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Optimism Over Despair

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By Steven Pearlstein
Tuesday, March 24, 2009

It fills me with a sense of despair that Paul Krugman is now "filled with a sense of despair."

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Even before the Treasury Department released details of its plan to buy up unwanted bank assets, the Nobel Prize-winning economist was writing in his New York Times column that the plan was certain to fail -- and that this failure would inevitably drag the entire world into a long and painful depression.

Krugman despairs that Tim Geithner, Larry Summers and Ben Bernanke are really nothing more than warmed-over Hank Paulson, so blinded by their free-market ideology that they refuse to consider the only viable option, which is to nationalize all the big banks.

The columnist also despairs that Barack Obama and Rahm Emanuel and David Axelrod don't really understand the political calculus they now face, which is that the near-certain failure of the Treasury plan will deplete the president's stock of political capital and render him powerless when he finally comes around to proposing nationalization.

Gee, and I was feeling rather encouraged by yesterday's developments.

If nothing else, it was certainly a good sign that the conversation has turned from AIG bonuses to the question of how to revive the global financial system. And a nearly 500-point rally on Wall Street led by financial shares certainly suggests some improvement in investor confidence.

More to the point, the plan looks to me like it has a good chance of bringing significant amounts of private capital back into the financial system and relieving banks of some of their worst assets.

On first blush, the Geithner plan looks rather complicated, but its general design is rather simple:

The government will go in as partner with private investors in newly created investment vehicles that will compete to buy up loans and securities backed by loans that banks want to sell in order to strengthen their balance sheets. As with most investment funds, this public and private equity or risk capital will be supplemented with additional funds that will be borrowed from Treasury, the Federal Reserve or from private investors who will receive a government guarantee that their loan will be repaid.

If the investments wind up making money, the profits will be split with the government in the same proportion as the equity that was put in. If the funds lose money, the initial losses -- roughly the first 15 cents on the dollar -- will be borne in the same proportion by the government and the private investors. Any losses beyond that will be borne by the government.

In the meantime, the banks will be able to strengthen their balance sheets in ways that will allow them to attract new private capital from investors who no longer will worry about the bad loans on the banks' books. They will also have the cash from the asset sales with which to make new loans.

Most importantly, by reviving the secondary market for the loans and securities backed by packages of loans -- the so-called "shadow banking system" -- the plan could revive the mechanism that in recent years has been the source of capital for half the loans to American businesses and households. (That's one reason why bank nationalization might work in a country such as Sweden a decade ago, but wouldn't work as well here.)

The blogosphere was full of Krugman-like criticism of the Geithner plan yesterday, with some complaining that it would be a windfall for hedge funds and other private investors and others arguing that it would fail to attract private capital. It's hard to see how both could be true.

There's no denying the fact that the balance of risk and reward for these investment vehicles are asymmetric -- more of the downside risk is assumed by the government, while more of the upside reward will go to the private investors. But some sort of asymmetry was inevitable for any plan that tried to lure private investors at a time when investors were refusing to participate with the usual risk-and-reward ratios. One can quibble that the proposed deals are too sweet or not sweet enough, but I can assure you that the folks at Treasury, having consulted widely with potential investors, have a better feel for those details than even the most sagacious newspaper columnists.

The larger point, however, is that the government has different goals than private investors. Investors want to make as much money as they can while taking the least risk. The government wants to revive the financial system and an economy in a way that winds up costing taxpayers the least amount of money. The asymmetries reflect those different goals.

Several bloggers, including Krugman, have complained that by making financing available to buy bank assets, the government was "artificially" inflating the market value of those assets from current levels. In a narrow sense that's true: The inability of investors to get loans to purchase loans and asset-backed securities is one big reason why the market value for these assets is now depressed. But looked at more broadly, the plan merely restores things to a more normal situation in which the market prices reflect expected cash flow rather than reflecting the unavailability of reasonable financing.

Krugman's assumption, however, is that the current, depressed market prices for loans is the correct price, from which he jumps to the conclusion that all big banks are insolvent and need to be nationalized. But even a casual observer can see that these markets are broken not simply because many loans are bad, but because of a lack of investment financing. It is the interaction of the two problems -- in econospeak, solvency and liquidity -- that has caused the market to break down and prices to collapse.

As for the nationalization mantra, it's hard to see what that would accomplish. If the government were to take them over and assure depositors and creditors they would be repaid in full -- which is what you need to do to avoid a collapse of the financial system -- then there is little effective difference from a plan designed to rid banks of their bad assets. Nationalization doesn't make the bad loans go away -- it simply moves them from the banks to the government, with the government on the hook for any additional losses.

For the worst banks, that may turn out to be necessary, as it was in the case of Fannie Mae, Freddie Mac, AIG and Citigroup, all of which have been effectively taken over by the government. But wholesale nationalization would likely require a bigger outlay of taxpayer funds, at least initially, while putting the government in the uncomfortable position of managing large and complex businesses with 535 members of Congress suddenly sitting on their boards of directors.

Now that would be something to fill any columnist with a sense of despair.

Steven Pearlstein can be reached at pearlsteins@washpost.com.


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