Since launching a week and a half ago, we’ve gotten far more attention and input than we expected. Thank you for your attention, your participation, and your comments. In addition to some of the comments I answered directly on the post in question, I answered some more below. I’ll try to do this periodically. I apologize if I didn’t get to your question; there are just too many to respond to all of them.
Update: I’m restructuring some of the blog to use fewer pages, so I copied the contents of the old page below. To do this I had to copy-and-paste the comments, but they are all still there.
For reasons of space, I’ll have to paraphrase some of the questions.
1. Why not use the bailout money to buy houses outright, which will also prop up the mortgage-backed securities everyone is worried about?
The proposal addresses one of the huge issues facing us in the wake of the bailout plan, which is that it does little for struggling homeowners and little to slow down the growing wave of foreclosures. We think that something major does need to be done in this area, but our preference is more in the area of restructuring mortgages or forcing (or encouraging, depending on your political persuasion) banks to rent homes back to delinquent homeowners. An outright purchase plan would be very difficult politically because it feels like a massive government intervention in the real economy. (I have also heard an argument that buying houses outright doesn’t actually help the mortgage-backed securities, because effectively you have foreclosed on the homeowner, even if the new owner will be nice to him or her.) The theory of the Paulson plan is that it is more efficient to buy hundreds of billions of dollars’ worth of securities than to buy millions of real houses. Another theory is that by effectively buying the mortgages, the government will have leverage to force (or encourage) the people servicing those mortgages to behave in ways that are good for homeowners and for the economy as a whole. I think we need a specific plan stating what we want to happen, rather than simply encouraging Treasury to use its powers for good, but that’s a longer discussion for another time.
2. Have the authorities considered what resources it would take to keep the short term credits sound in all this? That would seem more important, and more effective, than shoring up the mortgage backed securities market.
I don’t know if the authorities have considered this, but it is a very important point. If what we are facing is truly a pure liquidity run based on a crisis of confidence, then simply demonstrating that there is a buyer (the government) for one class of assets may not be enough. Put another way, now that the crisis of confidence has expanded from mortgage-backed securities to everything on a bank balance sheet, a solution focused primarily on MBS no longer addresses the real problem. The truly overwhelming solution would be simply to guarantee all of the liabilities of some set of banks deemed to be healthy, which should (I say “should” because very little is certain any more) put an end to any runs on those banks – at the cost, of course, of putting the taxpayer on the hook should they turn out to be unhealthy. I believe this is what Ireland did last week for some of its banks. Again, I’m not a policymaker, but I think this is an idea that should at least be considered.
3. What about transparency? … Would bringing additional required disclosure on the nature of the opaque assets be of benefit, and how could these disclosures be made to drive an orderly resolution of the troubled entities? At some point, the walking dead institutions will either have to be recapitalized or cleared. The more order the system can put in this unwinding, the less collateral damage that can be inflicted on the underlying economy.
In the long term, I think that more transparency is pretty much an unqualified good. If each bank knew more about what every other bank was exposed to, there would be less of the situation we saw over the last two weeks, when no one knew what third-party risks their counterparties might have. I’ve heard the objection that transparency will be bad for bank trading operations, but my feeling about that is, roughly, “tough.”
In the short term, though, I’m not sure it will do a lot of good. First, there is the problem you point out that it will only hasten the death of insolvent banks. Second, it might not even be enough to save a healthy bank. Having assets greater than liabilities is not enough to survive these days; you also have to be able to prove that you can raise sufficient short-term money to cover your maturing liabilities, and that isn’t a certainty no matter how high-quality your assets are.
As we said in an earlier op-ed, the Paulson plan is at least partially a bet that the government can pay a high enough price to bail out the banks without losing too much money on the other end. We would have preferred that the government do two separate transactions: a purchase at fair market value (that is, not very much) and then an explicit recapitalization to provide any additional money needed by the bank.
4. What do you think of the US’s political system ability to manage and respond to the crises? The House only passed the bill on the 2nd round, after billions of goodies were added. What happens if this does not do the trick and Treasury has to go back?
Great question. One of the arguments for the Paulson plan was that it would show that the government was taking the problem seriously and was able to mount a concerted response. Instead, you could argue, we saw how a combination of ideological rigidity and popular backlash could hold a bill hostage.
