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Sunday, September 21, 2008

Paulson Plan: Will it Work?

by Calculated Risk on 9/21/2008 04:38:00 PM

The primary goal of the Paulson Plan is to get the banks to lend again - or "unclog the system" as Secretary Paulson put it. Secondary goals are to "protect the taxpayer" and hopefully minimize moral hazard.

Will the plan achieve the primary goal? I think the answer is yes. By removing these troubled assets from the balance sheets of the financial institutions, the banks will able to lend again without lingering doubts about their solvency and viability. At first glance, the size of the plan seems sufficient.

UPDATE: This assumes some sort of recapitalization of the banks while they deleverage too. Something that isn't in the plan ...

It is almost guaranteed that there will be unintended and unanticipated consequences, but the plan will probably achieve the primary goal. And making sure the banks continue to lend will minimize the impact of the credit crisis on the general economy.

Unfortunately the Plan fails to address the secondary goals.

By definition the Government will pay more for these troubled assets than private investors (or the banks would just sell the assets to investors). The question is: will the government pay more than the intrinsic value of these assets? (intrinsic value in this sense would be the amount the government eventually receives for these assets).

This intrinsic value is unknown right now because we don't know how far house prices will decline (and the value of MBS is related to house prices), and we don't know how much the Government will pay for these assets.

Under an optimistic scenario perhaps the government might pay close to the intrinsic value for the MBS, and the taxpayers would lose little or nothing. A more pessimistic scenario would suggest that the government would lose something on every transaction - and because of the structure of the plan, this might cost the taxpayers $700 billion.

Note: This doesn't imply each asset is worthless. Imagine you start with $100. You buy an asset for $100, and sell it for 30% less - you lost $30. Now you invest the $70 and lose 30% again, and on and on. Even though you only lost 30% on each transaction, you eventually lose the entire $100 - this is possible with the structure of this plan.

So the plan does nothing to protect taxpayers or minimize moral hazard. This is fixable by adding some sort of options or warrants for preferred shares and / or senior debt that could be tied to the losses for each institution. If the government loses money buying MBS from a particular institution, then - after several years - that institution could reimburse the taxpayers or the shareholders suffer significant dilution.

And a final suggestion: In an effort for transparency, I'd like to see a website that listed each transaction purchased by the government. This could list the details of the asset, the PAR value, the selling institution, the underlying characteristics, the originators of the loans, the price the government paid (and eventual sold the asset for) and any other relevant detail.