The sticking points in the bailout plan

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It’s going to be an interesting week. Treasury Secretary Hank Paulson has asked Congress for a $700 billion blank check to buy junky mortgage securities. This was in keeping with the “trust me” approach that Paulson first tried out with Congress in July in the case of Fannie Mae and Freddie Mac–Give me the leeway to do whatever I deem appropriate, and I’ll do what I can to look out for taxpayers (which he did). It was also what you’d call a negotiating gambit.

Now the Democratic leadership in Congress is pushing back, and–far more importantly–so are the nation’s econobloggers (BusinessWeek’s Michael Mandel has a nice roundup, and Yahoo News has one so brilliant that it even quotes me). Oh yeah, and the commenters on this blog aren’t particularly thrilled either.

I’m going to start with the assumption that we do need a bailout, and that it’s going to cost in the vicinity of $1 trillion. There’s obviously–and understandably–a lot of opposition to this afoot among the citizenry. But as a taxpayer I’d prefer this kind of expenditure to a full-on, Great-Depression-style economic meltdown. Or even an early-1990s-in-Scandinavia meltdown. The latter was the potential predicament we were flirting with in the middle of last week–a full-on financial crash that sent GDP shrinking by three or four or five percent and unemployment skyrocketing into the double digits.

But how you structure the bailout is crucial. This isn’t like the Resolution Trust Corporation, which took over the assets of already-failed savings and loans and did a creditable job of managing them and eventually selling them off. Bailie Mae, as Arnold Kling has dubbed it, is supposed to prevent the collapse of lots of financial institutions by taking some of their most troublesome assets off their hands. Which raises some really important questions:

The first big question has to do with how you fairly price all these toxic assets that Treasury wants to buy. The second has to do with how you ensure that this isn’t just another case of “socializing risk and privatizing reward,” as Senate Banking Committee Chairman Chris Dodd nicely put it a while back. And the third is most basic: If we’re going to do a bailout, should it really be targeted at the financial world?

1) The big issue here is that there is no market at the moment for your dodgier collateralized debt obligations and related mortgage securities. So if Treasury isn’t careful it could end up overpaying to load up its fund with the worst mortgage securities of the most dishonest financial institutions. There are ways around this, and there are smart people at Treasury who are surely aware of them. But still, it’s important to get it right.

2) Even if Treasury does get the pricing right, the program would still amount to a massive bailout for the employees, shareholders and creditors of all the financial institutions (both U.S.-based and foreign) that played around in the U.S. mortgage market. In Congress most of the discussion at the moment seems to revolve around getting another stimulus package or maybe compensation limits on financial executives out of the deal. The former may not be such a bad idea; Paulson apparently opposes the latter as too punitive–and Congressional efforts at limiting executive pay have generally backfired in the past. A less punitive approach might be to give taxpayers a stake in any financial institution that gets taxpayer aid. Socializing risk and socializing reward, you might call it. Paulson has been a big proponent of this approach when it comes to institutions on the brink of failure–Fannie, Freddie and AIG. But so far he’s given no sign of backing it with Bailie Mae.

3) Several commenters have brought this one up, but the amazing Steve Randy Waldman has probably expressed it best:

The question we should be asking is not whether or how much, but to whom and for what. The financial crisis we are facing is a symptom of a much larger economic and social crisis. Wall Street is not the source of the pain. On the contrary, the financial sector has been put this decade primarily in the service of hiding, literally of papering over, unsustainable trends in the current account, income distribution, human and physical capital deterioration, and the sectoral composition of the American economy. The conventional wisdom is that this is a financial crisis, and that so far “Main Street” has been largely insulated from the catastrophe. That is rubbish. The cancer is on Main Street, and the tumor has been growing there for years. Wall Street provided drugs to hide the pain and keep us going, palliative but not curative.

What’s Waldman’s cure?

Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. … As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I’d rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let’s spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.