Debunking the Paulson plan
The good news is that the bail-out of Wall Street will probably save us from an imminent collapse of the financial system. But it raises disturbing questions. To what extent will it transform financial sector default risk into sovereign risk? What are the long-term implications for economic growth? How will foreign investors react if the gamble does not pay off? And what effect will it have on structure and incentives in the financial sector?
Under the proposed scheme, the US government will buy up any private sector debt securities from distressed US-based financial companies at a discount, with the intention of selling them later. Theoretically, the government could make a profit and rescue the financial sector at the same time.
But that would be a triumph of hope over logic. It would imply that the irrational event is the crisis itself, which has produced the current low valuations of risky assets, rather than the bubble that preceded it.
The size of the loss of this operation to the government will of course be proportionate to the future selling prices of these derivative securities. We have heard widely differing estimates, ranging from zero to large single-digit trillions of dollars. The truth is we do not yet know. The answer will depend on how well or badly the underlying markets perform.
Of those, property is among the most important and there the downturn continues. The Case-Shiller national home price index has already declined by 25 per cent in real terms since the start of the crisis. Another 15-25 percentage point drop would bring US house prices back towards their long-term trend. In the absence of overshooting, nominal prices may stop declining early next year, but the real price decline will go on for a while longer.
In the meantime, the US economy has possibly gone into recession already. The unemployment rate has been rising, albeit from a low level. The public will be less able and willing to service debts while house prices are falling and unemployment is rising. As the recession gets worse, corporate bankruptcies will increase, as will the default rate on corporate bonds. This, in turn, will reverberate in the market for credit default swaps, an insurance market in which buyers can protect themselves against payment default.
In the year to August, the default rate on corporate bonds was a mere 1.8 per cent. During the previous two US recessions, it was more than 10 per cent. But beware, default rates follow the business cycle with some delay. Edward Altman, professor of finance at the Stern School of Business in New York, says that the default rate is already likely to rise to a range of 6-9 per cent in a year’s time, depending on the estimate technique used.
He tells me that a rise in the default rate to above 10 per cent, or a default by one of the large US carmakers, could do serious damage to the CDS market. Detroit’s debt securities are among the most frequently insured reference entities.
It is fiendishly difficult to calculate net exposures in the CDS market. The market’s size is some $62,000bn (£34,000bn, €43,000bn), but this headline number refers to the gross value of securities against which contracts have been written. A large part of that consists of claims among banks, with offsetting claims in the other direction. If you net this out, a smaller number remains, perhaps not much more than $1,000bn, according to some estimates.
That number is difficult to verify. But with a default rate of 10 per cent and a recovery rate of 25 per cent, total losses might be below $100bn.
Depending on the distribution of those losses, such an event might still break one or two of the big players in this heavily concentrated market. The worst-case outcome would be a cascade of defaults among protection writers. The future of the global financial sector will depend to an uncomfortably large extent on how this fair-weather construction of a speculative insurance market copes under stress.
Any estimate of the financial damage of this crisis is prone to huge margins of error. There is, however, no doubt that the taxpayer faces a clear and present danger of a large loss. I would not be surprised if we ended up counting the costs of this joyride in thousands of billions.
Looking beyond the immediate crisis, a significant increase in the US federal debt may not be a catastrophe as such, but it has economic consequences. High indebtedness can weigh down on future economic growth, as it has done in Italy and Japan. It may affect foreign investors’ willingness to hold US assets. They may ultimately demand a higher risk premium, which could be another source of potential instability.
So one should not treat this purely as an accounting exercise where debt is shifted from one part of the economy to another. It has dynamic effects. Another open question is the effect on the financial sector itself. Will this bail-out produce healthier financial companies – or will it in the future encourage more of the same sort of reckless risk-taking that got us into this mess?
This mother of all bail-outs has shifted the burden of risk from the few to the many. But the ultimate outcome of this financial crisis is as open today as it was a week ago.
© The Financial Times Limited 2008