Author: James Kwak

The Death of Washington Mutual

Poor Washington Mutual … on any other day, its government-brokered takeover by JPMorgan Chase would have been the lead story, as opposed to Henry Paulson begging Nancy Pelosi on bended knee to save his bailout plan. At first glance, the purchase raises a glimmer of hope: is it really as simple as having the healthy banks buy up the unhealthy banks? But there is still a clear loser here, besides WaMu’s shareholders, who must have seen this coming: anyone holding non-secured debt is not covered by the transaction, since that liability remains with the WaMu holding company and was not transferred to JPMorgan along with the assets and the banking operations. According to Bloomberg, WaMu had $28.4 billion in outstanding bonds, which have just gone up (mostly) in smoke, triggering an unknown volume of credit-default swaps. (Remember AIG? Those are now the taxpayers’ credit-default swaps).

The transaction raises another worrying issue. Before yesterday, Washington Mutual had taken $19 billion in losses on mortgage loans. In the acquisition, JPMorgan acquired $176 billion in mortgage-related assets and immediately wrote them down by $31 billion, or 18%. This seems to be more evidence that some banks have these assets on their books at inflated prices, which is the problem that everyone is working so hard to solve.

Bailout Plan – The House Republican Alternative

And Now, Behind Door #2 …

Whatever the motivations of the House Republican plan – as distinct from the plan agreed upon by the Republican President, Republican Treasury Secretary, Republican Fed Chairman, Senate Republican leadership, and Democratic leadership of both houses – it is still a plan, and as such merits consideration. The “Common Sense Plan to Have Wall Street Fund the Recovery, Not Taxpayers”has two main elements: first, a Treasury Department insurance program for mortgage-backed securities that will be entirely financed by premiums collected from the holders of those securities, not taxpayers; and a combination of tax breaks and deregulation intended to attract private capital to the banking sector.

The insurance proposal amounts to more of the wishful thinking that has allowed the financial crisis to last as long as it has. Such a proposal would only work if the fundamental problem were an inability to distribute risk, and if there were no available insurance mechanisms. But the fundamental problem is not that banks can’t distribute the risk of deteriorating assets, but that they are holding assets that are already not worth very much, and therefore the insurance premiums for those securities would be prohibitive. (Instead of paying by writing down the assets, they would have to pay insurance premiums.) And there are insurance mechanisms already (remember credit-default swaps?), but that insurance is too expensive to buy. The only way a Treasury insurance program could change things is by offering insurance at artificially low premiums, which is just another way of handing taxpayer money to banks – with no recompense to shareholders.

The proposal to attract private capital to the industry is too little, too late. Washington Mutual, for example, was unable to find a buyer until the government used a forced bankruptcy to wipe out $28 billion of its debt; no one is lining up to offer capital to Wachovia. It is hard to see how offering tax breaks to banks (which is yet another way of handing taxpayer money to banks) will encourage new capital investment, at least as long as their mortgage-related assets remain under a cloud of uncertainty.

Given that few people want to lend to or invest in banks these days, it’s hard to see how a solution is possible without taxpayer money. The important thing is to make sure that the taxpayers get something in exchange for their money.

Update: Politico has a survey of economists’ reactions to the House Republican plan. The short version: economists were concerned by the original Paulson plan, but baffled by the House Republican plan.

The Paulson Bailout and Governance

Watch Your Wallet

Ordinarily, you would not hand $100 to your broker to invest on your behalf without some idea of how he or she would invest your money. You would be even less likely to hand over your cash to someone planning to invest it in illiquid assets with no established market prices. However, the original version of the government bailout plan, released on Thursday last week, handed $700 billion of taxpayer money to Treasury to invest in mortgage-backed securities at any price it saw fit.

Our Washington Post op-ed article discusses this governance question and floats a few possible solutions that could align incentives properly and promote transparency. At the same time, opposition from both sides of the aisle on Capitol Hill has greatly increased the chances that some form of improved governance will be included in the final plan. In following the ongoing debate, however, it will be important to make sure that there are adequate mechanisms for setting prices objectively and transparently, or else the opportunity for abuse will remain.