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Rien n’ira plus

March 24, 2009

It’s ‘good news, bad news’ time and the French Cowboy will begin with the good news – not only because such is the tradition but also because starting with the bad news would make the sharing of the good news obsolete.

The good news is that Monsieur Geithner has come up with a plan to ‘detoxify’ the financial markets (a genuine plan, this time, with specifics and all) and that in itself has reduced some major uncertainties and markets have reacted with relief. But there is more: the content of the plan has a positive aspect as well. It appears that the administration is acknowledging – for the first time – that the best way to determine prices that reflect actual values is through the market system. At least this is the impression you get from their plan to involve private investors into their scheme.

Rather than buying up the assets at prices that can be only guesstimates at best, the administration wants to match private investment into the toxic assets proportionately. That means that the evaluation of the assets is left to people who are most likely to be in the best position to do so. At least that’s the theory. In order to get private institutions to play along, government is laying out a huge carrot. First of all, the government will take up the lion share of the tab. 97% of it to be precise. Also, should the trouble-making assets turn out to be undervalued, private investors who bought them, as well as Treasury, are bound to make a profit (unless, of course, Congress decides to tax them at 90%).

But, hélas, that carrot may prove to be so large as to distort the private sector’s investment decisions in favour of the toxic assets to the extend that private money thrown into the scheme may not reflect the value of the assets at all. While this is not the White House’s narrative, Paul Krugman writes that the negative risk lies exclusively with taxpayers, not with private investors: “[…] if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt.” If this is true then forget about the administration’s claim of using “the expertise of the market” in evaluating those assets. Then the plan just offers private investors a free lottery ticket which they will accept if the potential profits are high enough to offset their fear of receiving the AIG treatment after ‘partnering up’ with the government.

Intermezzo: Paul Krugman is undoubtedly a smart economist. He is, also undoubtedly, a liberal. While the French Cowboy dismisses Krugman the Liberal’s opinions as a matter of routine, Krugman the Economist’s thoughts are worth noticing. And when Krugman the Economist argues against a liberal administration’s plan, that makes two reasons why Krugman is probably right.

And here comes the bad news. There is a likelihood that the toxic assets are currently not undervalued or not sufficiently undervalued for government to win this bet. And if private investors really don’t have to fear any losses then their 3% participation in the purchase of the assets is no safeguard against government turning a trillion dollars into sawdust. So we might end up in a situation in which government has made its best shot at solving the mess that caused the financial crisis – and missed. And, what’s worse, it will have no gun powder left for a second shot. As Brad DeLong puts it (and he is a liberal economist, too):

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn’t make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money–for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

So while the Geithner plan is trying to get a correct assessment of the toxic assets’ values through involving private investors, it may not achieve this because of the inbuilt distortion caused by the very incentives set out for private investors to get on board. As a result, the government may be about to lose one trillion dollars in what may bear closer resemblance to a game of roulette than to a risky investment.

The French Cowboy is wondering why the Treasury doesn’t simply buy up the toxic assets through a bidding system. Government could start out with a really low offer for the assets – even a negative one – and, absent an acceptance, gradually increase its bid until holders of the bad assets are willing to sell them. This would be a way to avoid overpaying for what may well end up to be truly worthless assets after all. The problem would be that the owners of the assets may expect government to be willing to pay any price, or at least too high a price, to get those assets off the market. But Treasury could play it smart and send the credible signal that it won’t increase its bids for ever because should those who currently own the toxic assets refuse to sell them at low prices it would demonstrate that they are undervalued after all, and that the toxic-asset scare really was just a spook. In this case there would be no more need for the government to buy them and the bidding process would end without a deal, but restored market confidence.

But in any case, just to be on the safe side, the French Cowboy recommends you to ‘buy American provision’ (the only context in which those three words from the ‘stimulus bill’ make sense) and store up in Spam, Campbell’s tomato soup and gas-cookable cheese macaroni to be prepared when the toxic-assets mess hits the fan.

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