Another view on the Paulson plan (updated x2)

Over at VoxEU.org Charles Wyplosz explains why Why Paulson is (maybe) right. Wyplosz writes,

The world’s bankers created a reckless mix of lending and securitisation that exploded in their faces last year; they’ve stonewalled since. It would be criminal to bail them out, but spilling blood for its own sake is foolish.

Wyplosz explains how the so-called "Paulson Package", which amounts to history's largest bet, just might work and might not cost taxpayers too much. It's too early to know which label to apply: "bailout" or "shrewd cleansing operation".

Wyplosz explains the situation as

Even though many serious economists (the likes of Robert Shiller and Nouriel Roubini) had warned for years – not months – that the credit boom and the housing price bubble would end up in tears, bankers superbly closed their ears and soldiered on, driven by greed and short-term analyses. When the mix of reckless lending and securitisation exploded in their faces, more than one year ago, they stonewalled and drove the economy down in the hope of being bailed out. It would be criminal to bail them out. It would guarantee even worse crises in the future. Conclusion, there must be blood.

This being said, spilling blood for the sake of it is a bit silly. Banks are not oil companies. When an oil company goes bust, by definition, it is because its liabilities exceed its assets. After bankruptcy, its assets remain as valuable as before. Oil is safely tucked away under ground, refineries and gas stations stay put above ground.

A bank goes bust when its assets have collapsed. Bankruptcy means that its liabilities collapse too and these are assets of other banks and of millions of hapless citizens. This is why contagion and bank runs occur more frequently than oil runs. Sure, with patience, both assets and liabilities can regain value, but in the meantime the financial system is impaired and the resulting credit crunch provokes an economic crisis that spares no one. This is why large, systemic financial institutions cannot be summarily dispatched to receivership. Avoiding a credit crunch ought to be every one’s priority.

As to the Paulson plan he writes

The details of the plan are not known yet, so it is too early to determine whether it is a bailout or more blood. All will depend on two things. The price at which the assets will be acquired by the yet unnamed RTC, and the price at which the RTC will dispose of these assets.

Indications are that these assets will be bought at auctions. These will have to be reverse auctions, probably of the Dutch variety. If the sellers are confident in their financial health, or just smart enough to collectively bluff Paulson, the price will be close to the purchase price and it will be a bailout. If the sellers are scared and unable to organise themselves, the price will be a deep discount. Willem Buiter argues that the auctions are likely to force the sellers to reveal their true reservation price and I tend to agree.

Assume that the toxic assets will be acquired at a deep discount and thus the RTC will hold a huge portfolio of these assets. But it will be in no rush to sell them?

Like the previous RTC, thanks to taxpayers’ money, it can take years to do so. If the toxic assets gain some value, the RTC and the taxpayers will make a profit and the financial institutions that sold them will definitely not have been bailed out. We will be able to call the operation a bailout only if toxic-asset prices go on falling, since it will then be established that the financial institutions managed to sell these assets above market price and at taxpayer’s expense.

Wyplosz's conclusion,

It is therefore much too early to call the operation a bailout or a shrewd cleansing operation. Judgment will have to wait until the yet-to-be-created RTC is folded, several years from now. Meanwhile, for the first time since mid-2007, we can foresee the beginning of the end of the crisis since the financial institutions will have either to promptly recapitalise or fold. This, in my view, justifies Paulson’s bet, probably history’s biggest ever.

For more commentary on the financial situation here's a list from Greg Mankiw,

1. Roger Lowenstein
2. Charlie Calomiris and Peter Wallison
3. Barry Eichengreen
4. Larry Lindsey
5. Thomas Sowell
6. Robert Samuelson
7. Anil Kashyap and Jeremy Stein
8. Martin Baily and Robert Litan

Update: The The visible hand in economics asks Is the US taxpayer being forced to surrender to Wall Street?

Update 2: More commentary on the financial situation, again from Greg Mankiw,

1. Lucian Bebchuk
2. Steven Landsburg
3. Anne Krueger
4. Glenn Hubbard, Hal Scott, and Luigi Zingales
5. Richard Epstein
6. Sebastian Mallaby
7. Robert Samuelson
8. Nouriel Roubini