Wednesday, September 24, 2008

Plan B

Email query from the Caribbean:

Dem bald man say, You gotta give us $700 billion by Friday.
Dem beard man say, We’ll get back to you on the rest of this.
Dem bank man say, No vote now, sky gonna fall.
Dem law men say, F--- y'all. If Monday show and we still here. Wat den?

It is, of course, all a confidence game.

Markets are a confidence game—perhaps trust is a better word—built on the belief that tomorrow will come around and it will be a lot like today. That buyers and sellers will show up. That the rules will be enforced. And most trades are completed on a handshake.

And politics is a confidence game. Despite all the appearances of a knife fight, it is not unlike a trading floor. Deals are made on a handshake, and you are only as good as your word.

Today, the two games are joined. 535 members of Congress have to take the measure of Henry Paulson and Ben Bernanke. More than anything, the members detest and resent having their backs pushed up against the wall.

Deep down, they suspect this is just a Wall Street gangbang, as the banks push to include credit card receivables and other questionable assets in the grab bag, as the lobbyists swirl around looking for the greatest payday in the history of paydays, and as the CEOs with their homes in the Hamptons call to plead their case.

More than anything, the members cannot abide being told they have forty-eight hours, and they have no choice.

But what if they demur. What if through the peculiarities of the vote, the votes aren’t there.

Perhaps the members of the Republican Study Committee hunker down and decide to vote their convictions, and demand that investors and homeowners alike pay for their bad decisions.

Perhaps Bernie Sanders and the smattering of liberals not yet co-opted by the Democratic Leadership Council put their foot down on the principle that public aid must come at the price of public ownership.

And then the broad swath of the Center, cringing in embarrassment at being upstaged by the principled fringe, heed the populist call and abandon the Paulson Plan.

What then indeed?

Congress would look for a Plan B. And perhaps Plan B would focus on the underlying mortgages that are the root of the problem, rather than simply bailing out the financial intermediaries. After all, the fundamental problem with the mortgage-backed securities market is the lack of good information. With good information—however bad the news—liquidity would return to that market. Securities would find their appropriate market level.

Under a Plan B, Congress might create an interim insurance facility that would guarantee a portion of CDO cashflows—pending a workout of the underlying mortgages. Congress could direct the HFA and state mortgage finance agencies to work with troubled homeowners to restructure the terms of their mortgages, perhaps swapping a portion of the mortgage value for an equity share in future sale proceeds, to keep people in their homes and recoup some value over time. They could give bankruptcy judges the right to recast mortgages in default. And they could score political points by directing the FBI to focus on fraud and corruption in the finance industry.

For its part, the Fed window would be flung wide open for the banks and others who did not make bad choices to grab market share from those who did. And the market would do what it is supposed to do. Those who made bad choices suffer. Those who did not do well.

And there is a lot of money to be made on the hundreds of billions of CDOs that Paulson and Bernanke proposed to purchase for $700 billion, once information on the underlying assets is confirmed and value can be determined. Under Plan B, however, these profits would flow to hedge funds and private equity groups that would move in to acquire the illiquid assets that are now being marked to market at levels well below their real value. With aggressive federal action to validate and fix the underlying mortgages, a market for these securities would reemerge, and, with the prospect of profits to be made, every incentive will be in place to find and fix the underlying mortgages.

The problem, of course, is that Plan B is purely hypothetical. And it means that Monday morning would come without a fix in place. It means facing down the two wise men and their bailout plan and playing a game of chicken. And watching to see if the sky falls.

And there could be a lot of pain in the short-term. And in this case the short-term is the forty days before 435 members of Congress get their report cards from their constituents. Better to cast a vote for $700 billion and blame the bald guy if it fails, than bet on Plan B, even if, in the long-run, Plan B might be the right choice.

After all, as Lord Keynes famously said long ago, in the long-run, we are all dead.

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