What Was Wrong With The Paulson Bailout Plan?

Mr. Paulson announcing he changed his mind about buying toxic mortgage assets

THE PAULSON SALVATION PLANS

by David Arthur Walters

It was certainly fascinating to see presumably rational experts relying on the fluctuations of the so-called wisdom of a volatile stock market to influence their judgments. When the indexes plummeted after Henry Paulson’s original asset management bailout bill was voted down, Congress hastily took up the bill again and modified it for quick approval, providing pork barrel incentives such as relief from taxation on children’s wooden arrows. Why, then, did the efficient stock market indexes fall, after the modified bailout was approved by congress?

Perhaps the Stock Market read the International Monetary Fund’s September 2008 Working Paper, ‘Systemic Banking Crises: A New Database, prepared by Luc Laeven and Fabian Valencial. One might reasonably presume that bailout mastermind Henry Paulson, U.S. Treasury Secretary and member of the Board of Governors of the International Monetary Fund, had read it too. After studying 42 well documented banking crises in 37 countries, where excessive credit expansion was among the many causes of the crises, one of the conclusions drawn by the researchers was that the use of government asset management companies to take over and manage distressed assets has been largely ineffective:

“Special bank restructuring agencies are often set up to restructure distressed banks (in 48 percent of crises) and asset management companies (AMC) have been set up in 60 percent of crises to manage distressed assets. Asset management companies tend to be centralized rather than decentralized. Examining the cases where AMCs were used, we find that the use of AMCs is positively correlated with peak non-performing loans and fiscal costs, with correlation coefficients of about 15 percent in both cases. These correlations may suggest some degree of ineffectiveness in AMC’s, at least in those episodes where asset management companies were established. In line with these simple correlations we find Klingebiel (2000) who studies 7 crises where asset management companies were used and concludes that they were largely ineffective.”

If we turn to Daniela Klingebiel’s 2000 report for the World Bank, entitled ‘The Use of Asset Management Companies in the Resolution of Banking Crises, Cross-Country Experiences’, we realize we should make a distinction between an AMC that takes over a bank whole-hog to restructure it and an AMC whose purpose is to rapidly dispose of distressed assets:

“The results of the analysis of the seven cases can be summarized as follows: Two out of three corporate restructuring AMCs did not achieve their narrow goals of expediting corporate restructuring. These experiences suggest that AMCs are rarely good tools to accelerate corporate restructuring. Only the Swedish AMC successfully managed its portfolio, acting in some instances as lead agent in the restructuring process. It was helped by some special circumstances, however: the assets acquired were mostly real estate related, not manufacturing that are harder to restructure, and were a small fraction of the banking system which made it easier for the AMC to maintain its independence from political pressures and to sell assets back to the private sector. Rapid asset disposition vehicles fared somewhat better with two out of four agencies, namely Spain and the US, achieving their objectives. The successful experiences suggest that AMCs can be effectively used, but only for the purpose of asset disposition including resolving insolvent and unviable financial institutions. But even achieving these objectives required many ingredients: a type of asset that is easily liquefiable – real estate, mostly professional management, political independence, a skilled resource base, appropriate funding, adequate bankruptcy and foreclosure laws, good information and management systems, and transparency in operations and processes.”

One of the successful outcomes was had through the Resolution Trust Corporation in the United States: “The RTC’s success was helped by the fact that most of the assets to be disposed of were real estate loans/or assets or mortgage loans that could relatively easily be bundled and securitized or sold via bulk sales. Moreover, a deep and sophisticated capital market and a recovery in the real estate market also proved advantageous for the RTC as did an effective organizational and governance structure and skilled personnel.”

Furthermore: “Adequate governance structures; professional management and extensive use of private sector contractors for asset disposition. RTC relied on a detailed set of directives and guidelines to its staff and contractors that covered a wide range of operations, including asset management and disposition, contract policies, bidding procedures and marketing. While this reduced RTC’s flexibility in handling individual cases, they minimized the possibility of fraud and made policy and cost evaluation more transparent and expedited resolution process. Effective organizational structure including information management systems that can handle large amount of information and management of assets which allowed RTC to collect 31% of the total assets transferred and reduced by one third the amount of assets needed to be sold.”

