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 Feldstein Proposal

There’s a resurgence of interest in the proposal originally made by Marty Feldstein.  The link to his recent Financial Times piece is here.  He wants the Treasury to borrow and on-lend to homeowners, in a way that would improve their cash flow and make it easier for them to avoid defaulting on mortgages.  Of course, anyone who participates would reduce their mortgage (a claim on their house) but create a debt to the government (to be collected, if necessary, by the IRS.)

I must say that I find this broadly appealing, in the moment we now find ourselves.  I know it doesn’t address mortgages already in default, and there are many questions about how it could be implemented.  And I agree that Congress, at this juncture, would need a lot of convincing.

Still, it’s one way to use the Treasury balance sheet to directly reduce likely mortgage defaults.  And, if it’s part of a comprehensive approach (including recapitalizing banks), I think this general approach could make sense.

I hope others will post reactions, or links to any variants with plausible details.

There Is No Alternative. Really?

This morning (September 25, 10am) I was on the Diane Rehm show, on WAMU.  The guest host, Frank Sesno, did a great job of moving the conversation from today’s White House Summit on the bailout plan to the likely impact on the global economy, with relevant stops along the way.  We spent a great deal of time on alternatives.

It turns out, of course, that there are alternatives to the current bailout plan — even if you agree that there is a serious problem and we need to move fast.  In fact, perhaps the one thing all three guests could agree on is the availability of workable alternatives.

I was really struck by Ken Rogoff’s points about the need to take over and close down many banks.  I think he puts more weight on that part of any sensible approach than I do at present, but I’m definitely taking his points on board.

The more I talk with people, the more I hear agreement that we really need to address the problems of homeowners who are having trouble with their mortgages.  It’s actual and expected defaults that got us into this mess, and attacking that issue directly is the best way to make sure we really get out.

Think of it like this.  The Treasury wants to use its balance sheet (i.e., it’s ability to borrow at low interest rates) to help the banking system get back on its feet.  If a substantial amount of taxpayer money is on the table, which it apparently is, let’s talk more about how to use the Treasury balance sheet to help homeowners get back on their feet.

It’s All About the Price

The debate on what the Treasury should or will pay for mortgage-backed securities has moved fast in the last week.  Last week, Mr Paulson said it would be “market prices.”  On Tuesday, Mr Bernanke said it would be “close to mark-to-model prices,” which you can presume would be above, and perhaps substantially above market prices.  Since then, Mr Bernanke seemed to back track from that statement, towards some version of market prices.

But what are market prices or any other prices in this situation?  You need to answer this question to know whether the Treasury is intending to overpay — or whether, after the fact, you can figure out if they did in some meaningful sense overpay.

We attempted to sort this out in The Price of Salvation on the Financial Times website (Economist Forum).  It’s hard to say if any of this is getting through, but we are a little bit encouraged by the reaction.

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.