Having read through the criticisms I linked to in my previous post, I'd like to take a stab at defending the Paulson plan. I think it could work IF it acts as a catalyst for future positive events rather than being seen as the end in itself, AND if the Treasury, acting as a self-interested capitalist on behalf of taxpayers, exerts the pitiless leverage befitting a rescue financier. I see the favorable scenario as follows:
1) Treasury purchases toxic debt instruments from financial institutions at a not-crazy premium to their balance sheet values. 600 million fingers are then crossed in the hopes that it did not overpay, something that won't be known for years.
2) This has the effect of modestly increasing the stated book value of these financial institutions. More importantly, with the toxic waste off the books, it improves the likelihood that an outside investor--Treasury itself, a sovereign wealth fund, even our man in Omaha--now feels able to value the enterprise. Hold your nose and admit it: the relatively few franchises that manage the capital raising and M&A activities of Corporate America are worth a lot.
3) Said outside investors collectively have enough capital to recapitalize the major Wall Street insitutions via injections of new equity. Here comes the tricky part: In exchange for their largesse, both the outside investors and Treasury (e.g. via warrants struck at the same price as the outside investor) must be allowed to invest on very favorable terms. In a perfect world existing equity holders and stock options would be essentially wiped out, a la AIG. In an even more perfect world, existing debt holders (i.e. unsecured lenders to Morgan Stanley, Merrill, etc.) would also take a big haircut, just as they usually do when corporations declare bankruptcy.
4) Both liquidity and solvency are restored, credit starts to flow again, and the downward spiral of asset sales is prevented, allowing whatever pain will occur to occur over time, and to be spread widely.
Another potential defense of the Paulson plan: as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG. Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets. Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself. Suppose for instance that tomorrow Treasury buys AIG's entire CDS book at something close to market value--wouldn't it instantly make a lot of money on its $85 billion bailout, while over time perhaps making money on the CDSs?
Question: Above a certain level of size and complexity and unfairness, does it not become preferable for Treasury to chuck this plan and instead simply provide relief directly to people having trouble paying their mortgages (thus indirectly making whole the holders of mortgages, MBS and CDOs)? Could the government do a massive sale/leaseback of houses, buying mortgages and charging rent to former homeowners in lieu of foreclosing? The government as quasi-landlord, you say? I can see an example of this as I look out my window, and it's not that bad.