But all was not peaches and cream at the RTC, nor were the results all too clear: “Sporadic funding of RTC (several pieces of legislation were required to approve funding) hampered speedy resolution of failed S&Ls and increased resolution costs. Rapid asset disposition was hampered by inconsistent objectives of agency. In addition to cost minimization and expeditious disposition objective, the RTC was also supposed to structure and time its asset sales to minimize any impact on local real estate and financial markets…. Real credit did not grow, and whether broader objectives were met or not is unclear.”

Naturally, a strong economic recovery is crucial to the success of asset management companies. And of course lackluster demand for real estate assets impedes returns where real estate is the underlying asset to be disposed of. We suppose the RTC would have netted a handsome profit on the disposition if it had held on to the assets awhile longer. But the experts believe rapid disposition is the key to successful resolution, and so would those well connected buyers who like to pick up distressed assets at fire sale prices:

“The warehousing of assets in the hopes of obtaining higher prices later may not prevent prices from tumbling since the future supply of assets will be discounted in current prices. This is especially the case for real estate assets, where fire sale losses need not imply an economic loss of value. At the same time, selling assets rapidly establishes floor prices that will promote a speedier recovery from the economic crisis. This may especially be so for public AMCs which typically have limited market insights. The success of rapid asset disposition and liquidation agencies will be measured by the speed of asset disposition. Here, an AMC is judged to be successful if assets, including banks, are disposed of rapidly that is within a five year timeframe.”

Ms. Klingebiel discussed the centralization-decentralization controversy: “There is an ongoing debate over the best model for asset management and recovery: should debt restructuring and workout be done by the banks themselves—the ‘decentralized model’—or should bad debt be transferred to a centralized publicly owned asset management company charged with resolving the overhang of impaired assets.”

On the one hand, the centralized approach “permits consolidation of skills and resources—centralization of work-out skills and information technology—in debt restructuring within one agency and may thus be more efficient in recovering maximum possible value. A centralization can also help with the securitization of assets as it has a larger pool of assets. It centralizes the ownership of collateral, thus providing potentially more leverage over debtors and more effective management. Moreover, distressed loans are removed clearly, quickly and completely from banks allowing them in turn to focus on their day-to-day activities.”

However, “A centralized workout unit may also face problems related to its size and ownership structure. If the agency carries a large portion of banking system assets, it may be difficult for the government to insulate such an entity from political pressure especially in cases where the government is also charged with the restructuring of the assets and where a large portion of banking system assets has been transferred. Moreover, a transfer of loans can break the links between banks and corporations, links that may have positive value given banks’ privileged access to corporate information. If AMC assets are not actively managed, the existence of a public AMC could lead to a general weakening of credit discipline in the financial system and lead to a further deterioration of asset values.”

The system might be better off where nonperforming loans (NPLs) are concerned, if we leave them to the banks to work out: “In general, banks should be better placed to resolve NPLs than centralized AMCs as they have the loan files and some institutional knowledge of the borrower. Leaving the problem assets on banks’ balance sheets may also provide better incentives for banks to maximize the recovery value of bad debt and avoid future losses by improving loan approval and monitoring procedures. Leaving NPLs with banks also has the advantage that these banks can provide new loans in the context of debt restructuring. Successful decentralized debt workouts require, however, limited or no ownership links between banks and corporates, otherwise the same party would be both debtor and creditor, adequately capitalized banks and proper incentives for banks and borrowers. For example, the very slow speed of restructuring in Japan is in part due to the extensive ownership links among banks, other financial intermediaries, and corporations. Moreover, successful debt workout by banks requires that financial institutions have sufficient skills and resources to deal with their problem loans.”

We may briefly compare those factors cited as favorable to resolution success in the International Monetary Fund and World Bank papers, to see if the factors are present or absent in our 2008 Bank Crisis:

A strong economic recovery was present in the past successful resolutions of bank crises, but a deep and lengthy recession is expected today.

The distressed banks involved in successful resolutions were small and the large banks were sound, which is not the case in 2008.

Competition from foreign banks provided domestic banks with an incentive to snap up recapitalized banks in successful resolutions, sometimes assuming significant losses in the process, which is in part true in 2008. Furthermore, in the present crisis, unlike previous ones, sovereign wealth funds have taken significant positions in troubled banks, a fact that has troubled patriotic domestic factions

The nonperforming assets disposed of by successful AMCs were very small, one percent of bank assets; in 2008 the nonperforming assets, especially if we include the trillions of dollars of contracts derived from the structured mortgages, are enormous.

