Politics

Deal Journal - WSJ.com : The Paulson Plan: 'Truly Idiotic'

November 25, 2008, 10:48 am
The Paulson Plan: ‘Truly Idiotic’
Posted by Dennis K. Berman

Charles Calomiris is angry. Hank Paulson’s plan to save the economy? “Truly idiotic,” says Calomiris, who is the Henry Kaufman Professor of Financial Institutions at Columbia University’s business school. “This whole thing has been complete nonsense. We did it in the 1930s ten times better than this. This isn’t complicated.”

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Deal Journal caught up with Calomiris late Monday to talk over the state of the financial world. Calomiris has long advised governments, banks, and private investors on financial crises. And while he spoke to Treasury officials during “The Lehman Brothers Weekend” in September, they appear not to be listening. Here’s an edited transcript of parts of the conversation.

Deal Journal: What the heck is going on out there? The Citigroup bailout isn’t a good sign of confidence in the overall financial system, is it?
Charles Calomiris: The key thing we’ve learned during the downward spiral of confidence is that you have to deal with the problem in the mortgage market directly. There are probably 18 million subprime and Alt-A mortgages out of 57 million total. Probably half will end up in foreclosure.

In the middle of a financial crisis, we’re using half measures designed in an inappropriate way, and we don’t accompany them with other measures. This has just been a completely mismanaged policy response.

DJ: There’s this perception that we can “fix” the price of individual mortgages. But shouldn’t the price of homes find its natural equilibrium?
CC: The market price is not decreed by God. The market price is an outcome of a variety of things. Recapitalizing the banks is helpful for giving them breathing room, and for providing credit in the meantime. But it doesn’t resolve the problem.

The problem is the completely opaque distribution of losses because no one knows how to value these mortgage losses. The way to solve the problem is from the bottom up.

DJ: So how can we do that?
CC: There’s loss-sharing to encourage write-downs of mortgages. It was done in Mexico in 1995. If holders can arrive at a write-down in lieu of foreclosure that leads to sustainable mortgage, we as taxpayers would sustain the rest. It lets the market work the problem out and creates the motivation for doing it quickly.

You could also have the government offer to buy any mortgage for 40 cents on the dollar. It would create immediate liquidity, because mortgage backed securities would rise on that scenario, all would be truncated at 40 cents.

Third, we could refinance all healthy mortgages at 5%, at 30-year fixed financing. Allan Meltzer has idea about giving tax credits for buying homes, they’re all good ideas. The problem with what we’re hearing from Paulson does not have much to do with any of this.

DJ: What about creating government incentives for the formation of new banks?
CC: Recapitalizing the banks is a good idea in principle. Starting new banks is a good idea. It’s all fine, but we have to come to grips that unlike any financial crises – and I’m an expert on them – this one is a complete outlier. In other crises, the uncertainty on the total of the losses was resolved in a matter of months. We’ve been trying to resolve mortgages and CDO tranches for a year and a half. It’s not going well.

DJ: So what’s the matter with some of Paulson’s latest ideas?
CC: Warrants are a bad idea. They dilute common stock holders, and make it harder to design common equity. It’s been a design flaw all along. It’s all a part of thinking of these things in terms of deals. They’ve got Warren Buffett envy.

But in terms of ways that truly recapitalize a bank, they’re truly idiotic.

If you attach warrants that are dilutive, it’s harder to issue common stock. If you want to make money, go buy stock. If you want to increase the net worth of a bank, make that coupon as low as possible and require matching common stock issues. If you learn you can’t do it [the common stock match] then have to decide whether to do a common stock injection, an assisted merger, or shut the bank down.

DJ: Why isn’t anyone listening to these ideas?
CC: The point is that they have made huge errors in the design of their assistance plan and they were forecastable errors.

For instance, Paulson doesn’t want there to be a stigma [around capital injections.] Does he really believe that by getting J.P. Morgan to participate, he creates the perception that JPM and Citi are the same?

Does he really believe that injecting preferred stock into banks is socialism but buying assets at above market price isn’t? Does he really believe that?

There actually is a stock of knowledge about this. The scandal is that when Congress has been considering this, not one independent economist has been allowed to testify. Do you know why they weren’t? Paulson and Bernanke didn’t want anyone causing problems.

DJ: Wait, that sounds like a conspiracy.
CC: Democrats didn’t want anyone [economists] testifying because it was before an election and no one was willing to stand before that bulldozer known as Paulson. No one wanted to make tough political decision before the election. They didn’t empower any experts to come in and testify. Why is that? They were playing politics, too. That’s what we’re dealing with–a complete leadership failure in Congress and the administration.

Don’t underestimate the role of politics in the decision not to fix things.

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