This behind-the-scenes account of the financial crisis by Phillip Swagel, the former Assistant Secretary for Economic Policy at Treasury, makes for absolutely fascinating reading. Swagel takes academic economists to task for their failure to understand the very real legal constraints on policymaking. This is something I've emphasized with regard to the ridiculous debate over "nationalization" or "managed receivership" of money center banks. As Swagel writes:

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.
Preach it, brother. Similarly, Swagel shoots down Luigi Zingales's widely-cited (but comically impractical) proposal to force banks' bondholders into a debt-for-equity swap:
As Zingales (2008) notes, debt-for-equity swaps could "immediately make banks solid, by providing a large equity buffer." All that would be required, according to Zingales, would be a change in the bankruptcy code. A major change to the bankruptcy law was enacted (for better or for worse depending on one’s point of view) with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, but this was the culmination of years of legislative debate. The idea of a further instantaneous change in the bankruptcy code was unrealistic. Indeed, efforts to make such changes in the middle of the crisis would have re-opened the debate over the 2005 Act along with controversial provisions such as the mortgage cram down. The simple truth is that it was not feasible to force a debt for equity swap or to rapidly enact the laws necessary to make this feasible. ... [T]he idea … that there should be a forcible capital injection [is] pure ivory tower, unfettered by the practicalities of legality, enactment, or implementation.
This same critique applies to Simon Johnson's absurdly unrealistic suggestion that the Treasury could use its proposed resolution authority for large financial institutions to deal with the current financial crisis. Most nationalization/receivership proponents seem to think that major changes to the U.S. legal code occur instantaneously, which betrays a stunning ignorance of the legislative process. Swagel also pushes back against the criticism—advanced most prominently by TARP watchdog Elizabeth Warren—that Treasury overpaid for its equity stakes in the banks:
An important consideration with regard to the terms of the capital injections was that there is no authority in the United States to force a private institution to accept government capital. This is a hard legal constraint. ... In order to ensure that the capital injection was widely and rapidly accepted, its terms had to be attractive, not punitive. ... The terms of the CPP were later to lead to reports that the Treasury had "overpaid" for its stakes in banks, which of course is the case relative to the terms received by Warren Buffett. But this was for a policy purpose: to ensure broad and rapid take-up.
Read the entire essay. It's well worth the time.


Anonymous said...

Spot-on! What the essay does well is render the idea of decision making (and communicating on decisions made) in real time and under (massive) uncertainty as well as legal and political constraints. I.e. virtually an impossible task. I would really love to be able to run a parallel history and to laugh seeing the Paul Krugman's of this world have their go, with their intelligent ideas and "models".....

Anonymous said...

Swagel misunderstands Prof. Warren's critique. Her issue is not that Treasury paid more than the bonds and warrants are worth, it is that Sec. Paulson repeatedly told the public and Congress that the transactions were "at or near par" when they were not. If there is a public policy reason to pay a higher price, Paulson should have been up front and honest about it. He was not, only further undermining confidence in our government's response to this crisis.

Anonymous said...

Yea, I'm only 10 pages in and I've loved it. Another biting critique I ran into is when he's describing the attempts at setting up a database to track the individual mortgages in the MBS. He writes:

"The paradox was that this database did not
exist already—that investors in mortgage-backed securities had not demanded the
information from the beginning."


Anonymous said...

Jolly ho good chap!

How about this: When a bank is insolvent, let it go bankrupt!! Pursuant to bankruptcy laws. Or create a new bankrutpcy law, instead of TARP, which was also a new law, which indicates complaining about a lack of laws is nonsensical.

The dumbest part of this paper is the conclusion that complaints about Nat City being acquired proved the nation would not tolerate bank bankruptcies.

Jolly ho toodle oodle!

Anonymous said...

Oh, and um, uh, the contradiction between acknowledging the purhcase of preferred stock was an intentional good deal (for the banks) to motivate banks to participate contradicts the notion that no way, no how was Treasury planning to overpay for the assets.

And, um, uh, why were "good" banks required to participate anyway? Just another gift to the "bad" banks to prevent them being called "bad" names?

Christmas came right on time for Wall Street.

Spot on!

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