The Nonsense "Free Market" House Republican Alternative
The House Republicans valiantly stood up and delayed the Paulson Plan, but their suggested alternatives make no sense. First, they want to lower the capital gains tax. That is good in general, but as some have pointed out, it doesn’t really help firms unload their MBS–they obviously will be selling them at a loss, and so taking away the capital gains tax shouldn’t make them more likely to sell.
On the other hand, an outside buyer would buy the assets for a higher price, if he wouldn’t be taxed on the capital gain if the assets recovered in a few years.
But putting the capital gains tax cut aside, the main proposal was for the federal government to set up an insurance program, rather than buying the bad assets outright. This made no sense to me. If the plan is voluntary, then why isn’t the government just replicating the credit default swap market? And if the plan is mandatory, then how is the government going to determine premiums? And how much coverage does each firm have to buy?
The whole thing is completely ridiculous. You could get an outcome where you’re trying to set up a fire insurance company that includes only houses that are already on fire. Or, you could get an outcome where everyone pays a fixed premium, and then scrambles to get their hands on assets most likely to default, because the government insurance indemnifies for above-market prices. So for a while, the market price of an MBS more likely to default could be higher than a safer MBS.
I admit I haven’t actually worked out a game theoretic model to prove that this could happen, but I think it could. Imagine there are two identical buildings, except one is located next to a fireworks factory. They normally would sell for $100,000 each. But now the government mandates that every building owner pays $5,000 annually for fire insurance, regardless of the value of your building, and if your building burns down you get a check for $500,000. I think in the new equilibrium, the price of the building next to the fireworks factory would be much higher than the other building.
In the same article linked above, they quote economist Robert Waldmann who wrote:
[T]he problem is the price, in this case the premium. If it is vastly less than the probability of default, the House Republicans have found a way to throw money at bankers and financial arsonists instead of just bankers. If it is actuarily fair, it will force liquidity constrained firms to unload the securities — they could wait and hope for no default, but they can’t pay actuarily fair premiums. When you are insolvent, risk, variance, double or nothing is your only hope of survival. Thus aside from the contribution to financial arson (which I guess will be huge) the plan would also force distressed banks etc to unload mortgage backed securities at fire-sale prices. Now I don’t think the current problem is mainly due to systemic margin calls due to mark to market and capital requirements, but making that problem vastly worse would hasten the collapse of the US financial system even without financial arson.
Why is it that our politicians keep proposing plans that an actual economist can explode with 5 minutes of critical thinking? Does that bother you?
