Model Portfolio athompson:TPSNX

The more I read about Treasury Secretary Paulson's bailout proposal, the worse it seems to me. The plan is to give the Treasury $700 billion of taxpayers' money to purchase difficult-to-sell securities (such as subprime collateralized mortgage obligations) from investment banks and other financial institutions. The idea is that once banks get the risky assets off their balance sheets, they will have the ability and the inclination to lend more money. Once investors see that the financial institutions are not going to go bankrupt, they will be willing to invest in those institutions. This will enable the institutions to raise more capital by selling additional shares, which they can then lend out. Additionally, once bond investors see that the government is willing to prop up Wall Street at any cost, they will more inclined to buy corporate bonds and mortgage-backed securities. This will free up the frozen credit markets, giving companies and home buyers the ability to borrow.

The reason that illiquid assets are such a problem for financial institutions is that accounting rules require the assets to be "marked to market," i.e., carried on the books at market value. Currently, many kinds of asset-backed securities fetch a very low price in the market. To take an extreme example, Merrill Lynch sold collateralized mortgage obligations for 22 cents on the dollar in July. So asset-backed securities have had to be written down, reducing the total assets and therefore the equity capital of the companies that own them. In order for Paulson's bailout plan to help the financial institutions, the government will have to buy the institutions' assets for a higher price than market value. Otherwise, the companies would just be replacing devalued assets with an equally small amount of cash, which would not help their balance sheets.

Paulson's hope is that the prices of asset-backed securities are just temporarily depressed, but they will eventually return to normal. So the government can now pay more than the current market price, thereby helping out the financial institutions, and then patiently hold the securities until their prices return to normal. At that point, the government can sell the securities, thereby recouping all or most of the taxpayers' $700 million.

Will Paulson's plan work? Well, for us to believe that it will work, we have to believe that government bureaucrats can appraise the value of securities more accurately than the market can. Of course, the government could get advice from experts about the value of the securities. But the experts are employed by the financial institutions that are selling the securities.

Paulson has said that the government will use “market mechanisms,” e.g., a reverse auction system, to set prices. In a reverse auction, there is one buyer and several sellers who are all offering the same product. The sellers bid on the price at which they are willing to sell. The problem here is that it's very difficult to tell if different asset-backed securities are effectively the same product. I assume that the financial institutions will try to dump their worst securities on the government. The low bidder could just be the seller offering the worst product. Paulson and Bernanke have said that they can't design the auction process; that would be done by experts. Again, where are they going to find unbiased experts? It seems to me that, at best, an auction will establish the price at which it's worthwhile to the banks to sell the securities. It won't tell us what the security will be worth at some later time.

Here's what I think we know about the price the government's going to pay: (1) it's going to be more than the market price; (2) the government has no reliable way of determining what a fair price is; (3) we don't even have any good reason to believe that the market price is too low; (4) in general, the private sector is better than the government at figuring out what assets are worth. Moreover, there's a lot of room for politics to influence prices. Politically connected investment banks might be able to sell their assets to the Treasury, which is headed by a career investment banker, for a lot more than they're worth. I don't know that will happen, but I'm afraid that it will. So we don't know whether the government will pay a fair price, but it seems likely that it will overpay.

Paying more for the securities than they're worth is equivalent to buying the securities at fair value and then giving the financial institutions a gift. Generosity is a virtue, of course. But given the huge federal debt, I'm not sure American taxpayers can afford to be so generous. I think the federal debt is one of the American economy's greatest long-term problems. Our economy has been supported for years by continued borrowing from foreign governments at low interest rates. But I'm afraid that at some point they're going to decide that's not such a good deal any more. Once that happens, the cost of financing our increasing debt will increase. Ultimately, I expect a dramatic devaluation of the U.S. dollar in order to make our debt manageable. Paulson's plan, therefore, may solve a medium-term problem—unavailability of credit—at the cost of exacerbating a much more serious long-term problem.

I was not wild about the government intervention in Bear Stearns, or the conservership of Fannie and Freddie, or the bailout of AIG. But I could live with those three. In each of those cases, the business owners and other responsible parties suffered some loss. Bear Stearns' shareholders saw the value of their stock fall dramatically. Fannie's and Freddie's CEOs were fired, stockholders lost a lot (the stocks may yet go to zero), and dividends on preferred shares were eliminated. AIG's CEO was fired, and the government loaned the company money at a punitively high interest rate. The people who made bad business decisions suffered (at least some of) the consequences, which is how capitalism is supposed to work. But in the case of the proposed $700 million bailout, the financial institutions that made really stupid decisions will be able to unload their bad debt at above-market prices with no penalty whatsoever. I think the moral hazard here is overwhelming. It seems that investment banks will have a strong incentive in the future to make risky investments.

There is another problem related to the compromise of capital principles. The financial services industry in the U.S. is too big. It accounted for 40 percent of total corporate profits last year. That level of activity is not sustainable. If individual financial institutions are going to be profitable (without continued government support), we need to have fewer of them. The bailout will prop up weak institutions and delay their failure.

I agree with Paulson that we need to address the lack of credit availability. It is difficult for businesses to even survive, much less flourish, without access to credit. Also, in most of the country, housing prices appear to be nearing fair value. The housing market can begin to return to normal if home buyers with good credit can get mortgages. This is unlikely to happen unless lenders can replenish their equity capital. However, there are numerous superior alternatives to Paulson's plan. For example, the government could inject capital into financial institutions by purchasing preferred stock, as was done with Fannie and Freddie. This would at least give taxpayers some upside if the institutions become profitable in the future. Also, "Why Paulson is Wrong", an interesting short article by Luigi Zingales, a professor at the University of Chicago business school, proposes an interesting solution. He suggests that creditors be forced to accept equity in exchange for debt. This amounts to a sort of instant Chapter 11. This would increase the equity capital of financial institutions not by increasing their assets, as Paulson's plan would do, but instead by reducing their debt. Since there are better ways to restore credit availability—some of which require no financial support from taxpayers—Paulson's plan should not be adopted.