On Monday, I was among a group of eight bloggers who attended a discussion with "senior Treasury officials" in Washington. Several nice accounts of that meeting have already been posted (see roundup below). Here's mine.

First, I'd like to thank the "senior Treasury officials" for taking the time to meet with us, and for being very gracious hosts. Whatever disagreements one might have, in statistical if not moral terms it was an extreme privilege to sit across a conference table and have a chance to speak with these people. And despite the limitations of the event, I'd rather there be more of this kind of thing than less. So a sincere tip o' the hat to all of our hosts. Thank you for having us.

Commenter "reason" asks a question:

...it is not clear to me that it is well understood why inflation sometimes can be seen in consumer goods and sometimes is manifested in "asset price inflation". Do you have any ideas on this mechanism? I know some people deny there is such a thing as "asset price inflation". Do you have a theoretical basis for your ideas in this area?

Wouldn't such a program constitute a stimulus to the economy? If sufficient leverage is allowed, it would lead in short order to a bunch of entrepreneurs founding companies on just a shoestring of equity and a whole lot of cheap, guaranteed debt. Firms with even a small likelihood of success would constitute real options worth more than the sliver of private capital at risk, so arbitrageurs would rush to create them.

Now it's dead, everyone else has been blogging it...

Extracting the vanilla from the CFPA is not, as Felix Salmon put it, "the beginning of the end of meaningful regulatory reform". It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it's the rest of us that get swallowed.

So I've belabored the distinction between transactional and revolving credit quite enough, I think. And I'm pleased, reading around the intertubes, that people seem comfortable with that distinction, and with the idea that it might be good public policy to treat these two forms of credit differently, despite attempts by credit card issuers to blur the lines. Yay!

But my previous piece seems to have left readers with two pretty big WTFs:

Megan McArdle...

[M]aybe it's worth remembering that the tyranny that credit scores exercise over our imagination have everything to do with the fact that we've built a society so utterly dependent on credit.

I am continually amazed at the quality of comments that Interfluidity attracts. But commenters to the previous post truly outdid themselves. I proposed a "novel" security intended to make debt-to-equity conversions gradual and automatic, in hopes of avoiding disruptive "discrete" bankruptcies. Commenters quickly pointed out earlier work along the same lines, and some serious problems that I hadn't considered. All in all, I remain convinced that "continuous bankruptcy" is a goal worth pursuing. But I'm equally convinced that the specific security I suggested would probably not quite do it.

First, it turns out that better minds than mine have considered debt-like securities that would convert to equity as firms became undercapitalized. The excellent Economics of Contempt pointed out two antecedents, Mark Flannery's "Reverse Convertible Debentures", and a recent proposal by the "Squam Lake Working Group on Financial Regulation". The Squam Lake piece is a diamond in the rough, but Flannery's ideas are carefully developed. Flannery considers and tries to address most of the problems I would have missed without help from the comments. He also includes a detailed review of related work.

True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I'm not a true believer, but I'll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I'll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. [1]

But that's not the point. The question isn't whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindsight, would it have been a good idea?

I've been unimpressed with this oft-quoted bit from Phillip Swagel's insider account of the Paulson Treasury.

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word "force" is used as a verb ("the policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.

Commenting on Nassim Taleb’s provocative agenda for fixing the world, Felix Salmon notes that:

Looking at the rest of the list, how on earth do you stop the financial sector from... creating complex products? Derivatives are, at heart, bilateral contracts: how can you ban two consenting adults from entering in to such a contract?

Divide the world into the consolidated financial sector and taxpayers. Under PPIP, each dollar a "public-private investment fund" overbids provokes a net transfer to the consolidated financial sector from taxpayers. The size of transfer to the financial sector increases with the degree to which bids are overpriced, and is maximized if the true asset value is very small relative to the price actually bid. If an asset is worth $6, and financial sector actors purchase a contract for $7 while the Treasury invests alongside, the consolidated financial sector gains a dollar. But if financial sector actors pay $70 for the same asset, the financial sector would receive a net transfer from taxpayers of up to $118. (For more detailed arithmetic, see below.) The more financial sector actors are willing to overbid, the greater the net transfer from taxpayers to the financial sector. In theory, the scale of the transfers is limited only by the quantity of asset purchases the government is willing to guarantee.

There are problems with this story. In real life there is not a consolidated financial sector, but a lot of different players who are usually in the business of competing with one another. PPIP includes rules and tools by which the government could prevent the use of taxpayer money to fund overpriced bids, and ensure that the parties who take small losses are distinct from the parties who make large gains, eliminating incentives to overbid. An important question is whether the government genuinely wishes to prevent backdoor transfers to the financial sector, or views such transfers as a desirable means of helping core financial institutions. (See Joe Weisenthal and Noam Scheiber.)

...a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

John Hempton has been arguing for the Australo-Canadian model of an oligarchic, heavily regulated, generously profitable banking system.

The plan involves the Treasury, FDIC, and Federal Reserve putting hundreds of billions, perhaps more than a trillion dollars, at risk. That should require some sort of Congressional approval, right?

James Surowiecki has been pushing the idea (first mooted by John Hempton) that since bank financing always involves non-recourse by taxpayers (via government deposit insurance), it's no big deal that the Geithner Plan is built around generous non-recourse lending. Surowiecki:

There is one detail of the plan, though, that people are particularly bothered by, and that is the fact that the plan involves the FDIC guaranteeing loans to private investors. (The way the plan to buy pools of mortgages is set up, investors will be able to borrow six dollars for every one dollar they invest. If their bets go bad, they lose only the one dollar they invested—the FDIC is responsible for paying back all the borrowed money.) Paul Krugman, for instance, calls this the “central issue,” and argues that because the non-recourse loans are a massive subsidy to investors—which they are—the plan will distort the prices that investors are willing to pay for these assets, and therefore "has nothing to do with letting markets work." Ezra Klein, similarly, argues that because the plan relies on these "non-recourse” loans, the prices it will produce will be in some way “artificial." Their point is that the Geithner plan, among other things, is supposed to produce real market prices for these toxic assets, which will then give us a better picture of banks’ balance sheets and allow us to avoid valuing these assets at prices that the government thinks have become unduly low because investors are so risk-averse. But by creating a plan in which investors have only a small downside and a big upside, we’re supposedly creating fake prices.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

The House has passed a very poor tax clawback bill (ht Conor Clarke). It is almost prospective — the law would apply only to payments made from January 1, 2009 forward. But almost prospective is like half pregnant. The bill is retrospective for just long enough to claw back the politically fetishized AIG bonuses, while leaving those who made out during the thick of the toxic credit bubble completely untouched. It has all of the philosophical distastefulness of an ex post law, and no offsetting benefit whatsoever, other than punishing a few trophy miscreants from AIG. I would support a well-designed tax clawback, but this ain't it. Hopefully the Senate comes up with something better.

Monday night, when I wrote about tax clawbacks, I was afraid that the idea would be written off too quickly based on an oversimplistic view of the law. Two days later, it's like a movement. At least six members of Congress are on record as trying to craft some sort of tax clawback, Conor Clarke has Larry Tribe opining that a well-crafted clawback would be Constitutional, and widely read bloggers like Kevin Drum and Felix Salmon have considered the idea supportively. Tuesday night Bloomberg reports that:

The senior members of the Senate Finance Committee from both parties proposed taxes totaling 70 percent on bonuses at AIG and other companies getting federal money during the U.S. financial meltdown. House Speaker Nancy Pelosi directed committees there to draft several alternatives and said her chamber may consider a bill as early as this week.