Friday, September 26, 2008

A (mild) Defense of TARP

Excellent, albeit slightly technical, commentary at VoxEU. Cites lots of economists, which I particularly like.

In general, the view that, for at least some of the troubled securities, there does not exist a price which would relieve the position of financial firms without imposing a cost to the taxpayers is not robust. Available data and even pessimistic projections on default rates show that “market” prices reflect a negative bubble rather than “fair” values: a thorough analysis led the Bank of England to conclude “that using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately incur”. For a large class of securities, therefore, the alternative is not as stark as the critics maintain: as chairman Bernanke believes, there does exist an intermediate price, high enough to provide relief, but low enough as not to inflict budgetary losses. The real problem lies in how that price can be discovered. The method of a reverse auction does not by itself prevent sellers’ opportunistic behaviour based on asymmetric information. As detailed in an important statement of the Director of the Congressional Budget
Office, the conditions to avoid this outcome are that the auction should be for shares in the same asset rather that in different assets (hence not different complex products but homogeneous tranches) and that those shares be widely distributed among many potential sellers. If the auction is well designed, on the other hand, the prices it establishes may provide the floor necessary to revive the markets, thereby re-creating liquidity. (What puzzles me about TARP is why cash is offered to purchase the troubled assets instead of guaranteed liquid bonds.)
William Buiter also shows some general support for the idea
The Paulson Plan addresses market illiquidity for toxic assets but the real problem is a lack of bank capital and the risk of widespread insolvency. Fixing this requires a government injection of new bank capital or a forced conversion of bank debt into equity. This column argues against the former as it would further socialise the US financial system. The Package needs some work, but Congress must stop its infantile posturing and act soon.
Charles Wyplosz is also mildly positive

This being said, spilling blood for the sake of it is a bit silly. Banks are not oil companies. When an oil company goes bust, by definition, it is because its liabilities exceed its assets. After bankruptcy, its assets remain as valuable as before. Oil is safely tucked away under ground, refineries and gas stations stay put above ground.

A bank goes bust when its assets have collapsed. Bankruptcy means that its liabilities collapse too and these are assets of other banks and of millions of hapless citizens. This is why contagion and bank runs occur more frequently than oil runs. Sure, with patience, both assets and liabilities can regain value, but in the meantime the financial system is impaired and the resulting credit crunch provokes an economic crisis that spares no one. This is why large, systemic financial institutions cannot be summarily dispatched to receivership. Avoiding a credit crunch ought to be every one’s priority.

No comments: