Streetwise Professor

October 13, 2008

Don Corleone Makes His First Offer

Filed under: Derivatives,Economics,Politics — The Professor @ 9:00 pm

Treasury Secretary Paulson called an assembly of all the major banking families, and offered them billions in equity in exchange for preferred shares. The money sentence: “The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.”

The first offer not to be refused. I doubt it will be the last.

I continue to believe that the Humpty Dumpty Option is worthy of consideration, and perhaps of another Don Corleone soliloquy. Although stabilization and recapitalization of the supermajor banks is certainly an important element to addressing the credit crisis, it will not be sufficient. It focuses on the biggest banks, and only on those in the US, but the problems exist at banks of all sizes throughout the US and the world. This intervention does not address the issue of the vast amounts of dodgy mortgage debt lurking in bank portfolios, and it is this dodgy debt that is at the root of the problem.

Interestingly, the Treasury seems to be moving away from the TARP scheme (praise the Lord). This may reflect (a) that it will take a long time to get the auction process going, (b) the Treasury’s dawning recognition that the auction program is likely to be impractical, and (c) that more urgent action was needed to stabilize things. This last consideration is somewhat worrisome, and I think that helps explain why other initiatives announced by the Treasury and other governments over the past couple of weeks have seemed to send the markets into a tizzy. The markets infer from every new move that the Treasury and other governments are signaling that things are even worse than originally feared.

Humpty Dumpty has numerous merits, some of which I pointed out in the original post. One advantage is that although it would require the exercise of Federal power to implement, it would not entail government ownership or direct investment, and could reduce the amount of government investment required to stabilize the banking system going forward. Under this alternative, the original investors in mortgages and mortgage derivatives would continue to own claims against these assets. This would limit the potential for wealth transfers between taxpayers and (current) asset owners. It would also limit the massive potential for mischief that accompanies the government’s holding large stakes in the financial system.

Such transfers would be inevitable under TARP, and it’s a heads we lose tails we don’t win proposition. If the transfer is from asset owners to the taxpayers (as would be the case when the government underpays), the program would do little to address the capitalization of banks, and could actually make them worse off, thereby prolonging the crisis and requiring additional injections of public funds later. If the transfer is from the taxpayers to the asset owners, well, that might effectively inject capital into some banks, but some of the windfall is almost certain to flow to asset owners who do not need assistance to avoid posing a systemic risk.

Furthermore, since it is almost certainly easier to value mortgage-based claims relative to one another, than in cash, valuation errors (and the related wealth transfers) should be smaller under Humpty. This would reduce the magnitude of the wealth windfalls–which again, under this plan, would be among asset owners who exchange their claims on the mortgage-based assets for shares in The Firm, and would leave the taxpayers out. In essence, The Firm would essentially pool and share valuation risk within the financial community (banks, hedge funds, and other investors.) This seems preferable than sharing that valuation risk with taxpayers. It should also be noted that if all asset owners participate, since many of them have diverse portfolios of mortgage-based claims, the variability of valuation errors on these portfolios will be smaller than the variability of valuation errors on individual components of them.

The Humpty Option also addresses the problem at the root, by undoing the complexity (and associated informational problems) created by financial engineering. Rather than razing that thicket, the TARP/auction alternative runs right into it. It would be infinitely easier to create a liquid market in shares of a portfolio of all the mortgage-based assets in question than in many of–let alone all of–the mortgage-based assets individually. If the liquidity discount on the individual assets is as large as Paulson and Bernanke suggested in touting TARP, the shares in The Firm would likely be much more valuable than the sum of the values of the individual assets even were the TARP program to improve liquidity in the market for the individual assets.

In other words, the Humpty Dumpty Option almost certainly would accomplish more than TARP, and without putting taxpayer funds at risk.

When thinking about Humpty over the weekend, a quote from Eisenhower came to mind (I quote from memory, but I’m sure it’s close to the original): “If a problem appears intractable, enlarge it.” That’s Humpty Dumpty in, well, if not a nutshell, an eggshell. Go large. Tackle the problem at the root.

It is not The Solution, but neither is making multi-billion dollar “investments” in the big banks. In conjunction with other efforts, however, it can make a big difference. Indeed, by mitigating the bad asset problem at no direct expense to taxpayers, it would reduce the cost of other measures necessary to restore the financial system to health.

By using the Don Corleone approach–and Paulson just crossed that bridge today–it would also be possible to avoid the adverse selection problems that will almost certainly bedevil TARP (and which would ultimately be the source of wealth transfers from taxpayers to asset owners.)

Print Friendly, PDF & Email

No Comments »

No comments yet.

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress