Tuesday, January 13, 2009

Cochrane on the Financial Crisis

Dr. John Cochrane, whom my colleagues and I hope to invite to speak at our university this spring, has a straightforward critique of the Treasury bailout plan on his website. Here's a glimpse:
The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again. To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs...

Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents. If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.

There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;” the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience. Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.

Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.
Cochrane also posits some less-risky, more proven alternatives to the Treasury's plan, including the orderly failure and re-purchase of banks, stock issues, and guaranteeing short-term credit between banks.


David W. said...

i officially now live in holy fear of reading your blog... you make me afraid for the future of our country. sadly not without reason. thank you again for exposing the fallacy of the whole bailout concept. keep up the good work.

gary said...

aren't you missing a big point? If a security is "worth" 80, trades at 40, and the treasury buys it at 60, operating under the theory that "price discovery etc" will magically solve stuff, if it doesn't, the treasury still made a profit of 20.

Also, this is purely academic, as TARP appears to be doing nothing like this, instead it seems to be buying preferred equity in big-name banks that are doing (relatively) well.

Chops said...

The Treasury didn't make a profit of 20 unless it's *actually* worth 80. If it's trading at 40, it's probably worth 40.

Presumably, the government's gamble will pay off if all these mortgages are as good as the salesmen said they were back in 2007. But isn't the lesson of the last 12 months that shady-mortgage-backed paper isn't worth what it was pitched as?

gary said...


so then buying at 60 will help the bank! Ahh!!! You can't have it both ways.

Barnabas said...

"Dr. John Cochrane, whom my colleagues and I..."
salim, you don't have colleagues!