Big Players, Again

I have discussed Koppl’s theory of Big Players before (see here and here). Today, we are treated to another example. From the WSJ:

“Like many others I made the mistake of buying what I believed was ‘value,'” Mr. Gwin says, adding that investors who bought at the time believed the loans were worth more than their market price. “We did not contemplate having our first liens invalidated by a sitting president,” he adds.

It is incredibly disheartening to see the government continue to change the rules in the middle of the game. Initially, I thought that the problem was confined to the Treasury department in the final months of the Bush administration, but clearly this mentality has carried over and has perhaps even become worse. Koppl’s theory seems more prescient each day.

Stress Tests

It turns out the stress tests were not all that stressful.

Quote of the Day

“The credit card stocks didn’t tumble or anything so my question is with all this cheap talk who is Obama pandering to? Even if the terms of sub-prime mortgages are a big mystery, the terms of credit cards aren’t. Everybody knows cards have high interest rates and that they always have. Who has accumulated large balances on their cards by making purchase after purchase, not paying down the balance every month and yet thinks these large debt burdens are somehow the credit card company’s fault?”

— Will Ambrosini

The SDR

David Beckworth and I discuss the SDR in the comments of his recent post.

Monetary History and Policy

Scott Sumner has an excellent post on the impact of Friedman and Schwartz’s Monetary History of the United States on our thinking about monetary history and policy. You can read my thoughts in the comments of that post.

Subsidizing Lemons

Suppose that you are in the market for a car. You have no knowledge of the actual value of each individual car. The seller, however, knows exactly how well the car runs, whether it has been in accident, how many repairs it has undergone, etc. Thus, deciding how much you are willing to pay for each individual car on the market is quite difficult. Ultimately, you must rely on some metric such as the average quality of the available used cars to make your decision. The problem, of course, is that this price likely will not be high enough to entice the owners of above average quality vehicles in the market. It this process continues, it could ultimately result in a breakdown of the market itself resulting in a “no-trade” equilibrium.

This is George Akerlof’s market for lemons. It is also a good way to think about the market for the so-called toxic assets on banks’ balance sheets. So when thinking about the Treasury department’s new public-private investment plan (PPIP), it is important to keep this story in the back of one’s mind.

Readers will recall that I was not a fan of the Paulson Plan. The same can be said for the PPIP, or Geithner Plan.

The problem with these assets is that we simply do not know what they are worth given the great deal of uncertainty surrounding their underlying value. The Paulson Plan was designed to simply buy the assets at the depressed values and then sell them at a later date and hopefully earn a profit. Those who designed the Geithner Plan seem to have recognized the idiocy of this plan. Nonetheless, they have decided to partake in the madness by announcing a plan that would subsidize the purchase of these assets by the private sector with the FDIC ultimately bearing the losses. As Andrew Ross Sorkin wrote recently:

It’s [the FDIC] going to be insuring 85 percent of the debt, provided by the Treasury, that private investors will use to subsidize their acquisitions of toxic assets. The program, extraordinary in its size and scope, is the equivalent of TARP 2.0. Only this time, Congress didn’t get a chance to vote.

These loans, while controversial, were given a warm welcome by the market when they were first announced. And why not? The terms are hard to beat. They are, for example, “nonrecourse,” which means that if an investor loses money, he owes taxpayers nothing. It’s the closest thing to risk-free investing — with leverage! — around.

But, as we’ve learned the hard way these last couple of years, risk-free investing is an oxymoron.

So where did the risk go this time?

To the F.D.I.C., and ultimately, to us taxpayers.

Here is the real kicker:

So how much does the F.D.I.C. think it might lose?

“We project no losses,” Sheila Bair, the chairwoman, told me in an interview. Zero? Really? “Our accountants have signed off on no net losses,” she said. (Well, that’s one way to stay under the borrowing cap.)

By this logic, though, the F.D.I.C. appears to have determined it can lend an unlimited amount of money to anyone so long as it believes, at least at the moment, that it won’t lose any money.

Essentially, what all this means is that we are essentially subsidizing the lemons and expecting that this will fix the problem — at zero cost and without any oversight. I never thought that I would utter what follows, but this is perhaps worse than the Paulson Plan. Sure, it is great for private investors, who are essentially being given money to speculate on worthless assets with borrowed funds on which there is no recourse, but it is potentially terrible for the taxpayer.

Subsidizing the lemons on financial balances sheets will not lead to price discovery. Rather it will merely artificially inflate the prices of these assets without improving our knowledge about what they are truly worth. Further, it creates an incentive for financial firms to unload what they believe to be the worst of these so-called toxic assets with the taxpayer footing the bill for the losses.

WSU Blogging

The Wayne State blogging presence is growing (at least for this week) as Robert Rossana is guest blogging this week for the Detroit Free Press on the stimulus package. Here is an excerpt from today’s post:

All governments have a budget constraint stating that, sooner or later, spending must be paid out of tax revenues. Equivalently, deficits today must be balanced by surpluses in the future. Given the deficits that we are now running and are likely to run next year – which are so large that it is unlikely we can “grow” our way out of them – taxpayers must rationally anticipate tax increases in the future.

So is it likely that households will go on a spending spree in response to this additional government spending or will they try to save more, anticipating these future tax increases? Some economists suggest that, because of these implied future tax liabilities, the Keynesian multiplier is actually less than one; as households save in anticipation of future tax liabilities, GDP will rise by less than the increase in government spending.

Big Players and Uncertainty, Part 2

Some readers may recall an earlier post in which I explained that many of the failures of the attempts at government intervention have to do with the fact that the government is exercising discretionary power that change the rules of the game on a largely ad hoc basis. Particularly, I referenced Roger Koppl’s theory of Big Players, in which a large entity that is largely immune from the profit-loss mechanism wields significant discretionary power. Under these circumstances, such discretionary power can be a major source of uncertainty and therefore causes market participants to shift resources away from productive uses and toward predicting the behavior of the Big Player (incidentally, Axel Leijonhufvud makes a similar point in his classic, “Costs and Consequences of Inflation“).

In the earlier post, I referenced the ad hoc behavior of the Treasury in developing the bank bailouts and suggested that, consistent with the theory of Big Players, such behavior only served to generate uncertainty. I have not been alone in this analysis. For example, John Taylor’s new book similarly criticizes such ad hoc behavior on the part of the federal government as exacerbating the crisis.

Thus, I was not at all surprised to read the following story from NPR, in which one bank CEO explains why he decided to give the TARP money back:

[CEO Joseph] DePaolo says Signature returned the money for three reasons: Legislation passed Feb. 17 would limit the compensation for salespeople, make it difficult to recruit bankers and cause uncertainty.

“With the new legislation, they changed the rules in the middle of the game,” he says. “We didn’t know how many more rule changes or legislation would come down, maybe telling banks, ‘This is what you can do with your lending. This is what you can do with your clients.'”

I will reiterate a point that I made in the earlier post:

If the government really wants to help, they can start by setting the rules now and following through on their promises. So long as they continue to change the rules on a daily basis, uncertainty will prevail, the stock market will remain volatile, and the credit markets will remain frozen.