The unintelligible crisis, Part I

I've been having the beginnings of a debate about the bank bailout with a friend. I sent him this criticism of Geithner's plan by Joseph Stiglitz and he sent me the below email in response, which I am now publishing in public with little guilt, mostly because I don't have many readers. For context, know that this friend is my oldest friend (since kindegarten) and also one of the smartest people I know, so we've had many discussions and debates like this over the years...

His email (without the end, which is quoted later):

So this guy could be right about all this but also he could be wrong, and i think the truth is that people like you and me just aren't really going to be able to know and judge that for ourselves. I don't know the details of the Geithner plan, and even if I did I wouldn't understand it. There are ethical issues we may have opinions about, but for the details of whether or not a particular plan will work I'd have to defer to those who know better than I. And certainly a ethical judgment may depend on assuming that a particular plan will work or has the best chance of working of any plans we have and can hope to enact in a reasonable time.

So, on an ethical level, you and I might differ on the idea that we should let bankers who got us into this mess profit hugely, with minimal risk to themselves, at the potential downside of taxpayers -- if that's what it takes to get us out of economic crisis. If a plan on those terms will work, and we don't have a better idea that we think will work, I say do it. It stinks rotten that the villains get a paycheck, but it's better than the alternative of our economy falling apart and everyone suffering for it. Now I don't know if this plan will work, or if we have a better plan, but that's where my ethical expertise is outstripped by my economic ignorance and I'm forced to just listen to people I trust.

Maybe I should trust Joseph Stiglitz. But I don't anything about him. He's got a Nobel prize, but so did the guys who ran Long Term Capital Management. I do know something about Warren Buffet though and I do trust him. Here's what he was saying back in October
http://www.charlierose.com/view/interview/9284

And a bit more recently:
http://www.cnbc.com/id/29595047

Ok, first, let me say why I am concerned about the Geithner plan, based on the limited research I have done, largely through the popular media. In addition to the Stiglitz op-ed, I would recommend this episode of This American Life as a good basic primer on how banks work and why they are in trouble (to the degree that it sort of obviates the need for this post...)

I would NOT actually recommend either of the Warren Buffet interviews linked to in my friend's email because he doesn't go into much detail, least of all about the bank bailouts. He seems to want to stay politically neutral and in support of the current administration (which changes from the first to second clip). This also rather comically leads him to incessantly mention pearl harbor in the second clip mostly as a way of saying, "yo, republican CNBC douchbags, STFU."

If in the below argument I misunderstand some fundamental aspect of the sitution or of economics, please know in advance that I don't actually know what I'm talking about here.

The one thing that Buffet does do is come out in favor of marking these "toxic assets" to market. So, following from the example in the TAL episode, let's say a bank owns a house which was originally purchased at $100, but is now worth $50. The banks actually wanted the government to buy that house above market value, like at $90. Then the banks would be fine, taxpayers not such much. Buffet won't say what he does like, but he does say he is in favor of marking to market, that is, setting the price to what it's worth, in this case $50, which the government would just buy en masse. When the banks are literally walking away from these things, it seems that this would at least stop the bleeding, as it were (which also shows how arrogant they are in not wanting to mark them to market). So that's a band-aid, and I guess still better for the banks then the value of the asset slipping even farther, but in this situation the banks have still lost tons of money, and therefore are insolvent, and certainly can't lend. Stiglitz explains:

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

So, the question is, how to recapitalize (eg. save) the banks, espcially since both the "ethical" and "pragmatic" imperative seems to be marking these assets to market. I think TARP tried to do this just by giving them money, but it wasn't enough, so they are still not solvent and thus not lending. Well, one option, supported by Johnson in this excellent Bill Moyers interview as well as by many others, is to have the FDIC nationalize the banks for a little while, then sell them to some private group. The so-called 'swedish model.' This article explains what that might mean:

The bank itself is shut down and its assets are transferred to a new entity controlled by the FDIC. The FDIC attempts to maximize the value of these assets, typically by selling them to another bank or banks.

I can understand this - the problem becomes more an organizational one than anything else. As indicated by the TAL episode, the government overpays on the toxic assets to recapitalize the banks, but then owns the bank. They can then break it up, reorganize the good stuff into a new bank, and sell the new bank to other rich people. They can hold onto the bad stuff until the market turns around, however long that takes. Moreover, from a "pragmatic" perspective, it doesn't involve breaking nor even substantially changing the system as it is, even though the banks themselves might be broken up and the current management fired sans bonus.

So having read all this, what do I think of Geithner's plan? Well, I don't know. The way Stiglitz describes it, it's actually not a mark-to-market program. In the example he gives the public-private trust buys the asset at 50% above its market value (this is not in his criticism, just in his description of how the program would work). So in his example a house that's worth $100 would be purchased at $150. This works to recapitalize the banks (hopefully), and if all goes well (say, the asset is really worth $200) the government would get their loan back plus a little extra money on the side ($138 in the loan, and $37 on the side). If it doesn't then the government actually loses more money than the asset was originally worth, and has to then pay out $138 to the private investor.

In fact, now that I think about it, that's crazy. Again, maybe I just don't understand what I'm reading, but wouldn't it be better to just overpay for the asset upfront? That is, if they want to overpay and buy a $100 house for $150, why not just put in all the money right away, instead having an investor come in for a paltry $6 in equity? The only problem with that is that it's a lot of money upfront...but won't they have to pay all these private investors at some point in the future when at least some of these assets go bust?

And aren't these assets already bust? In the proposal the banks sell us the worst of what are already called "toxic" assets. It almost seems like they're thinking that once investors start buying, the market will go up again, thus recreating the housing bubble, except this time it won't be a bubble. It'll be real. What? One thing Buffet does say in the CNBC interview is that there isn't a short term solution to this housing thing. What he means is, we need people. Grown-ups. With jobs. And money. To live in those houses. Why do they figure that the housing market is basically ok? To paraphrase a poet, sometimes a piece of exurban McMansion trash is just a piece of exurban McMansion trash.

Again, I could easily be horribly not understanding something basic about how all this works, but I think I've convinced myself. Geithner's plan seems to take the worst of all the possible options on the table, and somehow makes it crappier. Instead of going with the simple plan that has been known to work, he's inventing some elaborate band-aid that puts in faith in a bubble that has just collapsed and the very people who created that bubble. WTF?

But, as I mentioned, that is the most superficial part of what I wanted to say in response to Brett's email. Because, afterall, all I've done is the most basic of internet research to come to this conclusion. As he says, I am still trusting the opinion of experts. And this is what I want to talk about in part II...