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Who Should Pay for the Bailout?

Business  (tags: George Bush, Hank Paulson, Bernanke, Greenspan, Gramm, McCain, Republicans, bank failures, mortgage crisis, credit crisis, gas prices, BIG OIL, BIG PHARMA, markets, investments, hedge funds, Cmapaign 2008 )

- 3798 days ago -
Luigi Zingales' reaction to the financial market bailout plan, "Why Paulson is Wrong," has been getting a lot of attention...


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Blue B (855)
Monday September 22, 2008, 6:37 am

Luigi Zingales' reaction to the financial market bailout plan, "Why Paulson is Wrong," has been getting a lot of attention and a Vox EU version of the argument appears below (my initial reactions are here). The main point is that taxpayers should not pay for the bailout.

Several points on this. First, if the government does do a bailout, the size of the bailout won't necessarily be $700 billion, and it is unlikely that it will be. The government is using the money to purchase assets. Some of those assets will appreciate, some will depreciate, and we don't know for sure what the net result will be. We could make money on the deal, we could lose money, we just don't know. But one thing is fairly certain, it's unlikely that the value of every security the government purchases will fall to zero, and that would be required for the government to lose all the money it spends (invests). See knzn on this point.

However let me be clear, even if the expected value of this deal is zero, that is, even if we expect losses and gains to cancel over time, taxpayers still need to be compensated for the risk they are taking. There is a risk that this bailout could lose hundreds of billions of dollars, and, just like in any financial transaction, the parties assuming that risk need to be compensated for it.

Second, I am not too concerned about the particular mechanism that we use to compensate taxpayers for the risk they are assuming. One way is the method below recommended by Luigi Zingales where taxpayers are bypassed altogether, but charging a higher than market interest rate on loans, entering into a formal profit sharing agreement, increasing taxes for corporation who take out a loan, all of these are ways of recovering some of the investment, a way of sharing the upside with taxpayers, and these don't exhaust the possibilities. To me, what's important is to get this rescue in place as soon as possible, to compensate taxpayers for any risk they are assuming, and to be sure that if the bailout does cost money, that the people who did nothing to cause the crisis and who did not benefit from it are insulated from paying for it. The particular mechanism for extracting payment for the bailout is less important and will likely be dictated by the politics, some solutions will be more politically viable than others.

If it was up to me, I'd get a government bailout going as soon as possible, we shouldn't rush into a bad agreement but we shouldn't waste time either, and use progressive taxation as the way to extract the payment for the rescue operation. As I look at the large corporate profits in the finance industry, and as I think about what has happened to the distribution of income since the Great Deregulation begin in the 1970s, it seems pretty clear that those at the top received most of the benefits on the upside of the boom. So it's only fair that those who had the largest share on the way up ought to pay the largest share on the way down. If this bailout costs us money, that is who should be paying for it.

But why raise taxes for everyone at the top, shouldn't the burden be limited to people in the finance industry who made out like bandits? The benefits from the housing boom weren't limited to fat cats at hedge funds and other financial entities. If you built houses, poured concrete, sold doorknobs, had a roofing company, etc., you benefited from the housing boom. And there are secondary effects too. During a boom more cars are sold, people eat out at restaurants more, they buy more TVs, go on more expensive vacations, all sorts of business did better because of the boom, and hence, so did the business owners (the benefits probably weren't distributed equally at the top, but even if you were, say, a major league baseball player, if attendance was higher, if you starred in more car commercials and so on because of the booming economy, then you shared in the profits from the euphoria).

But not everyone did better. Workers, in real terms, did not get a share of the profits from the boom, their wages stagnated over this time period. So why should they pay for the bailout? This is nothing more than The Little Red Hen run backwards, they ate the bread first and now the hen is asking "Who will help me pay for the bread?" It shouldn't be those who weren't allowed to sit at the table.

So I would increase taxes progressively, and I would do it in proportion to the changes in the distribution of income over this time period. And I like this a little better than Luigi Zingales' solution for precisely that reason, it puts the burden directly on those who benefited from the boom.

