Arnold Kling  

The Ignorance Behind the Paulson Plan

PRINT
More Experts... Morning Commentary...

From The PBS News Hour on September 23:


JEFFREY BROWN: Let me ask you, stay with you. One of the issues that we heard raised in the hearing was the question of whether anybody can fairly value the bad assets out there, how this would work mechanically. What do you think? How should that work?

EUGENE LUDWIG: The plumbing can clearly be taken care of. This is not the first time we've dealt with these kinds of mechanisms or crises. We've had the RFC in the Great Depression, and the Home Owners' Loan Corporation, and the RTC.


Ludwig is one of the authors, along with Paul Volcker, of the op-ed that put the bailout proposal on the table in the first place.

I am sure that Henry Paulson, Ben Bernanke, and Eugene Ludwig know more than I do about the current health of the banking system, the state of credit markets, and the potential risks to the economy. Note, however, that the news hour transcript also includes comments by Allan Meltzer, a historian of central banking, who argues that the financial crisis is not as bad as it is being portrayed.

But an issue about which they know less than I do is mortgage credit risk. To them, the problem of pricing mortgage assets is a detail to be worked out later, as when Ludwig sniffs that he is sure that "the plumbing can be taken care of." Well, I'm a plumber, and I don't think so. Based on my knowledge of pricing mortgage credit risk, I believe that the bailout proposal is far riskier than other alternatives.

How did we get into this mess in the first place? We got here because financial executives took on mortgage credit risk without understanding what they were doing. Some of them were new to the business, like the high-flying Wall Street firms who entered the industry during the boom. Some of them thought they were insulated from risk, because of new derivative hedging instruments. Some of the executives never belonged in the business in the first place, including Dick Syron at Freddie Mac, who in 2003 took over a firm where there was lots of knowledge of mortgage credit risk and proceeded to flout the warnings of experienced middle managers and the Chief Risk Officer about the firm's plunge into subprime lending. Congressional and Administration meddling in support of "affordable housing" played a role, and those folks are still around working on the latest legislation.

I am wearing two hats in opposition to the bailout idea. One hat is my libertarian hat, which does not like the power grab. The other hat is the applied financial economics hat, which was my career in the late 1980's and early 1990's. Speaking from the latter point of view, I have to warn that nobody involved in the bailout proposal has sufficient knowledge of mortgage credit risk. They are like Dick Syron--in over their heads without realizing it. The last thing we need in the mortgage market is another large, inexperienced player.

You can say that after the bill is enacted, the big boys will hire technical economists to deal with the plumbing. But that will be too late. Technical economists will not be able to fix a concept that has such poor risk-reward trade-offs built into it.


Comments and Sharing





TRACKBACKS (4 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/904
COMMENTS (2 to date)

How can it come that they (Ben and Hank) are not prepared for this?

It was easy to draft a better plan, with a little knowledge about human behaviour and international affairs. It took me 30 minutes and you can read it here:
The 20 minute Bail out plan! Managing the needs of tax payers and considering the needs of honest people

Rahul writes:

I suspect recent downfalls on Wall Street are signal to a collapse in Empire America Incorporated. Hopefully, the American Congress will disallow an encore by heavily regulating the Federal Reserve’s pitch for a $700 billion bailout towards American banks.

More of my thoughts follow at:

http://winstoninwonderland.blogspot.com/2008/09/collapse-of-empire-america-incorporated.html

Comments for this entry have been closed
Return to top