Tuesday, November 25, 2008

Are Economists wrong or is Paulson deaf?

When the bailout plan first draft leaked to the media, a lot of economists are against it and most of them support an idea of purchasing equity stakes in the banking-financial firms. Here is what a group of five economists from the University of Chicago's Graduate School of Business (Diamond, Kaplan, Kashyap, Rajan and Thaler) have suggested back then:

"......The first could be accomplished by adopting much of the Treasury plan, perhaps with Mr. Dodd's proviso. The Treasury would buy assets through a reverse Dutch auction or some variant, but without any intent to overpay. The idea would be to jumpstart the market by establishing trading prices.

The second component, raising capital, could be achieved in other ways, for example through a mixture of a mandate and an offer of partial government support. The authorities could require all regulated financial institutions, no matter how well capitalized, to present plans to raise 2% of their assets in additional capital over the next quarter to preserve the stability of the financial system. This increased capital will not represent an increase in the permanent level of required capital for bank holding companies, but instead give institutions the extra capital that will allow them to lend. ......"

Notice that the economists never really completely rejected the idea of purchasing the troubled assets, which Paulson announced on November 12, 2008 that :

"Over these past weeks we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets. "

The Dow (DJIA) fell over 400 points on that day and as the Detroit 3 failed to prove to congress that they are worth saving and Citigroup fell deeper into trouble, the Dow declined close to 7500 points.

Then, on Monday Nov. 24, 2008, the bailout plan on Citigroup involves some kind of insurance on the toxic assets, and on Tuesday, Nov. 24, 2008, Fed and the Treasury put together a 800 billion package to facilicate lending in the consumer credit market.

So, what's that claim of no TARP money for toxic asset all about?

As Chris Probyn put it: "The government has subtly reversed course. The original idea of the bailout was to remove toxic assets from the balance sheets of banks. That was subsequently abandoned but they are getting back to it. ......"

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