The Paulson Plan

One more post in my drafts folder. I wrote this on Sunday (9/21/08) before we knew anything except that Paulson wanted $700B to buy bad assets from banks. I was right again: their solution is a bailout of the banks by buying well above the currently very low market price for mortgage backed securities. It’s unfair and I’m glad the Democrats are pushing for much tougher terms. It’s too bad they won’t let banks go bankrupt.

[originally written on 9/21/08] The markets nearly melted down last week, but Paulson and Bernanke offered a vague plan to buy up to $700B worth of collateral debt obligations (CDOs). The banks claim that no one else is willing to buy this stuff; therefore, they can’t write down their losses because they don’t know what the “mark value” should be. That’s BS. A few banks have sold big chunks of their CDOs at 50-80% below their purchase price. The problem is that most banks don’t want to sell at that low price because then they’d have to admit they are nearly bankrupt, which would lower their bond ratings and make survival less likely. They are hoping the gov’t will pay above fair market value.

The Paulson Plan could have two possible effects, depending on the price that the government offers to pay for this junk. If the price is fairly low and the banks sell, then everything goes fairly well: some banks fail, others get bought or recapitilized, and over time the gov’t makes some money on the CDOs. The more likely scenario is that the gov’t buys some CDOs at a fairly high price. This is effectively a bailout for a few desperate banks to stave off bankruptcy; free money for Wall St. Everyone else gets to mark their CDOs at that higher price and pretend they are solvent. They are hoping this will give them time to dig out of their hole, and the real estate market hits bottom and starts to turn around (which stabilizes the value of CDOs). Over time the gov’t sells off their CDOs and taxpayers take a loss.

The right answer, IMHO, is to force the banks to go bankrupt by enforcing the rule that they must “mark to market” all their CDOs right now. Change the bankruptcy laws to allow the courts to quickly sell off the CDOs and other junk. Then let the gov’t buy the rest at the same price as the lowest bidder. That way we have some assurance the gov’t isn’t getting screwed. Finally, the gov’t can change personal bankruptcy laws to make it easier to renegotiate mortgage terms to prevent widespread foreclosures. This will prevent the real estate market from going too far down and ensure the gov’t makes some money off this deal. Only the gov’t can change the rules to guarantee a profit.

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