#10408 Sep 24, 2008
A very clear explanation of the outlines of the proposed bailout. But I think the author
misses the point about compensation penalization. Most people who dismiss the
compensation penalization of executives fail to see that it is actually a "leverage" tool.
Companies are led into risky behavior by their executives, why? Because there is no
downside for them personally. If the bail out is done without some form of penalization
for the upper management's bad judgment, the whole mess will just start over again. The
amount of money involved to get better behavior is relatively small (compared to $700b),
but the effect can be very large.
Issue Is Payback, Not Bailout
By DAVID LEONHARDT
Published: September 23, 2008
The New York Times
So are you for the bailout or against it?
Many people, I'm guessing, don't have an immediate answer to the question. They
understand that the financial crisis is serious enough to require a big response from the
government. But they also hate the idea of rewarding Wall Street for its failures and are
wary of yet another assurance from the Bush administration that this step will be the one
that contains the crisis.
Imagine, then, what it's like to be in Congress this week. Most members of Congress have
no expertise in the byzantine details of mortgage finance . or even have aides on their
staff with such expertise.
"The problem here is none of us has that kind of advice," Senator Charles Schumer,
Democrat of New York, who knows more about Wall Street than most of his colleagues,
Yet in just a few days' time, members of Congress have to figure out how to improve the
bare-bones $700 billion plan submitted by Henry Paulson, the Treasury secretary, and
ultimately whether to vote for it.
Their best shot at success depends on keeping the debate tightly focused on the
questions that matter most. There are really only two: What steps are most likely to solve
the immediate crisis? And how can the long-term cost to taxpayers be minimized?
Everything else . reducing executive pay on Wall Street, changing the bankruptcy laws,
somehow slowing the descent of home prices . is either a detail or a distraction.
Over the last few days, Congress has done a pretty good job of identifying the biggest
weaknesses in the Paulson plan, like its vagueness. But as was obvious at Tuesday's
much-watched hearing, members of Congress have also been spending a fair amount of
time on sideshows.
Usually, it would be easy enough to dismiss these sideshows as the inevitable gear-
grinding of democracy. This is an extraordinary time, though. The credit markets are
nearly dysfunctional, leaving the economy at risk of falling into a downturn unlike any
most of us have lived through, and the government is about to commit billions of dollars
after only a week of political debate. There's no time to waste.
The first thing to understand is that a bailout plan doesn't have to cost anywhere close to
$700 billion, so long as it's designed well. The $700 billion number that you see
everywhere is an estimate of how much the government would spend to buy deteriorating
assets now held by banks. Eventually, the government will turn around and sell these
assets, for a price almost certain to be greater than zero. So this $700 billion is very
different from $700 billion spent on a war or on Medicare.
"Much of the discussion of the cost of the bailouts is getting it wrong," David Colander, an
economist at Middlebury College, says. "What matters is what price they buy the assets for
and the price they sell them for. That's where the real action is."
Figuring out how much to pay for the assets is the first problem. The drop in house prices
and rise in foreclosures have made it clear that these securities are worth considerably less
than banks expected. But there is enormous uncertainty about how much less.
Based on the underlying fundamentals (like the current foreclosure rate and the one
forecast for the future), many of the securities appear to be worth something on the order
of 75 percent of their original value. But thanks to the fear now gripping the market . not
necessarily an irrational fear, given that most forecasts have proven far too sunny over the
last year . very, very few of those securities are trading hands. Among those that have,
the sales price has been roughly 25 percent of the value.
Which price is the government going to pay? As Mr. Colander puts it, that's where the
It clearly shouldn't pay 75 cents on the dollar, or anything close to it. That would mean
the Treasury Department . which, in the end, is really you and me . was assuming
nearly all the risk. But it probably can't pay 25 cents. That might fail to fix the credit
markets, because it would do relatively little to improve financial firms' balance sheets.
Firms might then remain unwilling to lend money to businesses and households, which is
the whole problem the bailout is meant to solve.
The most obvious solution is to pay more than 25 cents on the dollar and then demand
something in return for the premium . namely, a stake in any firm that participates in the
bailout. Congressional Democrats have been pushing for such a provision this week, and
it's one of the most important things they have done.
The government would then be accomplishing three things at once. First, it would take
possession of the bad assets now causing a panic on Wall Street. Second, it would inject
cash into the financial system and help shore up firms' balance sheets (which some
economists think is actually a bigger problem than the bad assets). And, third, it would go
a long way toward minimizing the ultimate cost to taxpayers.
Why? The more that the government overpays for the assets, the larger the subsidy it's
providing to Wall Street . and the more it is pushing up the share prices of Wall Street
firms. As Senator Jack Reed, Democrat of Rhode Island, notes, the equity stakes allow the
government to recapture some of the subsidy down the road. It's a self-correcting
Some details of a bailout will have to remain vague, in part so that Treasury officials have
the flexibility to respond to an obviously fluid situation. But Congress can still do a lot this
week to make sure the final cost is a lot closer to, say, $100 billion than $700 billion.
Instead of a laserlike focus on the big issues, though, Congress has been devoting a good
chunk of energy to secondary matters. Some of the proposals, like changing bankruptcy
rules to help some homeowners avoid foreclosure, are perfectly reasonable but just won't
do much to cure the credit markets. Others may not even meet that standard.
One of the fashionable ideas of the week, supported by both Democratic leaders in
Congress and John McCain, is to limit the pay of top executives at any Wall Street firm that
sells assets to the government. In effect, this is an attempt to tell Wall Street how to split
up a government subsidy among its various employees and shareholders.
Personally, I couldn't care less how much of the subsidy goes to Wall Street's chief
executives and how much goes to Wall Street's shareholders. I care about the size of the
subsidy that we taxpayers are paying. And in a frenzied week, any time spent on talking
about C.E.O. pay is time not spent on designing the toughest possible bailout package. I
found it telling that the relentlessly pro-business United States Chamber of Commerce
it can support executive pay restrictions.
The efforts to punish executives and help Main Street are based on a worthy instinct . to
address not just the crisis but also larger problems like inequality. The best way to solve
those problems, though, is to make sure the government spends as little possible on an
A few hundred billion dollars saved today will leave a few hundred billion tomorrow to
spend on a better health care system, a saner energy policy and a healthier economy.