Thanks to Sal's video presentations on the economic crisis and the bailout plan
I think I finally get what's going on here.
But what I don't get is why the Fed, the president, the Senate, and even Warren Buffet are supporting the Paulson plan. It seems like only a half solution that is fraught with risk.
I think it would make a lot more sense to take an equity stake in failing banks rather than simply buying off their toxic "assets" (more like "liabilities" at this point) that are dragging them down into insolvency.
Check my thinking:
We have to infuse enough money into a struggling bank to offset the downward drag of the toxic CDOs regardless
of whether we do the Paulson plan or take an equity stake.
Say Bank A has toxic CDOs which they appraised to have a notional value of $3bil. But those CDOs may actually be worth nothing. And certainly no one's going to buy them on the open market for $3bil in this environment. But the bank's balance sheet is so precarious that if that $3bil disappears from their assets, they'll fall into insolvency and will have to file for bankruptcy.
Let's say that they only need $2bil in cash to remain solvent. So they could either sell those CDOs at a discount for $2bil (even though they thought they were worth $3bil and would write down a $1bil loss) OR they could sell a share of the bank itself and raise $2bil in capital.
Either way the Fed is the only one who's got that kind of cash and the willingness to step in. So either way it's going to cost the taxpayers $2bil to save that bank.
Paulson's plan would have the Fed buy the CDOs outright to get them off the bank's books. The government would then own the worst CDOs on each struggling bank's books.
Downside: Many of those horrible CDOs could very likely be worth nothing.
Systemic Upside: The bank remains solvent and continue operating (though Sal argues it'll have a black mark on its forehead as a "troubled bank" that needed a Fed bailout and therefore will remain looking like a risky investment to other lenders).
Taxpayer Upside: Maybe someday some of the luckier CDOs will see some money trickle back in. However, claiming that these investments might even turn a profit some day is overly optimistic. Any defaults in the underlying mortgages will hit these CDOs first.Equity Stakes
Taking an equity stake would put the SAME amount of money into the bank, but the bank could write the CDOs all the way down to $0 value, BUT still retain ownership of it. The government gains a large, if not controlling, stake in the bank.
Downside: Federalization of our banking system (significant portion of our banks are government-controlled). Who knows if we'll run them properly--it'll be more big bureaucracy. Our fortunes are tied to the bank's well-being; if it collapses, our capital investment goes down with it.
Systemic Upside: With the Fed having a stake in keeping the bank afloat, creditors should be more willing to extend credit knowing that someone with deep pockets owns the biz. The bad CDOs become a nonfactor in the bank's books.
Taxpayer Upside: If the bank rescue is a success, it will recover value and our equity stakes will INCREASE in value. Remember, we'd be acquiring these banks at bargain basement valuations. We can slowly sell off our equity stakes to liquidate funds and maybe eventually get back our investment or even turn a profit. Those bad CDOs are still owned by the bank and if any of them actually return money, that's just a nice bonus on top of the bank's recovery.So which one makes more sense?
Well would you rather spend $2bil so that you can hold an imploding hot potato or would you rather spend $2bil to buy a business that you might be able to help turn around? It's the difference between buying the poison and taking it ourselves OR neutralizing the poison and leaving it where it is.
Unless I'm missing something, I don't see how the Paulson plan makes sense. Either way we're acquiring a stake in those CDOs, the only difference is what else we're getting for our money. Doesn't capitalism work better when both partners have incentive to work towards the same goal? With an equity stake in a bank, we profit when the bank profits; that's capitalist cooperative synergy.
But paying someone to shovel their shit over to our side of the fence makes no sense at all.So why is everyone in Washington so hot on the Paulson plan?
Let me start with a different question: who would stand to LOSE if we took equity stakes?
If we take an equity stake in these struggling banks, we necessarily dilute the value of the current shareholders. Specifically the major
shareholders. Major shareholders would stand to lose a lot of value, even in banks whose valuation has plummeted in recent weeks.
That brings us to the conspiracy theory.
And what's the profile of major shareholders? Rich white guys. How do they vote? Republican. Who's in control now? Republicans. Whose plan is it to avoid the equity stake route? A Republican appointee.
The GOP is wholly driven by rich white guys. The evangelicals and gun freaks are pandered to for their votes, but it's the rich white guys that run the show and fund the campaigns. If the GOP made the major shareholders take the hit for this crisis, they would be committing political suicide. Their party leaders would be obliterated.
I'm not a fan of conspiracy theories--especially not partisan conspiracy theories. So perhaps there's a less insidious explanation for favoring the Paulson plan.
That theory is simply this: status quo.
It may be that Hank Paulson and the whole financial and political establishment are just too accustomed to the status quo to even conceive of changing it. Clearly a move toward a Federalized banking system would be a dramatic paradigm shift that would completely overthrow the status quo.
Perhaps Paulson has been so much a part of the metaphorical box that he is incapable of thinking outside of it, nor sees any reason to reshape it.
This is a legitimate perspective. Paulson is clearly saying, "How do I fix the system from within the system?" whereas taking equity in failing banks would require him to say, "How do I fix the system by reinventing the system?"
In many ways it's hard to fault anyone for thinking this way, thinking within the status quo. The $700 billion plan itself is already a radical departure from the norm (though I would argue that it merely pushes the boundaries of the box but does not fundamentally alter its structure).
In this view then we can only fault Paulson and the establishment for its lack of creativity; that they are not willing to "boldly go where no one has gone before" is regrettable but excusable. And that is certainly more palatable than the partisan conspiracy theory.