Wednesday, September 24, 2008 2 comments ++[ CLICK TO COMMENT ]++

The Key Issue In The Bailout Is Not Executive Pay, But Risk To Government

The massive bailout being debated the US government seems to have taken a turn towards the absurd. It seems an inordinate amount of time is being spent trying to negotiate a requirement to curb executive compensation. The fact of the matter is that executive pay is almost meaningless in the grand scheme of things. Lest one forget, employee compensation is set by the shareholders and if shareholders are happy paying their executives high compensation for blowing up their firms, they should be allowed to. The government meddling will only create a bigger mess in the future. Sadly, the Democrats seem to think the executive pay is a big deal, while the Republicans (Paulson and Bush in particular) think it is worth fighting for this. Both should just forget about this issue and move onto the following.

The real issue is the risk taken on by the government and the proper compensation for that. The real discussion between the Democrats, who control the Congress and Senate, and the Bush administration, which seems to favour transferring huge sums from government to select individuals, should be the price that is paid by the mortgage asset sellers. The government should spend all its time trying to craft a deal where money isn't given freely to resurrect those who initially profitted immensely, only to blow everything up in the end, and are now running up to the government. The players who got us into this mess in the first place, not to mention investors such as Warren Buffett and Bill Gross (thanks to the Hackensack blog for article link) will try to spin the case and say that there should be no penalty. Paulson, being from the industry and an ex-Goldman employee and knowing that Goldman Sachs is one of the biggest benefitiaries from this deal would simply want to give away the money freely. The Democrats should drop all this posturing over executive compensation and deal with this latter issue.

I am of the opinion that a good deal would entail the government receiving contingent warrants for their purchase of the questionable mortgage assets. Perhaps create it so that the warrant is exercisable if the asset deteriorates significantly in the future (medium to long term; short-term price fluctuations should not matter). Such a scheme would automatically allow the government to re-capitalize these firms, which mostly likely would be in trouble if the situation deteriorated, when they exercise the warrants. Instead of the draconian 79.9% ownership seized by the government recently, the warrants here can be set based on the amount in question and the size of the firm. It can be as little as 10% or as much as 79.9%.

If the assets turn out to be good and recover their value, the seller loses nothing and ends up with valuable cash during a liquidity crunch; but if it turns out to be toxic, the seller ends up giving up a chunk of ownership in the business to the government.


2 Response to The Key Issue In The Bailout Is Not Executive Pay, But Risk To Government

September 24, 2008 at 3:40 PM

At the risk of repeating myself:

The Paulson plan is about confidence.

With a huge government backstop to everybody and their granny confidence should return that there are no major bank failures coming.

With .gov buying MBS at a relatively high, but not necessarily money-losing, price an actual market for this paper could form. Currently potential buyers, all distressed debt specialists, will only offer a few pennies on the dollar knowing they are the only game in town. Banks are not selling because selling at those prices will sink them for sure. Better to wait and pray. Consequently nothing moves and the market dies of anxiety thinking about all those level 3 assets and their potential impact if all the scare stories are true.

Paulson's aim here almost certainly is to use very little of the $700b but he needs authority for the whole lot or nob ody will believe it. The bond market "saw" his houding bill bazooka and raised him spreads that bankrupted the GSE's so a takeover was necessary.

The thing is that it also only works if all banks, especially the relatively healthy ones, have access. And that won't work if the terms are to onerous. If banks refuse to use the facility and rather roll the dice confidence is not restored and the financial system will continue to lurge from one crisis to the next until it all falls apart.

Now congress can play to the peanut gallery at Calculated Risk following in the footsteps of Andrew Mellon and deciding that everything must be liquidated, all the excess credit, all the excess investors, all the excess workers, all the excess population, or it can try restore some stability.

In case you missed it: Hong Kong just had a bankrun too. This is getting rapidly out of control.

September 25, 2008 at 10:35 AM

You are almost calling for transferring public money to select individuals and organizations.

I'm not against the plan but am against it as it stands. As the current plan stands, it not only avoids punishing the risk-takers who caused all the problems, but also rewards them. I wouldn't be against the plan if there was penalty if the assets turn out to be toxic.

I think there are two items where we disagree.

One is whether the government is in the business of handing out free money to people, not to mention those who caused the crisis in the first place. You seem to believe that the companies that caused these problems should be allowed continue as if nothing happened. That's not my notion of free market capitalism.

Capitalism, to me, entails two concepts: creative destruction (not applicable here) and profits/losses to those that risk capital. If you made mistakes, you lose. If you take away the downside penalty, it's nothing more than an almost fascist-like system.

Some of these companies will go bankrupt no matter what. Just like how some of these mortgages are basically worthless (housing divisions in the middle of nowhere, NINJA loans, fraudulent loans, etc)...

The other point where we seem to disagree is with the impact of this. Although it will have an impact, some of the stuff that is happening out there have little to do with any of this. The Hong Kong case that you cite probably can't be avoided by any of this. Don't forget that there could be a few more waves--hope not but just mentioning the worst case--where we could see big corporate bond defaults (I can see one of the big three automakers going down.)

The problem is that risk of all types were underpriced over the last 5 years. US housing was the worst because it's so large, but there is likely to be problems in other areas that can blow up as well. Then what? The govt, which is already financially weak, unable to do anything at that time?

Post a Comment