I understand that this may not be the best solution politically, taxation is a hard sell, and so is the argument that the benefits from the boom were general rather than confined to the finance industry. But if it was up to me, I would do a government bailout as soon as possible, and raise taxes progressively to compensate taxpayers for risk and to cover any losses. But in the end, I will be happy with any solution that insulates taxpayers in the middle and lower income classes from sharing in the burden of the bailout, a solution that places the costs directly on those who benefited most from the housing bubble.

Update: Comments are not pleased with this post, so let me potentially dig the hole a little deeper by trying the argument from another perspective:

Another way to think about the progressive tax approach is that it internalizes all of the costs. If there are indirect benefits from a boom, then those people who get the indirect benefits have an incentive to encourage a boom - it helps them while it's on, but they can argue it's not really their doing, so why should they be penalized for the clean up? They at least have an incentive to look the other way, to not get involved in stopping whatever behavior leads to booms. Why should they? While it's on, they do better, when it's over, the cost of the bailout falls elsewhere (assuming it's not a big crash that eventually leaves them worse off on net).

We want this to be internalized - we don't want people indirectly supporting a boom, we want them to say hey, stop that, if it continues it's going to cost me money.

Update: Before getting to Luigi Zingales' argument, let me insert this from Paul Krugman:

Thinking the bailout through, Paul Krugman: What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.

First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk.

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Let’s not be railroaded into accepting an enormously expensive plan that doesn’t seem to address the real problem.

Here's the argument from Luigi Zingales:

Why Paulson is Wrong, by Luigi Zingales, Vox EU: When a profitable company is hit by a very large
liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices – the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity. The old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt holders can agree to trim the face value of debt in exchange for some warrants.

Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well-established approach not used to solve the financial sectors current problems?
No time for bankruptcy procedures

The obvious answer is that we do not have time.

Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. The negotiations would take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector.
But at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay.

Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price?

The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich – at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis.
But, again, at what price?

The answer: billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.
A alternative to Paulson’s RTC

Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move.

During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision.

My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices but bond prices as well soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equity holders, but also the debt holders.

If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?

· First of all, there is a coordination problem.

Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay.

· Secondly, from a debt holder point of view, a government bail-out is better.

Thus, any talk of a government bail-out reduces the debt-holders’ incentives to act, making the government bail-out more necessary.

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.

But if it is so simple, why no expert has mentioned it?
Taxing the many to benefits the few

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt-forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill. The financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.
Profits are private but losses are socialized?

The decisions that will be made this weekend matter not just to the prospects of the US economy in the year to come. They will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?

For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.


Blue B (855)
Monday September 22, 2008, 6:55 am
Now that the final step has been taken, can anyone deny that Phil Gramm, Jim Leach, and Tom Bliley knew exactly what they were doing?

Blue B (855)
Monday September 22, 2008, 7:27 am

#fullpost {display:none;}
CNN does some he-said, she-said, but throws in some data:

The administration's proposal also requests that Congress authorize an increase to the nation's debt ceiling. Currently, it's set to rise to $10.6 trillion for fiscal year 2009 - which runs from October 2008 through September 2009. But the proposal requests that limit be increased to $11.315 trillion to allow for the purchases of mortgage-backed assets. [emphasis mine]

Now, strangely, I have always heard that assets have a positive value. When I buy $100 worth of a stock—say, PWND—my Net Asset Value doesn't change. The same should be true of buying a MBS worth $0.30 on the dollar.

So why would we need to increase the deficit ceiling by $700,000,000,000 if we're buying assets worth $700,000,000,000?

The only reasonable conclusion is that we plan to pay $700,000,000,000 above market for the securities. No wonder it has to be "clean and quick."