On balance, however, I’m cautiously optimistic. The negotiations over the bill did produce a lot of improvements, and the more the public learned, the more they liked the plan. The major risk right now is that many people probably think that the bailout bill that was passed will be sufficient, while most economists have adopted the view that further steps are necessary. Therefore, our political leaders need to start laying the groundwork now by (a) setting the expectation that more will have to be done and (b) talking about what those steps will be. Fortunately, the Democratic majority (which is almost certain to survive the elections) is likely to be supportive of mortgage restructuring and fiscal stimulus, which are two important steps. A lot will obviously depend on who the president is.
Comments (copied from the original page)
Matt Korner, 10/7/08:
Has anyone discussed the possibility of nullifying the credit-default swaps and other derivatives contracts? They are legal creations, after all, and the government can decide to prevent them from being enforced fully. Such a move could reinstate the status quo and institute regulations ex post facto.
James Kwak, 10/7/08:
It’s a plausible idea that we might be better off if CDS and other derivatives didn’t exist in the first place. (Many people would disagree, but I won’t try to express an opinion here.) However, I think that nullifying these contracts after the fact would have two problems. First, the government is legally limited in its ability to unilaterally undo contracts. It can do so under certain circumstances, such as bankruptcy, but I’m not sure what it would take to nullify a contract between to consenting parties who are both still solvent. (At this point, the contract favors one or the other, and the party “in the money” will not want the contract nullified.) Second, it would have a destabilizing effect, because for every bank on the losing end of such a contract, there is another who is counting its gains on the contract. More likely, each bank has many contracts on both sides, so it would be impossible to predict what would happen.
Nadine MacLane, 10/8/08:
Does anyone know if CDS’s are still being written? If not, how long will it be until they all expire, since I understand that they provide a guarantee for a limited period of time.
Is it sufficient to keep the house of cards from falling until the majority of the CDS’s expire (assuming that most of them are still associated with credit given to solvent companies)?
James Kwak, 10/8/08:
5 years is a typical maturity for a credit default swap (if you hear about the credit default swap “spread” for a company, it is usually for 5 years, on senior debt). And they still can serve a useful purpose, so they are still being bought and sold in the market. So they are not going to go away anytime soon.
On the plus side, you are right that most CDS are on the debt of companies that are generally healthy. The goal of policymakers is – or should be – to restore enough confidence in the financial system that banks do not become susceptible to sudden defaults, which will reduce the chance that many of these insurance policies will ever have to be cashed in. At the same time, a bank recapitalization program would increase the chances that, should they have to pay out on the insurance, the banks involved will actually have enough money.
As for the house of cards – a major test will come on Friday when an auction will determine the price at which CDS contracts on Lehman debt will settle. If those swaps can be unwound without causing collateral damage that will be a major relief.
Nadine MacLean, 10/8/08:
I have one more question. The CDS (Credit Default Swap) panic was born of the CDO (Collaterized Debt Obligations) crisis. Your explanation on the “Financial Crisis for Beginners” page is great, it adds more dimension to the issue.
But, at a basic level, I read elsewhere that 21% of the loans made were sub-prime. Assuming all of them fail, there’s still the house as an underlying asset. Assuming the house decreases in value by 47% (chosen by convenience), that equates to a 10% loss over all mortgages.
If I was at the back of the line for my piece of the security pie, I’m out of luck, but for most of the pie, the money is still coming in. What am I missing, or where are my numbers wrong?
James Kwak, 10/9/08:
Those are good questions. I can think of three responses, but there may be more.
First, I recommend the Marketplace video on CDOs that is listed on the Financial Crisis for Beginners page. That video shows how slices of CDOs were used to create secondary CDOs. (A primary CDO is a collection of mortgages; a secondary CDO is a collection of CDOs.) In the secondary CDO, it’s possible that even the people at the front of the line will not get any money from the underlying mortgages.
Second, a given CDO does not necessarily include mortgages of all types. There are CDOs that were built entirely out of subprime mortgages. In that case, the total cash flow into the CDO (in your example) is only 53%, not 90%. (Still, though, you would think the first people in line would be fine, if it’s a primary CDO.)
Third, you may just be right. Some people – including Ben Bernanke, a couple of weeks ago – have argued that these CDOs will be worth much more, if held to maturity, than investors are willing to pay for them today. The financial panic is definitely depressing the prices of these things on the open market. The problem is that if I’m a bank holding these assets, even if I think they will be worth 70 cents on the dollar if I hold onto them, I may need to raise cash right now, and for that purpose they are useless.