Krugman: "This is the Most Socialistic Move ... in God Knows How Long"

Krugman criticizes Treasury Secretary Paulson's bailout plan:

Happy 10th Birthday, Wall Street Bailouts!

Today is a very special day! Today is the 10th birthday of the Wall Street bailouts. It was ten years ago today, on September 23, 1998, that the Federal Reserve bailed out Long Term Capital Management. MarketWatch takes us on our joyful 1998 flashback:

LTCM was a hedge fund run by former Salomon Brothers bond whiz John Meriwether and a half dozen other traders. They raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built on leverage, when the bets turned bad and lenders started asking for their money in the summer of 1998.

LTCM was strapped for cash. So, rather than unwind its positions and send the market into turmoil, the Federal Reserve Board of New York organized a $3.75 billion bailout paid for by Wall Street banks. The cash allowed LTCM to meet its obligations as it unwound its trades.

Maybe it's because the numbers seem small by today's standards, but LTCM caused a lot of anxiety at the time. The day after the bailout was announced, the Dow Jones Industrial Average fell 2%, mostly because investors feared the banks would lose their investment. The fall was followed by another 3% drop two trading days later when investors worried the Fed didn't do enough.

Flash forward to 2008. ... You can't blame Rick Wagoner at General Motors or Glenn Tilton at UAL Corp. for passing the hat to Uncle Sam. These CEOs have seen what a little government intervention can do, whether it be banning naked short selling for a few bank stocks or propping up the entire mortgage banking industry with billions in backing.

The taboo against bailouts has been broken. Now the problem is that everyone is rushing the government at the same time. Wall Street firms ran up risk for a decade after the LTCM bailout precisely because there was a bailout.

The unwritten message, what the bankers call moral hazard, was simple: come a crisis, the government will do everything it can to avoid a collapse.

It makes a nice bedtime story, doesn't it?

The Fed chose not to worry about moral hazard then, because it felt the immediate problem was far more important than any increased financial risk-taking it might encourage in the future. Such short-term thinking only causes greater problems in the long run. The Federal Reserve and the U.S. Treasury are again making short-term decisions without any regard to the long-term consequences.

Upcoming REO Auction in DC Area

There is a new auction of bank-owned homes coming up in the Washington, D.C. area in early October. The homes up for auction are open for inspection this weekend. A few months ago when I last saw an auction advertised, they were all P.O.S. homes. This time, there seem to be some nice ones available.

Auctions in other parts of the U.S. are listed here. They include:

• Georgia
• Dallas, TX
• Southern California
  

Update: It appears that REDC auctions are a scam.

Poll: Should Homeowners be Bailed Out, Too?

Vote in the CNBC online poll: Should homeowners be bailed out, too?

Krugman on Treasury Proposal: "The more I think about this, the more skeptical I get"

Princeton economist Paul Krugman thinks the bailout through and doubts it will be effective:

What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, 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.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Senator Chris Dodd now has a competing bailout proposal. Krugman likes Dodd's proposal better:

I’ve had more time to read the Dodd proposal — and it is a big improvement over the Paulson plan. The key feature, I believe, is the equity participation: if Treasury buys assets, it gets warrants that can be converted into equity if the price of the purchased assets falls. This both guarantees against a pure bailout of the financial firms, and opens the door to a real infusion of capital, if that becomes necessary — and I think it will.

Can this be done? Can the Paulson juggernaut be stopped? I’m starting to think yes. Paulson displayed a lot of arrogance here — he basically marched in and said Daddy knows best, don’t worry your pretty little heads about the details. He offered no, zero, zilch explanation of how the plan was supposed to work — just “it’s a crisis and we need to act now.” And he overreached, especially with that demand for immunity from any review.

Now we’ve had a lot of pushback from economists and financial analysts, and the realization has sunk in that this particular daddy has shown very little sign of knowing best. So there’s a real chance to do something quite different.

Update: It appears that Paulson has agreed to the Dodd plan.

Realtors Nested in Politics

"A 2004 photograph from a report by the Homeownership Alliance, an advocacy group for Fannie Mae and Freddie Mac, shows John McCain with Ken Guenther, a former chairman of the group, left, and David Lereah of the National Association of Realtors." NYTimes: Loan Titans Paid McCain Advisor Nearly $2 million

Denninger speaks truth to power.

Denninger speaks truth to power.




Hat Tip: Housing Panic

Regulators Still Failing to Do Their Job

Here is more opposition to the Treasury's bailout proposal. Sebastian Mallaby also points out a regulatory failure that I've been concerned about for almost a year:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Why are government regulators allowing financial institutions to pay out dividends during a financial crisis? By paying out dividends, banks are reducing their capital at a time when they should be doing everything they can to preserve capital. I suggest three new regulatory rules, one temporary, two permanent: 1) All financial institutions must suspend dividend payments during this financial crisis. 2) Any time a regulated financial institution is unprofitable, it must suspend dividend payments until profitability is restored. 3) Regulated financial institutions may not pay out quarterly dividends that are greater than quarterly earnings.

If a bank is actually healthy, suspending dividend payments doesn't mean shareholders won't get their money. It just means they will have to wait for it. The money can simply be held on the books until the financial crisis or unprofitable period has passed, and then be paid out to shareholders as an extra-large dividend when the rough period has passed. If a bank is actually unhealthy, the retained capital reduces the probability of a bank failure, which would be a benefit to shareholders.

Allowing financial companies to pay out dividends to shareholders during a financial crisis is reckless, period. The Federal Reserve and other regulators are still failing to do their job competently.

Hat tip to Greg Mankiw.

Why You Should Hate the Treasury Bailout Proposal

Why You Should Hate the Treasury Bailout Proposal.

Hat tip to Greg Mankiw.

Economists Start to Object to the Treasury Bailout Proposal

Many economists are opposed to the U.S. Treasury's proposed bailout.

For starters, let's look at the objection of Princeton University economist Paul Krugman:

I hate to say this, but looking at the plan as leaked, I have to say no deal. Not unless Treasury explains, very clearly, why this is supposed to work, other than through having taxpayers pay premium prices for lousy assets.

As I posted earlier today, it seems all too likely that a “fair price” for mortgage-related assets will still leave much of the financial sector in trouble. And there’s nothing at all in the draft that says what happens next; although I do notice that there’s nothing in the plan requiring Treasury to pay a fair market price. So is the plan to pay premium prices to the most troubled institutions? Or is the hope that restoring liquidity will magically make the problem go away?

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

And there’s no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.

I hope I’m wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.