The CRA and the Bubble
Notes to Self: For Wednesday...

Reasons to Be Cheerful: Why the Dodd Plan Is a Good Idea

Paul Krugman writes:

Balance sheet baloney: There’s a turn of phrase I hate in the current discussion, because it sounds smart and serious but is in fact a complete evasion of the key issue. And I’m sorry to say that Ben Bernanke uses it in today’s testimony:

More generally, removing these assets [i.e., toxic mortgage-related waste] from institutions’ balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.

“Removing these assets from institutions’ balance sheets” — what an evasive phrase.... Hank and Ben are talking about... turning the assets over to Uncle Sam, and getting cold hard cash in return. And then the question is how much cash they get in return. It’s all about the price. Now, if the price Treasury pays is very low — anything comparable to what financial institutions are able to sell the stuff for now — it’s going to do nothing for confidence and capital. If the price is high, confidence and capital will improve — but taxpayers may well take a big loss. The premise of the Paulson plan– though never stated bluntly — is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

This is why the Dodd plan is good. Say the Treasury pays the bank Y for a bundle of assets, and finds that in the long run it is unable to sell them for more than X < Y. Then the difference Y-X is deemed to have been invested in the common stock of the bank as of the date of purchase.

The bank gets the cash: Y. Its balance sheet improves. After the fact, we look back and assess what share of that improvement was capital and what share was a recognition that the asset was worth more than its October 2008 fire-sale value, and we divvy up profit-and-loss accordingly.

In the words of the immortal Frederick Frankenstein: "IT--COULD--WORK!!"