The successful AMCs had adequate funds; the 2008 AMC was to have $700 billion, which some experts deem insufficient, to be doled out piecemeal, but since the Secretary of the Treasury has changed his mind as to the utilization of the funds, the AMC, if one is actually funded, will get far less than $700 billion because much of it will be otherwise expended, say, in the purchase of capital stock in banks.

The successful AMC must be politically independent; the 2008 Paulson Plan provides virtually absolute discretion to the Secretary of the Treasury, who is obviously a political creature, a free market fundamentalist ideologue and investment banker who was instrumental in creating the credit expansion that led to the 2008 crisis, and in delaying the remedies, to select and fund asset management companies and otherwise dispose of the taxpayer funds allotted by Congress.

Successful techniques for credit crises resolution depend on the credibility and creditworthiness of the government. The majority of voters and their representatives believe the Bush Administration is untrustworthy and incredible. Many ordinary Americans suspect that the bailout plan may ultimately amount to a colossal rip-off of the American people by the political-economic power elite. They believe it is more than coincidence that the very people who brought the crisis down on America are the ones in charge of the resolving it, and with the same spendthrift means that caused the disaster. They do not think it is a coincidence that one of the main beneficiaries of government intervention thus far has been the firm where Mr. Paulson made his $700 million in investment banking, Goldman Sachs, and that he has surrounded himself with people from that firm, hopefully the “professional management” and “skillful resource base” essential to successful crises resolutions. Mr. Paulson has effectively eliminated much of Goldman Sach’s competition, and is currently forcing prudent banks that did not participate in the subprime mortgage craze to sell stock to the government, thus watering down their stock and harming their prudent shareholders. Yet an environmentalist who loves birds, believes in global warming and gives priority to the gap between rich and poor cannot be so bad; we think he was just another cork swept up the creek, and got caught with his pants down. A man who earns millions upon millions year after year must believe he is doing something right, and tends to stay the course.

Successful government interventions targeted debt relief programs to distressed retail borrowers to restrain the adverse effect of financial distress on the real economy; the U.S. administration has been dragging its feet in that respect, preferring to bail out banks instead of blanketing the entire nation with immorality. Now that delinquent borrowers are getting some relief to forestall foreclosure, others, who have been paying their debts, have an incentive to default to get into the program.

Perhaps the most historically successful technique of all is simply to get the presses running and inflate the country out of the debt, giving debtors raises in the process, which may allow them to believe that they have avoided immorality. Watch the treasury yield curve for current clues.

Now the information provided by the International Monetary Fund and World Bank researchers may or may not shed some light on the wisdom or the mood of the Stock Market in respect to the 2008 bailout plan. No doubt such studies should give our financial gurus cause to pause for thought instead of running around from one plan to another like chickens with their heads cut off yet still exercising their political instincts. The studies may provide useful guideposts, but we must admit that the data is rather thin, and, in respect to AMCs, merely anecdotal. One researcher remarked that “general principles have proved elusive,” and we expect them to remain elusive until the private capitalist business cycle gives us a thousand manias and panics from which we may get a representative sample to induce hypothetically general principles to see if they are deducible in current affairs. But international state capitalism might save us the trouble long before we have sufficient empirical data to work with.

Now pundits are wondering who came up with the latest bailout feature, the partial nationalization of banks via “capital infusion” or purchase of stock with taxpayer money. A few people are giving and taking credit for the proposal. They might have consulted with stealth statesman George Soros, whom the new president should appoint Treasury Secretary so he could turn the post down yet be honored for his untaken good advice over the last few years.

We are loath to suggest that they got their capital idea from Hugo Chavez’ suggestion, that 51% of the stock in national and state banks and other crucial corporations be purchased by the U.S. government, and that a handsome proportion of the profits from that 51% be reinvested in national health care and social security funds. If the entities in question refuse to cooperate, Mr. Chavez recommends involuntary dissolution or full nationalization.

However that might be, we now await word from the Stock Market and opinion polls and crystal balls on what the future holds in store as a consequence of the latest salvation plan. In the alternative, we might admit that credit is a confidence game, and stop depending on other people or things external to restore our confidence.

What we need is faith. We want instant salvation: we want to be born anew from the liquidity. But it is difficult to make people have faith in anything, particularly in their fellow creatures if not in the supreme personality. One thing is certain at this historical juncture: we desperately need better confidence men and women.

XYX