More information has come out about the plan over recent days and it’s a little different to my first impression in that I thought it was going to resemble the early 90’s Resolution Trust type set up.
It seems that Credit Suisse’s characterization that it’s a close copy of the Japanese bailout is probably pretty accuract. Seeing that they may include warrants- that is long-term options- set at favorable prices to the government shows similar characteristics to the Swedish bailout of the 90’s where the Swedish government walked away with some large profits on exercising those warrants.
People have begun to criticize the bailout for legitimate reasons while others don’t make a lot of sense.
However I want to focus on one set criticisms, which are that Paulson’s plan doesn’t offer much information, it keeps the Congress out of the picture while allowing the treasury secretary far too much power in how he manages the operation going forward.
Paulson is a trader by profession and I believe he’s looking at this problem from a trader’s perspective and that it carries numerous permutations. He can’t legitimately explain to non-traders what he’s going to be doing because he probably doesn’t know yet in terms of the strategy as there are several different ways to proceed.
This is a very delicate trading operation. He has to be able to have free rein in terms of where he first sets the buy prices so that it doesn’t create far too much panic in case the banks stampede and begin having to mark to market downwards before they can sell the securities.
Correctly in my view he seems very loathe to set up an auction system because I think he is extremely worried about what it will do to the mark to market valuations if some banks simply crash the gates and go to the lowest possible price if they get into a panic mode. The effect of this is that it could actually cause even more severe stress and possible unintended bankruptcies all at the same time. So I can see the reasoning of this intelligent and insightful man as to why he wants start the market above most of the mark to market valuations but not too high as his is a value judgment or a traders call.
Ideally I think he also wants to be able to create a secondary market for these securities that would allow him to set a floor when necessary rather than have to buy all the paper outstanding, as this would eliminate the need in having to use up all the capital. Even before the process starts he is possibly thinking of strategies to try and talk the market up a little that would coax private buyers to participate hoping to score a bargain. The objective is to unclog this constipated market at little cost to the taxpayer. These are things he doesn’t want to telegraph out at the moment. I certainly wouldn’t if I were he, as you want to keep all your cards close to ones chest.
Remember that paper only has to trade once and telegraphed to the market to change the mark to market for all the players.
A lot of this toxic waste is tailor made and not commoditized the way you would expect say a regular equity or the government bond. They have lots of bells and whistles and require separate and individualized valuation off synthetic benchmarks etc., so it may not be easy to mark to market. Others do of course.
My hunch is that Paulson’s prime objective would be to set a floor and subsequently begin to see a secondary market develop above current valuations where provisions have been made. This could allow banks to write back provisions thereby reducing the need for further capital infusions in to the banking system.
Seeing, as I think, he’s looking at this as a trading position the only way to be able to manage the process is to have a relatively free hand and not be second guessed by committees populated by people that have little understanding of what he is doing and why. It’s not the process that ought to be important; it’s the final outcome. Traders don’t like being second-guessed in the middle of what they are doing.
Even if you don’t agree with the bailout I think Paulson’s plan would offer the best outcome along with crossing one’s fingers and hoping it works otherwise we really do have a problem.