Monday, September 22, 2008

In Favor of the Dodd Plan

. Monday, September 22, 2008

(Sarah posted a great comment to my post earlier today. At the bottom of my post, I linked to Sebastian Mellaby's citation of several academic proposals which bear some similarities to Sen. Dodd's counter-proposal to the Paulson plan. In the next few posts, Sarah and I are going argue the merits and demerits of the Dodd and Paulson plans. All of this is off-the-cuff, but hey: it's a blog. Apologies for the length.)

Dodd's plan accepts the basic assumptions of Paulson's: that massive government intervention has become necessary in order to stabilize markets and prevent financial market contagion from sinking the real economy. But Dodd's plan differs from Paulson's in several key areas. In my view Dodd's plan improves Paulson's on balance, but I have caveats. The list:

1. Paulson wants unilateral authority, with no review from Congress or the courts. This is insane, undemocratic, illegal, etc. Dodd wants an oversight committee comprised of the Chairmen of the Fed, FDIC, and SEC, plus two representatives from the financial industry. Paulson would still essentially serve as the CEO of United States, Inc., but his board of trustees would be comprised of this committee, which would presumably report to Congress and be subject to the judicial process if necessary. Dodd's proposal alleviates concern along two fronts: first, that too much discretion would be given to Paulson with too little accountability; second, that potential for moral hazard will be lessened because Paulson's actions will be more transparent and authority will be more dispersed.

2. Paulson wants broad discretion to use the cash in any way he sees fit, and has intimated that this will mostly entail buying "bad debt" so that banks won't have to carry them on their balance sheets any longer. This basically means one thing:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

Why? Well, most of the "toxic debt" is still in the form of CDOs, especially mortgage-backed securities (MBS). These things were never intended to be bought-and-sold like other securities. As such, they don't really have a "market price" in the same way that stocks and T-bonds have. Even if they did, that "market price" is effectively $0 at present; simply put, nobody will buy these MBS at any real price. If the problem for banks is that they are short on capital, selling MBS at a massive loss to the Treasury (or anybody else) isn't going to do any good. In order to balance their sheets, they'd still have to sell more equity or dump assets at fire-sale prices. As Krugman has noted, the Treasury will essentially have to over-pay in order to create the desired effect. But that means that the U.S. government and its shareholders (i.e. taxpayers) will be essentially guaranteeing a pretty major loss for itself in order to reduce losses for banks who made bad decisions. This is corporate welfare in the extreme. If Bush and Paulson want that sort of action, then they should have to properly sell it to the American people and her Congress. They don't want to do that, for obvious reasons, so they shouldn't be allowed to get away with it.

3. One way around this problem is to force banks to stop paying dividends and/or to issue more equity (see the Mellaby piece linked in my first post). No banks will do this on their own, because that is a powerful market signal that that bank is failing, a sell-off will ensure, and the firm's value will fall. If the government forces all banks to do it, then credibility can be maintained. But not all banks are on the brink, so why punish those who managed their money well? You could put downward pressure on an already reeling market. And if you only mandate that "sick" banks act in this way, then that will be a strong signal as well, and firm value will still plummet.

So what to do? Dodd proposes that the Fed provide the needed liquidity for firms to roll over their paper. In exchange, those firms will provide equity equal to the size of the government's "investment". In other words, U.S. taxpayers will get equal value for their dollar by paying present market value for partial ownership. We will still be taking on some risk, but now we have a share of the upside and not just the downside. If the firms do well, we may make money. If the firms do poorly... well, the Paulson plan has us taking on that risk anyway.

This is not ideal, in my view. There are still a lot of questions to be asked and answered, and I expect Sarah to spell them out in more detail in her post. But we aren't dealing with "first-best" scenarios here. This may be the best we can do in a bad situation.

As an alternative, Arnold Kling proposes instead to drop the capital requirements for banks. He acknowledges that this will still mean more risk exposure for U.S. government since they insure banks. Not only that, but his proposal doesn't kick in for another year and the crisis is more immediate than that. Lastly, if one of the main problems in this financial trouble is too little risk-aversion by banks (or poor risk judgment, if you prefer), then it seems a bit presumptuous to give more casino credit to these banks and practically dare them to gamble with it. Which leads to...

4. CEO compensation. A loaded topic, to be sure. Dodd's plan, contra Paulson, has provisions for punitive damages for CEOs whose firms have done poorly. Executive compensation and severance packages could be arbitrarily reduced, presumably by Paulson's oversight committee (or Congress?) if it "is in the public interest". Well, what does that mean? What is the public interest? What levels of reduction? Matthew Yglesias wants "punitive measures". John McCain says that CEOs of bailed-out firms shouldn't be paid more than the U.S. President ($400k/year). I automatically recoil at vague language like that in the Dodd plan, but even ignoring that for the moment: what's the incentive facing executives if that clause remains? It's for CEOs and their boards to keep gambling and not seek help from the government if that action would mean that their personal compensation is going to fall from millions to mere thousands. It effectively creates moral hazard for these executives, and that's a really dumb thing to do right now. The government can only respond in four ways to executives who choose to take the gamble: do nothing and let the firms collapse, which defeats the point of this whole exercise; unilaterally violate compensation contracts, which would violate centuries of legal tradition; forcibly nationalize firms which don't want to be nationalized, which is a step (or twelve) further than anyone really wants to go; or appeal directly to shareholders. But shareholders are incentivized to gamble too since they will probably lose everything if the government bails out the firm (see AIG). In any case, such a move would likely take too long when firm survival is measured hour-to-hour.

In the grand scheme of things, CEO compensation is not a big deal. A few dozen million might sound like a lot, until you realize that we're really talking about hundreds of billions right now, at the least. Democrats and progressives would be wise to save that fight for another day; it just doesn't matter right now, and might actually be counter-productive. I'm guessing that these CEOs won't be getting salaries quite so big at their next job anyway.


In Favor of the Dodd Plan




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