely important that it is done right. Several University of Chicago economists have proposed improvements to the plan.

I also don't think the bailout will solve the financial crisis, but I think it will help. Bernanke and Paulson (or their successors) will likely be going back to Congress begging for more help in the future.

To put things in perspective, $700 billion is about $2,304 for every man, woman, and child in America. Hopefully, however, the Treasury would be buying assets worth roughly the same amount, so it wouldn't be $2,304 out of pocket for American taxpayers.

The Paulson bailout isn't enough. It is ridiculous that the government is planning to spend $700 billion to bail out the financial system when bank regulators haven't even taken the simple step of requiring banks to preserve capital by suspending dividend payments.

How do Bubble Meter readers feel about the bailout?

An Analysis of the Financial Crisis

University of Chicago economist Robert Shimer analyzes the financial crisis:

Let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues.... As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information ... makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. ... But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

Dumbest. Plan. Ever.

From The Hill:

The House Republican Study Committee is set Tuesday to officially unveil its proposal to address the financial crisis through a “market-based” approach.

The conservative group, which has strong objections to a federal bailout that would cost hundreds of billions of dollars, is touting its plan as a “true alternative” to Treasury Secretary Henry Paulson’s plan to rescue the financial markets.

The RSC plan, which will be unveiled at noon, calls for a two-year suspension of the capital gains tax.

“By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy,” an outline of the proposal said. “After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains.”

The group’s plan would also transition Fannie Mae and Freddie Mac to private companies “in a reasonable time,” seeks to stabilize the dollar, and would “suspend the mark-to-market regulatory rules for long-term assets.”

Justin Fox points out a glaring flaw in the Republican plan:

[The plan] of the House Republican Study Committee, seems to be a joke. It calls for a two-year suspension of the capital gains tax to "encourag[e] corporations to sell unwanted assets." But the toxic mortgage securities clogging up bank balance sheets are worth less now than when they were acquired. Meaning that no capital gains tax would be owed on them anyway. If you repealed the tax, banks would have even less incentive to sell them because they wouldn't be able use the losses to offset capital gains elsewhere.

In short, suspending the capital gains tax when everyone's sitting on losses is harmful.

Stabilizing the dollar would also be harmful. A nation's currency should fall during times of economic weakness, because a falling currency stimulates the economy.

I hypothesized yesterday that mark-to-market accounting may be causing a vicious cycle in the credit markets. If this is correct, their plan to suspend mark-to-market accounting for long-term assets might help in the short-run. The problem is that the alternative is "mark-to-make-believe," which in the long run would give financial institutions too much leeway in making up unrealistic numbers.

Prediction: Buffett Will be Asked to Manage Bailout

Assuming this bailout (Troubled Asset Relief Program) becomes law, I predict Warren Buffett will be asked to run it, pro bono.* With $700 billion of American taxpayer money at stake, politicians will have an exceptionally strong incentive to recruit the absolute best person for the job. Warren Buffett is the obvious guy to pick. Also, this is the year that both presidential candidates are advocating national service—putting country before self. Asking the world's greatest investor to put country before self isn't too much of a stretch.

I estimate the probability that Buffett will be asked to do it is less than 50%, but far higher for him than for any other individual alive.

Here's Vince Farrell's take on CNBC:

Buffett is smarter than I am. He's probably smarter than a lot of other people as well. ...

I did love his comment that he wished he had $700 billion to buy the derivatives with. Maybe we should ask him to do it! And I'm not kidding!

And here's billionaire T. Boone Pickens, interviewed by CNN:

Roberts: In fact, you have said, Boone, that you would like to see Warren Buffett handle a lot of these illiquid assets that the government buys up in terms of their disbursement.

Pickens: Can you imagine anybody better? Sure, that'd be great if he'd do it. I don't know whether he would or not. But you need to get somebody like Warren to do it.

Roberts: You don't think they have the expertise at the Treasury Department to do it?

Pickens: Oh, they do have. They may need some help. And that kind of help — you can't pay for that kind of help.

If Buffett doesn't do it, billionaire "bond king" Bill Gross has volunteered to do it for free.

* For the world's second richest man, a typical government salary is essentially pro bono.

