Sunday, October 5, 2008

Why Paulson is buying assets

I have been thinking a lot about this $700 billion "bailout" or "rescue" package. One of the primary questions I have been trying to figure out is why Treasury Secretary Hank Paulson thinks he needs to use the money to purchase the troubled assets (Mortgage-backed securities, etc.).

If the problem is simply liquidity, meaning the banks have these assets but are unable in the short term to sell them quickly enough to keep enough cash on hand to meet their immediate obligations to creditors and investors, then why not just simply loan money to the banks to inject enough liquidity to keep otherwise stable institutions afloat?

The credit market, where the banks loan money to each other, has totally seized up. The reason is that banks have a total lack of confidence in the ability of other banks to repay the loans. One of the major reasons for this is the collapse of the market for MBS's, so the banks are uncertain how much value the assets at the other banks are worth.

Most of the assets have underlying value, even if the market has currently collapsed for them temporarily. Paulson wants to use the $700 billion to buy up a lot of these troubles assets. The more I think about it, I have realized that the reason he is going this route is because he is not just trying to inject liquidity. More importantly, he is trying to attack the causes of the confidence crisis. Once these troubled assets with uncertain value are taken off the balance sheets of banks, the banks will have much more confidence they know the real financial status of the other banks and will resume lending to each other.

The credit market did not sieze up because there wasn't enough money to be lent or not enough money needing to be borrowed. It siezed up because of uncertainty, and Paulson thinks he can remove enough uncertainty by unloading these troubled assets. It is the psychology of the market he it trying to fix. He has already tried injecting liquidity several times, and the dominos just kept falling.

The hardest part now is figuring how much to pay for these troubled assets. Pay too much and the taxpayers and therefore politicians of America will hate you forever when the government is unable to recoup their investment from the sale of these assets. Pay too little and the market price for these MBS's gets set too low and triggers a bunch more bank failures.

Politicians need to step back and let Paulson and other professionals use their best judgment in doing what they need to do to solve the financial crisis. The cost to everyone in the economy if the financial crisis worsens is much greater than the cost to the taxpayer if the government overpays some for these assets.

As an aside, I'll pass along another interesting feature of the current financial crisis. The only way the financial system is staying afloat at the moment is by money flowing through the governement. Banks that have money to lend are buying Treasury bills (which is why the interest rate on these bills is getting pushed down close to 0%). Treasury is then sending the money over the Federal Reserve, which acts as a lender of last resort to banks that need to borrow money. So at the moment, the government is borrowing and lending a higher volume of money than usual to act as a de facto intermediary for lending between banks.

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