Why The Paulson Plan Won't Work

Make no mistake, something must be done quickly. WaMu, for example, may be just days away from bankruptcy. The Paulson Plan might possibly succeed in saving WaMu for another couple months. But I believe it will fail to save the financial system. I have been in favor of all the bailout efforts up until now, but the plan put forward by Secretary Paulson might be the worst approach possible. I can actually explain why with a single Wikipedia page. Honestly.

As you may know, the largest financial market in the world has crashed. No, you didn't read it in a headline when it happened. No, nobody in the government told you that it happened. The level of denial and disbelief has been astounding. But I am telling you, that it is 1929 and the market has already crashed. Forget the stock market, we're talking here about a market that is deeper in the heart of our financial system. You can see the crash start August 9th, 2007 in a chart of the LIBOR interest rate many know all too well:

The market was the market for American mortgages, mortgage-backed securities and contracts derivative of this market. Contrary to the irresponsible reporting that prevails in all but the financial press, selling mortgages is NOT a new practice, of course. It is many decades old. It helped get us out of the Depression. It is completely essential to our financial system. But right now, banks cannot sell their mortgages into a crashed market.

Thus the Paulson Plan's simple premise is for the government to start buying these mortgages, putting - they hope - a rational price on them when a crashed market has failed to. It seems reasonable. It would even work and I would support it wholeheartedly and shout down the critics if the problem in the secondary mortgage market was simply a lack of "liquidity" or money. But I fear the problem is different and must be addressed with different means.

As for Secretary Paulson himself, a cynical person might suggest that investment banker Henry Paulson, was previously treating America as his client - getting us equity when we extended credit - but is now treating the banks as his client and America as a "customer" - the lowest form of life for an investment banker. A cynical person might suggest that Paulson is simply "jamming bonds" down our throats. Actually a non-cynical person might suggest that also, because it's true. But let's get to the real problem.

The the real problem in the mortgage market is this guy:

Banks were inviting people into their used car lot of mortgages and saying things like:

"This one? Oh, this one's a beauty. It's a $500K mortgage on a house assessed at $510K, which we made to a guy with a 700 FICO score who makes $125K a year . Oh, and I will throw in an insurance policy on it that's worth $400K. Wanna buy it?"

And people bought.

But it turned out that the loan above was actually a $500K mortgage on a (then) $400K house with its assessment inflated by $110K made to a guy whose credit score had been inflated and who made...well, we really have no idea what he makes, but it's probably more like $45K. And that insurance policy? Yeah, turns out that was actually worth $0K - nothing. Hence, we the citizens now own 80% of AIG. Oh, and that house isn't even worth $400K any more, it's worth more like $300K and dropping.

So the market for these loans quite naturally dried up.

The banks were selling were Lemon Loans. And if you don't think "Lemon Loan" is strong enough and think something like "felony fraud" would be more appropriate, so do I. However, I choose "Lemon Loan" because of a theory for which some guys got the 2001 Nobel prize in economics, but about which Henry Paulson seems to have forgotten.

The Nobel-prize-winning theory is called "The Market For Lemons" and if you follow the link to that single Wikipedia page I promised you, you will see that the Nobel was for a paper which revealed why markets crash when they become filled with bad merchandise passed off as good merchandise. Of course we all know this through common sense, but you don't get Nobel prizes for common sense.

For comparison, let's use another little no-regulation nightmare and yet another market predictably destroyed by fraud: How many of you would buy powdered milk from China right now?

I'm sure China produces many tons of perfectly good powdered milk that would be healthful for anyone to drink. However, it has been revealed in the last few months that they have also been producing fraudulent powdered milk that has proven toxic to some children who drank it. If you are in the market for powdered milk you are not, I predict, going to spend the valuable money in your wallet on something with very uncertain value - Chinese powdered milk - something that might even be toxic. Likewise, America produces and can produce trillions of dollars in sound mortgages that would be wise investments for anyone to buy and own. However, it has been revealed in the last few months that we have also been producing fraudulent mortgages that have proven toxic to the balance sheets of some institutions who bought them.

Would you buy Chinese powdered milk simply because you read that Chinese government had started to buy it? I think not. Therefore, it is my belief that people in the secondary mortgage market are probably not going to start buying American mortgages simply because the American government is buying them. I think people are going to wait for proof that these mortgages are not toxic to their balance sheets before they put down cold cash. If we give buyers good information and sound guarantees, they may come back and buy. If we don't, I fear they will not.

To be technical for a moment, I think the information in the market for American mortgages became too "asymmetric" and thus the market reached a "no-trade equilibrium." This has caused a glut in the supply of high-risk assets so huge that portfolios simply cannot absorb them and maintain a normal risk-weight, let alone the more-conservative risk-weight they desire right now. I think this is also affecting other liquid, high-beta equities and credits. Here's the MSCI Emerging Markets ETF:

By the technical talk I mean that nobody will buy our mortgages until we turn ourselves from this guy:

into this guy:

I believe that the world desperately wants and needs safe American investments. If we are straight and honest with the world; if we reassure them with a next-generation financial information system; if we give them quality government guarantees; they will buy our bonds and mortgages. It will take a huge effort. Ultimately we may have to tell the truth about, and guarantee to the maximum extent possible, every non-fraudulent home mortgage in America. It sounds daunting, but only is such a project possible, it would bring monetizable value and innovation to our economy. It would allow us to survive a disaster which might otherwise destroy whole communities.

To those who would say "let the destruction happen" - you're simply being childish and foolish. We can't afford to lose an entire market every time some fraudsters get together and try to cheat people. We can't let the sleaziest capitalists in our system define the value of our markets. That's not a free market. That's anarchy ruled by villains.

If we the citizens act to bring honesty, information and government-guaranteed quality to our financial system, we can survive this. The choice is ours.

May you live in interesting times