John Cochrane on Why the Bailout Plan Would Be a Disaster

My colleague John Cochrane has written an insightful piece on the bailout. In short, he believes that the Treasury plan needs to be shot, have a stake driven through its heart, and be buried.

His arguments, posted on his website, are reprinted below:

The Monster Returns

By John H. Cochrane

A Guest Post

Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the government. But this plan is fundamentally flawed. It won’t even work if we leave aside its horrendous cost and long-lasting damage to the financial system. The additions and sweeteners in the Senate version, and those on the table in the house, make it even less likely to work.

A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short-term credit markets. These are not new and untested ideas; these are the tools that governments have used for 100 years to get through financial turmoil. However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes.

The Problem

The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose values have fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent. Credit market problems are a symptom of this underlying problem. Nobody really knows which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.

A credit crunch is the danger for the economy from this situation. Banks need capital to operate. In order to borrow another dollar and make a new loan, a bank needs an extra, say, 10 cents of its own money (capital) — so that if the loan declines in value by 10 cents, the bank can still pay back the dollar it borrowed. If a bank doesn’t have enough capital — because declines in asset values wiped out the 10 cents from the last loan — it can’t make new loans, even to credit-worthy customers. If all banks are in this position (a much less likely event), we have a credit crunch. People want to save and earn interest; other people want to borrow to finance houses and businesses; but the banking system is not able to do its match-maker job.

Solving the Problem

O.K., if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real businesses can borrow money again and start lending it out. The core of any plan must be to recapitalize the banking system. How?

Issue stock — either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffett last week, or by merging or selling the whole company. There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock because it seems to dilute current stockholders, and it might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so. In many previous “bailouts,” the government added small (relative to $700 billion!) sweeteners to get deals like this to work.

Let banks fail, but in an orderly fashion. When a bank “fails,” it does not leave a huge crater in the ground. The people, knowledge, computers, buildings, and so forth are sold to new owners — who provide new capital — and business goes on as usual; a new sign goes in the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the administration — nobody likes losing money — but their losses do not imperil the financial system. They earned great returns on the way up in return for bearing this risk; now they get to bear the risk.

We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days. At the end of the week, JPMorgan took over Washington Mutual. Depositors and loan customers didn’t even notice.

As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.

This process does need government intervention; “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging. Until that gets fixed, we have to muddle through.

An important long-run project will be to redesign bankruptcy; delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short-term creditors) and how much regulation that protection implies; and design a system in which shareholders and debt holders can lose the money they put at risk without creating systemic risk. But not now.

What is simple to describe economically — wipe out shareholders, write down debt, marry the operations to new capital — is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.

Fancy ideas. The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes.)

The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to; not because they can’t borrow overnight from other banks. (And the “other banks” are still there with excess deposits.) If the Fed is worried about commercial paper rates, it can support those.

The one good part of the current proposals is a temporary extension of federal deposit insurance. The last thing we need is panicky individuals rushing needlessly to ATM machines.

By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, which leads quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for government to smooth failures.

In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.

Banks vs. the Banking System

Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down — so long as there are other competing banks around who can make loans — the banking system is fine.

I think many observers, and quite a few policy makers, do not recognize the robustness that our deregulated competitive banking system conveys. If one bank failed in the 1930’s, a big out-of-state bank could not come in and take it over. Hedge funds, private equity funds, foreign banks, and sovereign wealth funds didn’t even exist — and if they did, there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock. If a bank failed in the 1930’s, a competitive bank could not move in and quickly offer loans or deposit and other retail services to the first bank’s customers. JPMorgan could not have taken over WaMu. But all those competitive mechanisms are in place now — at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had nine months of historic financial chaos, and only now are we starting to see real systemic problems.

There is a temptation for regulators and government officials to hear stories of woe from failing banks, their creditors, and their shareholders, and mistakenly believe that these particular people and institutions need to be propped up.

The Treasury Plan

The Treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again.

To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks; we bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed instruments in good times and signed up for the risk in bad times. This is the mother of all bailouts.

There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging.

Someone had a great idea: let’s blow up the dam and drain the lake! O.K., it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.

Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents. If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 cents or even 100 cents, we haven’t done any good at all; and $700 billion is a drop in the bucket compared what that would take.

There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price.” The hope is that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope — at least it is completely untested in any historical experience. Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market,” and substantially raise the overall market price.

Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting — i.e., to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks will know this and will lend anyway. We might as well just ban all accounting if we don’t like the news accountants bring. No, we need more transparency, not less.

Many of the changes in new versions of the bill make matters worse, at least for the central task of stabilizing financial markets.

The Senate adds language to protect homeowners: “help families to keep their homes and to stabilize communities.” That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank-stabilization problem much worse. Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of the mortgages that we’re trying to raise.

Yes, we need to do something. But “doing something” that will not work — with potentially dire consequences — is not the right course, especially when sensible and well-understood options remain.


st

Mac, if I take out my retirement (I'm over 60) and put it in land, I lose, too. Property taxes rise every year where I live.