Blue B (855)
Monday September 22, 2008, 7:33 am

. (0)
Monday September 22, 2008, 9:34 am
Smoke and Mirrors don't feed the bulldog. Does anyone want to guess where this money will ultimately 'really' be going? It has been speculated by mainstream media, at least once, that if you trace every link in the dominoe chain, it will lead you straight back to September 11th, 2001. It has been reported that every financial move since 911 has a connect the dots cause and effect!
As to 'who should pay'? The worldwide oil industry, and every nation on Earth, because if our lights go out, then they all go out!!!

Blue B (855)
Monday September 22, 2008, 2:30 pm
The Democrats in Congress must hold out for everything they want. This is basic negotiation. So what if Secretary Paulson wants the cash upfront with "the reforms need to come later."

Here's what this Democrat wants:

1. No more $ for the Iraq War.

2. Expand Medicare and/or Medicaid to include all members of the population.

3. Codify the "Fairness Doctrine" of the FCC removed by R. Reagan. Return the public airwaves to a marketplace of ideas.

4. Triple the amount of money available for students under the Pell grant program.

All of the New Deal, or none of the New Deal.

There MUST BE NO bailout without considering the following facts:

1. Paulson was Goldman Sachs-CEO, before he became US-Secretary of the Treasury.

2. Goldman Sachs is the only invesment-bank, which not only SURVIVED last week's bloodshed, but THRIVED on it. (Question: What did GS know, to thrive, while others faltered - something, that other Investment Banks apparently didn't know - and HOW did they get to know this?)

3. Paulson now suggests that the USA shall unconditionally buy toxic debt from the remaining Banks and Investment Banks - aka Goldman Sachs.

4. Goldman Sachs will shed all her toxic debt and sell it unconditionall to the taxpayer, only keeping the good, profitable debt in her portfolio.

5. After January 20th, Paulson will very likely return to the board of directors at Goldman Sachs. But even if he didn't return, He had $632,000,000 in Goldman Sachs stock when he left.

1 + 2 + 3 + 4 + 5 = Everybody at Goldman Sachs is laughing their sleeves up, celebrating their unprecedented bravery and recklessness in looting America

A pattern. Anyone?


So let me get this straight, Mr. President and Mr. Secretary. We taxpayers have to give $700 billion dollars to Wall Street right away, no questions asked, so they can lend our money back to us with interest? Insulting.

Blue B (855)
Monday September 22, 2008, 3:52 pm
Has anyone seen any mention of the infamous Section 8 of the Paulson Bailout Plan mentioned in any major media outlet?

Here's the textjust as a reminder:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

It is critical that this gain traction this week. Write every outlet you can think of to cover this massive power grab. And if you see any mention of it, please note it in the comment thread.

Well, at least Jack Balkin is paying attention. It's a must read.

Write you your House Representative, here. Write to your Senator here.

Update: Ian notes that Obama seems to have drawn a line in the sand: NO DEAL! Although I must note, after reading Obama's remarks, I don't see anything about Section 8 or legal oversight in them AT ALL. And that is disturbing. Here are the key points:

First, there must be no blank check when American taxpayers are on the hook for this much money.

Second, taxpayers shouldn't be spending a dime to reward CEOs on Wall Street.

Third, taxpayers should be protected and should be able to recoup this investment.

Fourth, this plan has to help homeowners stay in their homes.

Notice anything missing?

Update 2: Lambert points out that McClatchy is on the case.

Yvonne White (229)
Monday September 22, 2008, 4:17 pm
"'s only fair that those who had the largest share on the way up ought to pay the largest share on the way down. If this bailout costs us money, that is who should be paying for it." Amen!
I still think the Best Plan is to Take that $700 BILLION & Nationalize Healthcare, shore up Social Security, and then ReNegotiate Every Stressed Homeowner's Loans (but not speculators & Donald Trump-types!)!

Eric Straatsma (3802)
Monday September 22, 2008, 8:50 pm
First, McCain was against bailing out AIG... that is Conservative values for sure.

The next day, McCain was FOR bailing out AIG.. that is liberal values for sure. I think that is a record for the fastest flip flop ever, or did someone do it faster? I think he should get an award for that.

