The $700 billion Paulson Plan is dead on arrival

I have taken my time to let the basics of the Paulson Plan seep in before I rushed to judgment. But, the time to judge has come and the plan comes up short on all counts. His plan is geared more toward Wall Street and protecting the financial services than toward main street and protecting taxpayers.

Paulson and President George Bush have said that Congress must pass this bill quickly or else we risk further turmoil and calamity. But, this proposal is the financial equivalent of the Patriot Act that was passed in the wake of 9/11. It uses a climate of fear and panic to give the executive branch a blank check with zero oversight. Congress must this time hold firm and refuse to roll over again.

Yesterday, I listened to The Diane Rehm Show, where market commentators Greg Ip of the Economist, former Fed Vice Chairman Alan Blinder and Law Professor Michael Greenberger discussed the proposal. Blinder was shockingly direct in his denunciation of the proposal, going so far as to say that Hank Paulson should be fired for it. On the whole, I agree with Blinder and I recommend we each fight this proposal tough and nail. My Senator Barbara Mikulski has already come out denunciating the proposal, so I am heartened by her stance.

However, before we give our heretofore feckless and spineless Congress a free pass, let’s ask two questions. What is wrong with the Paulson proposal? And if it is so bad, what should a banking crisis bill look like? Here are my thoughts.

Naked attempt to preserve status quo

The Paulson bailout proposal is a naked attempt to bail out the financial system at taxpayer expense, leaving the status quo intact as much as possible. It is a stealth recapitalization of the financial services industry using taxpayer money, but without any concessions on the part of banks as a binding condition of the proposal.

Where the financial services industry is now imperiled by the toxic assets on their balance sheets, under Paulson’s proposal, taxpayers would bear the future risks of these assets. Such a remedy maintains the status quo in the financial services sector to the degree possible, despite this state of affairs having led to disaster. It perpetuates moral hazard by allowing private companies to keep gains while socializing downside risk. And it maintains overcapacity in financial services, preventing the sector consolidation that should rightfully occur.

In short, the Paulson proposal is absurd. What America needs is wholesale change in how it conducts and regulates finance. However, before we get this change, we must first deal with the crisis at hand, which the Paulson proposal fails to do.

What we must address first

First and foremost, regulators’ responsibility is to prevent unnecessary dead weight loss in the financial sector from damaging the real economy. A credit crisis seizes up the normal functioning of the financial sector, putting healthy companies and unhealthy companies alike at risk. Financial assets of good quality decline with those of poor quality. It is this indiscriminate nature of crisis that policy makers must address in the first instance lest it lead to damaging long-term economic consequences. Any bill should be designed to address these issues.

In the U.S. financial system, this role falls primarily on the Federal Reserve because it is the lender of last resort. Walter Bagehot’s theorem says the lender of last resort should lend freely at a steep cost in order to provide liquidity to the financial services sector. The Federal Reserve has certainly provided enough liquidity, but it has not been enough. The problems are too severe. Hence the need for a legislative solution.

The legislative solution’s primary goal must be to help the marketplace discriminate between financial institutions that are suffering due to short-term liquidity constraints and those that are fundamentally insolvent. In a credit crisis, liquidity is so constrained that even sound institutions fail. This must be prevented by separating the bad assets from the good assets as quickly as possible. There are a lot of mechanisms to do just that. I have suggested the U.S. adopt the Swedish model which I outlined in a post in August. Irrespective of which plan Congress adopts, these will be the factors to consider:

1. Guarantee of most deposits. Unfortunately, when a legislative solution becomes necessary, jitters amongst bank customers have reached a point where bank runs are likely. The only way to prevent bank runs at this stage in the crisis is to make a blanket deposit guarantee. This will mean a significant bolstering of the undercapitalized FDIC or a transfer of certain bank deposit guarantees to the new RTC-like administrators. That way, people can go back to worrying about making money and stop worrying about their life savings.
2. Separation of good assets from bad assets. As Lehman had proposed before it went under, making a ‘bad bank’ and sticking it with all the ‘bad’ assets will increase bank counterparty confidence in the resultant ‘good’ banks and, thus, restore liquidity.
3. Discrimination of bad banks from good banks. Illiquidity is due to counterparty distrust. Therefore, the bill must provide a mechanism to identify which banks are solvent and which are fundamentally insolvent. When financial institutions become reassured of the solvency of their counterparties, liquidity will return to the credit markets.
4. Liquidation of bad banks. Once the companies that are fundamentally insolvent are identified, they must be liquidated as quickly as possible. There is no reason to beat around the bush. The faster the liquidation process is complete, the sooner confidence will be restored.
5. Defense against politicization of the process. The last time I checked, the Treasury was a step away from the President and, therefore, easily manipulated for political purposes. Having the U.S. Treasury control the crisis resolution process is setting the United States up for a politicization of the process. The ‘Bad Asset’ or ‘Bad Bank’ buyer must be an independent body free of all political influence. The RTC certainly was.
6. Reduction in moral hazard. Any bailout scheme must align risk and reward as closely with the same agents as possible. Whoever takes the risk, also gets the reward or loss. There should be no free riders. An example here would be bailing out a fundamentally insolvent company to the benefit of existing shareholders rather than taxpayers. These types of shenanigans have to be stopped.

Paulson’s plan is a trap

Whether you like Paulson’s plan or not, Paulson has been very crafty in making his proposal. He is obviously a good negotiator because he has anchored the discussion around a false set of goals. Congress, which had been unable to present its own proposal, will probably take the bait and use this proposal as a baseline from which to craft legislation, rather than start from scratch with their own initiative.

Moreover, it remains to be seen whether this proposal will ultimately cost a measly $700 billion. Experience with Iraq War funding proposals and the history of Japan’s experiences after their property bubble burst tell us that this is the first of many handouts that will be requested. And once the first request is passed, it will be very difficult for legislators to admit that the handouts were not money well spent. So, additional handouts are likely to pass as well.

If Congress allows this plan or some other remedy like it to pass, it will have confirmed its uselessness to the American citizenry. Just as with 9/11, Congress will have allowed the executive branch to usurp powers that are constitutionally held in the legislative branch. Therefore, in the end, when this proposal ends up costing much more than $700 billion, I will hold Congress to blame more than the Bush Administration.