Our position has been that the Paulson Plan is imperfect but is still a valuable first step toward restoring confidence in the financial markets, and so we are glad that it passed today. One remarkable development over the last two weeks has been a shift among both economists and the public from thinking the plan was an application of massive force to thinking that the plan is a relatively small part of the long-term solution. As discussed in our most recent baseline scenario, the next steps are to work on financial sector recapitalization, housing market stabilization, and fiscal stimulus (and, of course, regulation).
At the same time, though, implementing the Paulson Plan will be a major task, and one that will require oversight both from Congress and from government-watchers. Not surprisingly, Treasury is already moving to use fund management firms as outside contractors in buying securities. There are some valid practical reasons for this, but it creates the potential for conflicts of interest that we warned about in an earlier op-ed on governance; fortunately, the final bill includes much more emphasis on transparency of contracting than did the original proposal. Pricing the assets will be perhaps the trickiest problem, whether it be through reverse auctions (which can be difficult to implement) or through direct negotiations with banks. Price will determine how many warrants the government gets in participating companies, which are another improvement in the final bill. Finally, although the plan specifies multiple forms of oversight, figuring out how to make that oversight effective in a fast-moving environment will be difficult.
So while passing Plan A was a good thing for the financial sector and for the real economy, making it work will require a good deal more effort both inside and outside the Beltway. And the sooner work starts on Plan B, the better.
Where there are $700 billion of funds to manage, there will be fund managers. And whether because of the ideological (small-government) preferences of the administration, or because mortgage-backed securities really are hard to analyze and value, or because of the speed required, it is highly likely that those fund managers will be working as contractors, not as employees of the Treasury Department.
Simon and I wrote our first op-ed last week on the challenges of aligning fund managers’ incentives with those of investors (in this case, taxpayers), but with all of the events of the last week this topic has not received a lot of attention. Christopher Dodd did add language addressing the problem of conflicts of interest, but it’s not clear how conflicts will be avoided in practice. Fortunately, Philip Mattera at Dirt Diggers Digest has been focused on just this issue for the past week. His prediction? The big winner could be the bond specialists at Pimco – who boast a special advisor named Alan Greenspan.
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.