As a long-time taxpayer, almost ready to retire, I can't win. :(

Joe Smith

Taking a step back from all this:

Investors around the world have invested in mortgage backed securities which are now considered "toxic". When they bought those assets did they not know what was in them and if not, why not? It seems to me that a lot of people bought assets which they had to know they did not understand.

Mac

Fundamentally correct. The reason that the Government has to do something forceful, yet not foolish, is because the taxpayer is on the hook for literally hundreds of billions of dollars in FDIC insurance payments that may result from a situation that was caused, in large part, by the government. The bailout bill is a disaster. The only way it can be at all effective for the financial market is if the government buys up the toxic mortgages at face value or very near face value, thereby transferring the short term loss to the taxpayers. No one knows exactly where this is all going, because no one knows what has been created here. Considering the real estate market, it might be a good idea to take your long term investment capital out of the stock market and invest in land.

Jim Perkins

I like John's idea (#60). Has anyone analyzed the positive effects on the economy - and every solid institution - of sharing 50% of the bailout equally with every citizen over 18 years of age? That would be approx. $130,000 per person I believe. Let the taxpayer decide how it is spent - the cumulative brain power and decison making put to work would far exceed the combined smarts of all the CEO's and politicians who have voted for greed over sensible risk management over the last 20 years.

Andy Kneeter

The government can artificially inflate the value of homes & mortgages for awhile by pumping money into a declining market, but it's at a cost & the remedy isn't permanent.

The cost is further dollar devaluation that results in inflation & rising interest rates (inflation is an invisible tax on everyone). If adjustable rate mortgages aren't rewritten to fixed rates, there will be increased foreclosures. Also, higher interest rates directly decrease home prices, because monthly payments of new buyers increase. Housing deflation resumes, possibly worse than before.

The better solution (proposed by the Republican Study Group, but ignored), is to adjust policy to attract capital to financial institutions. This could be done by temporarily suspending capital gains taxes, repatriation taxes on foreign capital, & even corporate taxes in the financial services industry to support sound financial institutions that acquire other institutions & support their loans & depositors. This could even be applied to start-up financial institutions.

Also, any plan that doesn't privatize Freddie, Fannie, & revoke the Community Reinvestment Act isn't serious about addressing the core causes of the sub-prime meltdown.

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jonathan

Though this thread is now old, a clarification is needed about the price Treasury intends to pay. Bernanke never said we should pay high prices, just that Treasury should pay between "hold to maturity" value and "fire sale" value. The phrase "fire sale" is not the same as market value; it has a real meaning and that is a sale when there's no market. Buffett's comment fits Treasury's goals to pay sensible prices, meaning they examine and value securities and pay a price that should generate a reasonable return - which has a better chance of happening because the cost of the government's investment is lower than any private investor's cost. Get it? When they referred to paying more than "fire sale" they were referring to when there is no market, when you take whatever you can get because the merchandise is otherwise worth zilch. That is specifically NOT a plan to buy above market, but is a recognition that the market is not currently functioning and they'll have to set one. Making the market work is the point of the plan so, if you think about it, there's no way they could currently pay market prices because those prices don't exist.

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Erich Riesenberg

"@ charles (#2)

Buffett wants the government to buy the MBSs at market price, not above it as the Treasury wants to do.

At least, we finally see a critique of the plan on this blog. I wouldn’t support a plan that offers anything less than an equity stake along with a debt-to-equity swap.

— Posted by RR"

Thank you RR, this has been the one point I would like clarified. Buffett made it clear on CNBC and Charlie Rose that he would bargain hard, while Bernanke and Paulson have said they would pay above market. I would like someone intelligible to ask Buffett to explain the misunderstanding.

Derek

The bailout sounds like a manufactured crisis.

The EU would fall apart if it didn't adopt a new constitution, the European politicians said. Not!

Saddam Hussein will terrorize us with his WMDs, the Bush Administration said. Not!

We must bail out the financial institutions to prevent the economy from crumbling... NOT!

Joe Torben

To Kevin H and a few others: if you seriously believe that the government will likely make some money from buying these distressed assets in the long run, please explain why there isn't a long line of investors willing to make that bet as well. Not everyone is short on cash, after all.

Could that possibly be because the idea that it's likely that the government will make money from these assets is "spin" (which is the PC word for "a complete lie")?

Jake Summers

The market is recovering but none of you see it that way. The market is reasserting the natural price. I don’t see how you can solve this problem with price fixing. Doesn’t price fixing cause it’s own crisis down the road? Didn’t we have interest rates to low for to long?

Of course we always want growth and we think that comes from credit creation and rate cuts? And rate increases limit growth? Isn’t what we see a cause and effect of price fixing interest rates?

I doubt this will be the last bailout or money drop. Look how all the other bailouts failed to stabilize the market. Won't this simply make the recession longer for Main Street as we continue to prop up Wall Street?

If you are going to have a government solution though, I tend to agree with Nouriel Roubini.