Congress (Dis)Agrees on Bailout Proposal

Here is Congress's "Agreement on Principles" for the Troubled Asset Relief Program:

1. Taxpayer Protection

a. Requires Treasury Secretary to set standards to prevent excessive or inappropriate executive compensation for participating companies

b. To minimize risk to the American taxpayer, requires that any transaction include equity sharing

c. Requires most profits to be used to reduce the national debt

2. Oversight and Transparency

a. Treasury Secretary is prohibited from acting in an arbitrary or capricious manner or in any way that is inconsistent with existing law

b. Establishes strong oversight board with cease and desist authority

c. Requires program transparency and public accountability through regular, detailed reports to Congress disclosing exercise of the Treasury Secretary’s authority

d. Establishes an independent Inspector General to monitor the use of the Treasury Secretary’s authority

e. Requires GAO audits to ensure proper use of funds, appropriate internal controls, and to prevent waste, fraud, and abuse

3. Homeownership Preservation

a. Maximize and coordinate efforts to modify mortgages for homeowners at risk of foreclosure

b. Requires loan modifications for mortgages owned or controlled by the Federal Government

c. Directs a percentage of future profits to the Affordable Housing Fund and the Capital Magnet Fund to meet America’s housing needs

4. Funding Authority

a. Treasury Secretary’s request for $700 billion is authorized, with $250 billion available immediately and an additional $100 billion released upon his or her certification that funds are needed

b. final $350 billion is subject to a Congressional joint resolution of disapproval

I see nothing in here that requires the Treasury to buy at market prices.

Update: Apparently, while Democrats are claiming they have a deal, Republicans are saying they don't.

America's Sovereign Wealth Fund

Harvard economist Greg Mankiw is critical of his former employer:

Here is the key passage from President Bush's speech last night:

as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.

In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own.

Greg Mankiw is right to be suspicious. It is very presumptuous of government officials to assume they know the proper value of mortgage-backed securities better than the free market does—especially since Bernanke and Paulson have been consistently wrong about the housing market.

However, Warren Buffett's comments yesterday seem to support a hypothesis that I've had in my head for a while now. Buffett thinks the government will get a good rate of return. This suggests that Buffett, himself, thinks MBS's are underpriced.

My hypothesis is this: Even if the mortgage-backed securities would be a good investment in the long run, highly-leveraged financial institutions can't risk buying them if the price continues dropping dramatically in the short run. With mark-to-market accounting, the declining prices could cause any highly-leveraged buyer to find itself insolvent in the short run, even if it is holding assets that will pay off in the long run.

The problem with MBS's is that the only natural buyers of them are highly-leveraged financial institutions. Ideally, unleveraged sovereign wealth funds could swoop in and purchase MBS's on the cheap, but while the world's sovereign wealth funds are flush with cash, they are not sophisticated investors with the courage and instinct to buy undervalued assets during a panic. Thus, the only solution for this problem is for the U.S. government to essentially establish its own sovereign wealth fund, and buy up the undervalued assets. (Investors like Buffett are puny compared to the size of the market.)

In the meantime, there is no natural buyer of these assets that can afford to buy them. Since the price of MBS's is determined at the margin, every time a financial institution tries to deleverage by selling MBS's, it forces all other financial institutions to take losses. This in turn forces them to deleverage by selling off MBS's, thus creating a vicious cycle. The market is not being irrational; the market is being forced to deleverage. The goal of America's sovereign wealth fund (the Troubled Asset Relief Program) is to stop the vicious cycle.

A far cheaper solution than this bailout would be for the U.S. to abolish mark-to-market accounting, but that would likely create more problems than it solves.

Krugman: A $700 Billion Slap in the Face

Paul Krugman points out why the Paulson/Bernanke plan is severely flawed. This should have been a full NY Times article, but Krugman made it a blog post instead (probably due to a desire to make it public ASAP).

The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work. So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry.

Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.

Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.

That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. It’s more or less what would happen with the Dodd plan, which would buy bad debt but get equity warrants that depend on the later losses on that debt.

But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.

It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.

As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling.

So, three points:

1. They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.

2. They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?

3. Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.

Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.

President Bush Addresses Nation Regarding Bailout Plan

In a first for his administration, President Bush went 15 minutes without lying.