What is a bailout called when the government buys out the controlling interest in a private corporation, and replaces the CEO with their own hand picked person who is under their control?

How can Conservatives and Liberals agree that Communism is now needed, when we have been fighting it for generations? The definition of Communism is government controlled enterprises.. right? Read it for yourself...

If we are going to become loyal Communists, and our best friends with most favored trading nation status is Communist China, why not go all the way, and take over all of the biggest corporations, starting with the OIL companies? Start by distributing checks to all Americans as they do oil 'royalties' checks in Alaska, out of the profits from all of these companies that the Communist government is taking over, including Fannie Mae, Freddie Mac, and all the rest?

If it works for Alaskans, and for Saudi Arabia, why not for the rest of us? It seems we are going to live under an authoritarian government controlled by corporations, which tries to shove solutions down everyones throat under threat of total collapse if we do not take the deal. It seems we are going to live under an authoritarian government that does not debate issues or talk about issues of any substance. The least we can do is nationalize these corporations that the government is bailing out on our behalf., In return, the least these corporations can do is hand out money in return for us bailing them out of their mess.

Blue B (855)
Tuesday September 23, 2008, 4:04 am
The facts show that the problem was caused by allowing the market to operate without regulation. So logically, Paulson's solution is to allow him to make thing right by not regulating his actions. Only in Alice's Wonderland would anyone suggest such an idea.

Make certain that oversight is accomplished by a majority of non politicians. Let's include 1 Republican, 1 Democrat and 3 others. The other three will have to be agreed upon by both parties. Guys like Buffett would do nicely.

Finally, and most importantly, drop the word bailout. Change it to loan. All of us know that when we go to the market for money, it's always expected we will repay the loan. Whether that is in the shape of ownership or preferred stock, we must insist on being made even. Make certain that bankruptcy won't avoid repayment. Insist that executives pledge their company stock and pension guarantees to insure the debt is repaid. Bottom line. This isn't a bailout. It's a loan. Limit executive compensation until the loan is repaid. We'll be told that's unfair by some. Tell them to go somewhere else for a loan then.

This is a defining period for America. We must adhere to the American principals that business understands. There is no free ride. Take it or leave it.

Blue B (855)
Wednesday September 24, 2008, 3:16 pm
McCain admits he knows nothing about the economy and hasn't even read Paul$on'$ plan.

McCain Wants A Time Out -- But Why?Bush was able to debate Kerry while he was president.
For all of his sudden urgency, McCain acknowledged just yesterday that
he had not even read the administration's three-page bailout proposal.


Blue B (855)
Wednesday September 24, 2008, 6:25 pm
Why did Paul$on'$ firm: Goldman $ach$ survive???

The Long and Short of It at Goldman Sachs

Goldman Sachs sold hundreds of Billions in subprime/CDO's and shorted them at the same time.

A new analysis by Goldman Sachs Group, Inc. finds that “Wall Street banks, brokerages and hedge funds may report $460 billion in credit losses from the collapse of the subprime mortgage market, or almost four times the amount already disclosed.”

The degradation of accounting The folly of fair value accounting, which helped to drive up executive bonuses based on illusory values, is increasingly exposed by the US financial crisis. Goldman Sachs now has "assets" for which no market exists valued at twice the firm's capital. That route leads to insolvency.


Blue B (855)
Wednesday September 24, 2008, 7:00 pm
There is no doubt in my mind, where Paulson´s loyalties lie. He is
pushing for the plan as Bush was pushing for the Iraq war. By using
politics of fear the ultimate scare tactics they always use. And in my mind there is no doubt about his loyalties either. He needs a job come January and where would that be for a banker?
The price tag for his plans? Much, much more than $700 Billion.

Blue B (855)
Wednesday September 24, 2008, 10:55 pm
Timing ...

naked capitalism: On the dishonest sale of the bailout plan

Yes ... the Bu$hie$ were sitting on this plan; waiting for the right opportunity ... 41 days before ELECTION DAY.
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