Friday, 26 September 2008

Breaking the Paulson Plan

In today’s Wall Street Journal, Professors Diamond, Kaplan, Rajan, and Thaler published an op-ed piece titled, Fixing the Paulson Plan. Despite my considerable respect for this group (I completed my doctoral studies at Chicago), their recommendations are fundamentally flawed.

In their article, the professors start with some important observations. For example, the authors state, “the real concern about the financial sector is that it is undercapitalized, both because of the losses it has sustained and because of the growing risk aversion of lenders. Undercapitalized financial institutions are forced to try to reduce their assets, and, of course, this means they will make fewer loans, even to the healthy portions of the economy.” In fact, I expressed similar observations in my blog post, Batten Down the Hatches, on Wednesday of this week.

The professors also identify a problem with the Paulson plan that I believe is potentially fatal to its success. In their words, “it is not clear how that hypothetical [held-to-maturity] price will be established through competitive auctions.” This is not a detail to be glossed over now and addressed later. It is key to the entire issue. As I wrote in my earlier piece, a reverse auction, as suggested by the Treasury, has the potential to result in transfer prices that are lower than the values at which many banks currently have these securities marked, precipitating further writedowns and further reductions in bank capital.

Despite correctly diagnosing the problems with the banking sector and with the Paulson plan, the authors offer policy prescriptions that are unlikely to improve matters and may further exacerbate the situation. For example, the authors commend Senator Dodd’s suggestion that taxpayers receive contingent equity from the banks, equal to 125% of any losses the government subsequently realizes on transferred assets. So rather than being long the underlying assets, the banks would be short put options with 25% more downside exposure than they had previously. And of course the banks will have none of the upside.

Supporters of this proposal may argue that this arrangement would be beneficial to the banks as long as the government paid above the current market price for the assets. But presumably the strike prices for these put options would also be set at the above-market transfer price. In that case, the banks would immediately recognize a gain equal to the difference between the market price and the above-market transfer price. But unless this transfer could permanently increase the market price of the assets, the banks would be short put options whose intrinsic value was 125% of the difference between the market price and the above-market transfer price.

Perhaps the supporters of this plan are relying on these asset transfers having a permanent impact on their market prices, in which case there may be some economic benefit to the banks, despite the 125% put options. But if the original assets have proven difficult to value recently, the puts would be a nightmare to value, requiring not only current prices for the underlying assets but also assumptions about the volatility of the asset prices – and even the statistical distributions used to model the future asset prices – going forward. And since these options only increase the downside exposure of the banks, they won’t be able to ignore these accounting issues. Overall, the merit of the Dodd proposal appears doubtful.

But the crux of the Professors’ proposal involves two questionable strategies for achieving two laudable goals. In the words of the professors, the first goal is “to ‘liquefy’ certain moribund markets, thus allowing financial institutions to sell illiquid assets.”The second goal is simply “to raise capital levels in financial institutions.”

In pursuit of the first goal, the Professors suggest implementation of the Paulson proposal, in which “Treasury would buy assets through a reverse Dutch auction or some variant, but without any intent to overpay.” In their words, “the idea would be to jumpstart the market by establishing trading prices.” I’m certain the authors didn’t feel that this WSJ op-ed piece was an appropriate forum for discussing financial theory, but they offer no arguments whatsoever, persuasive or otherwise, for believing that liquidity can be re-established in these markets with a government “jumpstart.”

My own view is that a reverse auction, if successful, would allow the market to see the prices at which some institutions were willing to part with these assets. But it wouldn’t allow the market to see the prices at which other private institutions would be willing to purchase these assets. And if the gap between the willing sale prices and the willing purchase prices remained significant – as it appears currently – then the markets would remain illiquid, and this goal would not be achieved with a reverse auction. But on the other hand, some of these Professors are deservedly renowned as experts in modeling these sorts of issues, so it’s quite possible that they could offer some compelling arguments in support of their view. If that’s the case, they could contribute to the public debate by at least summarizing these arguments.

The most problematic proposal offered by these authors is in pursuit of their goal to raise capital levels in financial institutions. In particular, they suggest that government require all financial institutions, healthy and otherwise, to present plans to raise capital levels by 2% of their assets to preserve the stability of the financial system. They also suggest that the government could contribute up to half this amount in exchange for non-voting preferred equity in the event that an institution was having difficulty raising capital in the private market.

The main problem with this idea is immediately apparent simply by considering the supply and demand curves for bank capital. The demand for capital on the part of banks is an increasing function of their equity prices, whereas the supply curve for capital on the part of investors is a decreasing function of bank equity prices. As seen from numerous deals recently, the market for bank capital is currently very active relative to historical norms, and the market for bank capital appears to be clearing fairly well. The effect of this proposal would be to alter the demand curve for capital to have an inelastic segment at the quantity equal to 2% of assets.

Under this proposal, two scenarios are logically possible. First, the 2% floor could be below the current market-clearing quantity, in which case it would have no effect. Bank deals of the sort we’ve seen recently would continue to be arranged at prices determined by the intersection of these supply and demand curves. This proposal would do no harm, but neither would it accomplish anything positive.

The other scenario is that the 2% floor would be above the current market-clearing quantity. In this case, the inelastic segment of the demand curve would intersect the supply curve at a lower price than the current market price. In this case, a government mandate to raise capital would result in a decline in bank equity prices.

Given that the government has only recently introduced bans on the short sale of many hundreds of financial stocks, it would be highly questionable to impose a mandate on the banking sector that either would have no impact or would drive bank stocks to even lower prices.

Of course, the authors suggest that government could offer support for institutions that had difficulty raising the mandated capital via government purchases of up to half the required increase. But this raises other issues. For example, under what conditions would the government conclude that an institution was having difficulty raising capital? If there is no price at which private investors are willing to supply capital, then a government purchase of preferred shares appears futile. And if there is a price at which private investors are willing to supply capital, the government should allow the market to clear at that price. Government participation can alter the demand curve for capital by lowering the effective floor at which the demand curve must become inelastic, so government participation can increase the equity price. But in this plan government participation is only partial, and it only occurs in the context of a government mandate to raise capital. As a result, the net effect is either to lower the equity price or to have no impact whatsoever on either the price or the quantity of bank capital.

The authors suggest that the real benefit of a mandate is that it would remove the stigma associated with banks needing to raise capital. On this point, the Professors appear to be seriously out of touch with the current dynamics in the market. At the moment, there is no stigma associated with capital raising. Goldman Sachs recently raised considerable capital in a series of transactions for which they’ve been widely praised. Morgan Stanley also raised considerable capital recently. In fact, in the current environment, the ability to raise capital is seen as a sign of strength. There simply is no stigma to be overcome by a government mandate to raise capital.

I do believe the Professors make a useful contribution to the debate with their observations regarding the problems with the Paulson plan. But their proposals for fixing the Paulson plan appear to be poor policy prescriptions. The Dodd plan increases bank risk and decreases bank capital unless the asset transfers somehow permanently raise the market prices of the troubled assets – a proposition for which I see no basis. Their view that a reverse auction would somehow ‘’liquefy” the market isn’t supported by any arguments. And their proposal that government require banks to raise capital appears destined to lower bank stock prices – if it has any impact at all. Rather than fixing the Paulson plan, these proposals would appear merely to break it further.

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