In basic it is:

1. Take assets off the balance sheet.

2. Recapitalize the banks.

3. Reduce the debt burden. (Homeowners I believe)

As for Paulsons plan I don't see how he can determine the value of these assets. There is no way for him to really know so the Treasury will be speculating at best. This isn’t really a plan but instead is shopping for toxic waste at the taxpayer’s expense. The taxpayer’s are being told with a gun to their head to go around Wall Street and buy all the worst garbage no sane person would touch. We are not looking for deals, we are buying Wall Street feces left by the wolves and their insatiable appetite for profits at all costs. This won’t fix the debt burden on Main Street though while dumping the tax burden on them. And this is a consumer led recession that is going to be severe.

The American people are also right to assume that they will not see a return. As far as I know bailouts, rescue plans, and price fixing always fail to yield the results. It seems very unlikely the American people will see any value and any suggestion is pure speculation. Nor should we, as taxpayers want to go into the business of such idiotic speculation for the benefit of Wall Street. You don't speculate with the taxpayer’s future debt burden when we have maxed the credit line and are staring into a severe recession on main street.

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Alex

@Kevin H -- Often times the institution sells off the low risk assets and maintains the high risk assets on their balance sheet at full value (or overstated market value).

Leo

I'm waiting for Wolfers' "Economists and Bailouts: Mea MAXIMA Culpa."

grover

Rats. I wish I hadn't misread the headline as "John *Coltrane* on Why the Bailout Plan Would Be a Disaster."

That would have been an altogether more entertaining article.

LP

John: so you do not think once the Treasury sets a floor price for those MBS, the market will arbitrage them to that level.

jeffreytg

Wait, I thought that I learned via a previous blog entry that only the uninformed would be against the bail out.

A. Yung

Does $700 Billion dollars worth of toxic assets sound absurd to you? (The 7-Year Taxpayer’s Bailout Plan)

Look no further.

What the Federal Reserve is imposing IS NOT the only way to solve this crisis. Instead of shutting Main Street out of the equation, this proposed plan lifts the heavy weight of mortgages off of homeowner’s backs temporarily while covering all mortgages (Freddie, Fannie, Bear Stearns, Lehman, WAMU, etc.).

It’s a plan where the Government and the Homeowner work together to funnel revenue back into the economy.

1. Revise mortgage loans at 75% of the original value, with a new 30 yr, 6.5% fixed interest rate. (Current average monthly payment: $1,389)

2. The Government pays the difference of new mortgage and old for 7 years (NEW average monthly payment for YOU: $846)

3. Original debt held by Government as a second note. Then a 40 year note with payments starts after the seven years. You can pay this debt off at anytime, but can not refinance without paying down.

It’s simple.

It gives the economy 7 years to recover. It relieves the heavy mortgage debt on YOU. It cost CONSIDERABLY less on YOU and the Government than this $700 Bailout plan. Think about it. Less cents equals MORE SENSE.

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DaveL

If they do buy these distressed assets at this low price, what is the purpose of the government getting involved? To make money for the government? The banks would still have the hole in their balance sheet and it would be fully realized. This will help them loan money to businesses and consumers.

When you go to the auto dealer (if they are still in business) you will not get a car loan or you may pay through the nose. Your restaurant will not be able to buy from restaurant supply to stock the pantry, they may not be in business much longer either. Your local retailer will not have money to stock clothing or whatever.

The reason Paulson wanted to ram this through is based on financial history going back hundreds of years. It had to be implemented rapidly and it had to be effective. Delay would increase the costs and make it less likely of being successful. A perusing of Milton Friedman's Monetary History, the Great Depression chapter would be in order to illustrate how speed matters in a crisis like this. As more institutions fail the costs go up as the damage cascades.

of course did not got through quickly, and now its adorned with plenty of pork to make it palitable. I guess Paulson's Hamiltonian moment did not go down any better with the common man than his predicessor's.

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David Stewart Zink

If a friend and a stranger make exactly the same argument your friend will always be a little more convincing.

Which is why it is not necessarily a criminal accusation that Ben bailed out Goldman Sachs's stake in AIG but let lehman go hang despite equal merit.

Was tacky if he really did have GS in the room with him at the time, though.

tom hammond

John: Your asuumptions is based on 700B is an inconsequential amount. So how big is the problem?

Shouldn't you match maturities of assets values rather than using mark to market which is a shortterm measure on a longterm asset. It sounds like you are mismatching assets.

Kevin H

@MikeM #5

That would be exactly the same effect as if the Government simply buys the MBSs at '80 cents' in Cochrane's terms.

The chief winner would be anyone holding an MBS as they would basically have zero foreclosure risk (they would still have prepayment risk, but that's not currently very large).

If they really extended that program through the whole economy, it would cost in the hundred of billions to trillions of dollars. I think there are something like 20 million expected foreclosures, and I'm going to guesstimate a average home price of $200k/house. That's $4 trillion in net home worth. If we assume that the worth of the houses is 90% of the cost of the total mortage (which is optamistic), we have a cost of $400 billion. Keep in mind that the average mortgage costs twice the value of the house at its beginning (which would mean $2 trillion in losses to the government if everyone defaulted on their very first payment) and $700 billion, where probably wouldn't loose a cent looks pretty good.

And again just for emphasis, we aren't spending $700 billion, we are investing it in a market that has taken a nose dive, and has large short to medium run risks. Buy low, sell high is how you make profit.

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