A lot of the opposition to Hank Paulson’s plan (voted down yesterday by the House) stems from the perception that it amounts to fat cats on Wall Street raping the taxpayer. According to Larry Kudlow, that’s not quite right:
Let’s walk through this hypothetical for a moment. Through a market-driven auction, the Treasury will purchase some dollar amount – say $100 billion – of loans that banks will sell. The Treasury will then buy those loans at the prices that fill the auction, starting with the lowest prices and working up. Now, the Treasury will hold those bonds either to maturity or for a sale in the open market if rising prices in the market make that sale attractive. In other words, suppose the Treasury buys a bond package at 20 cents on the dollar. They hold it for a while, and if market conditions improve, they sell it for 50 cents on the dollar to some buyer (e.g., an investment fund, a private-equity fund, a hedgie). The Treasury will make the sale at the higher price in order to gain a profit for taxpayers.
In the meantime, as the Treasury holds the loans, the government will get monthly cash-flows coming in on the mortgages, or on any other loans that it owns. So it is win-win for taxpayers. First, taxpayers get the cash flow generated by the assets. (Something like a 10 percent interest rate.) Second, if the loan is sold for profit, the taxpayers will own that profit. And the new law must of course stipulate that all the cash flows and/or profits go for debt-reduction to protect taxpayers.
As Kudlow describes it, the plan isn’t so much a bailout as a method of price discovery. Markets need prices to work, and if nobody is buying the troubled assets (which are surely worth something), then the market is stuck.
A related problem, as many commentators have argued, is that in the current environment of market duress, mark-to-market accounting rules force companies to unrealistically write down the value of these troubled assets. Kevin Hassett explains that under these rules
… when a run on a risky asset occurs, driving its value down, accountants then value the firm that holds that asset’s financial position at the latest market price. As the value of risky assets plunges, firms are forced to sell into the declining market to raise cash. Those sales drive the prices down further, necessitating even more sales.
The Securities and Exchange Commission can suspend mark-to-market accounting rules on its own authority without an act of Congress—meaning this reform could be accomplished with zero political theater.
Update: The Dow closed 485 points higher today. While interpreting the Dow is a bit like alchemy, it is worth noting this report:
“News that the SEC is working with FASB [Financial Accounting Standards Board] on ‘fair value’ accounting rules that could delay implementation of the onerous mark-to-market provision are giving stocks fresh legs higher,” according to analysts at Action Economics.