Thursday, October 02, 2008

More from Morris Davis

This morning he writes to me:

Now that a week has passed, I'd like to restate my original points on the
bailout as first proposed: (1) a blank check of $700bn to Paulson seems
irresponsible since he has been wrong about the crisis from day 1; (2) we
have not adequately forecasted and compared the cost to GDP of doing nothing
versus the cost to GDP of doing something; and (3) are we sure that free
markets aren't going to work? I've heard there is quite a lot of private
equity waiting on the sidelines. More on this in a bit.

The fourth point I made is that Paulson offered no simple and convincing
explanation of the problem. To talk about a solution requires knowledge of
the problem. Let me now offer two things: 1. My beliefs about the core
problems and 2. What I think we should be discussing.

1. I've learned that our financial accounting statements are inadequate.
Example: John Oros gave a talk here at Wisconsin last week. Oros is a
director at JC Flowers, a private equity firm, and they had the option to
try to buy AIG. (JC Flowers has also had the option to buy Bear Stearns,
Lehman, Morgan Stanley, ...). Last week he told us that, before his team
went in, AIG HAD NO IDEA HOW MUCH CASH THEY HAD. AIG brought in stacks of
books for Oros's team to look at to try to figure out what was on their
balance sheet. This is AIG, the company with 150,000 (?) employees and the
world's largest insurer.

2. The government has created and is creating confusion in the marketplace.
Bearn Stearns and AIG bondholders were paid in full; Lehman and WAMU
bondholders got nothing; maybe the bill will pass, maybe it won't; etc.

In addition, there is a failure of analysis at the top levels of government.
For example, has anyone outlined what happens to GDP if we do nothing (i.e.
just let the banks sort it all out) and what happens to GDP if we do
something. We should know best-guess costs and benefits.

Unfortunately, right now most of what we hear from the government and the
news media looks like fear mongering: Look at Japan! Look at the Great

That is not analysis. I could say: The US economy had a stock market crash
in 2000, in 2001 there was 9/11 and an anthrax scare, and in 2003 we had a
hurricane wipe out New Orleans, and GDP barely noticed. Why is this episode
fundamentally different? And, how do these differences translate to GDP

One reason I am opposed to (more) government intervention is that I
fundamentally believe that the U.S. economy is more resilient to shocks and
disruptions than most acknowledge.

3. My understanding of the problem of financial institutions, from those I
trust, is that banks and financial institutions do not have enough capital,
and are therefore hesitant to originate new loans. If true, then if we are
to do something (debatable), then maybe we should inject equity into the
banking system. The government could partner with a set of private equity
firms to inject equity and claim ownership.

I realize the twice revised Paulson plan tried to do something like this in
a back-door fashion. What I couldn't figure out is if the revised plan
essentially created enough equity to be successful in recapitalizing the
failed institutions.

5. Many analysts, myself included, think house prices are going to fall
another 6 to 10 percent over the next 12 - 18 months. This will create more
distress in the financial system, since it implies that defaults and
foreclosures will rise and not fall. Thus whatever solution we come up with
now should be forward looking, in the sense that it should expect more
distress in the future.

My previous posts should make clear that I do not agree with Morris--the TED spread tells me that there is some urgency here, and if frozen credit markets inhibit capital formation, the pain from our current problems will last for a long time. I don't like the plan passed by the Senate last night either, but my view is the same as Krugman, Thoma and DeLong--Congress should hold its nose and pass it.

But I have enormous admiration for Morris' intellect, and so (with his permission) pass along his thoughts.


Anonymous said...

We have to keep in mind that part of Paulson and Bernanke's jobs is to support public optimism. They can't express pessimism even if they do so believe it themselves.

Anonymous said...

I read a similar perspective on Don Tishman's blog on real estate and politcs:

Thought it was a timely argument. J.W.

Anonymous said...

I'll try this one again tomorrow, but if it's easy, could you repost it without the hard carriage returns?