Here is the proposed bill. Read it. It says simply that the Treasury secretary is given a 700 billion dollar credit line and told to go out and play the mortgage backed security market, appointing whoever he chooses, and buying and selling without any oversight, concurrent or retroactive. Can I imagine a better prescription for political corruption? I'm not imaginative enough. I'm imaginative enough to think that however good the intentions of the (politically appointed) Secretary might be, the people who do the buying and selling will feel sympathetic to their friends and will want to do what they think the boss man would "want them to do" towards his friends. Some will not give in to the temptation. Others will. And on the other side those who receive lesser bailouts will think that it is unfair and driven by politics - regardless of whether or not it is.

Even the financial markets being bailed out currently seem skeptical of the totally unfocused nature of the plan.

Bear in mind also: with this kind of stake it is easy to make money and it is also easy to crush firms. The AIG bailout may have already done that. AIG stock lost over 100 billion with the Federal bailout. Best estimates of current housing market losses falling in the financial sector is on the order of 2-300 billion. That doesn't account for future losses, but it also measure peak to current time, and not all houses were purchased at the peak. As far as I can tell the AIG mortgage exposure was in insuring mortgage backed securities, so they don't seem to have been leveraged beyond their exposure to the fall in housing prices. That means unless they are responsible for about half the losses in housing, there has been a wealth transfer from AIG shareholders to the Federal government.

The banks have also requested that U.S. accounting rules be changed so they don't have to mark their assets to market (some of them are very illiquid and are trading for distressed prices that don't necessarily reflect their value based on the underlying cash flows). Otherwise the government will pay artificially low prices in another sort of wealth transfer to Washington from the banks' shareholders.

The concerns you expressed may all be valid. My issue with many of the posts covering this topic is that they seem to be silent on the incompetence demonstrated by the private sector in this situation. The financial institutions were given their wish, less regulation and cheap money. Instead of acting responsibly they acted irresponsibly (like an unsupervised child in a candy store), they leveraged themselves to the hilt. Furthermore, as a commentator on CNBC reported, where were the risk managers? The logical conclusion is that these highly paid supposedly expert corporate executives really weren't competent and the firms lacked proper accounting controls. These are self-inflicted wounds.

Lehman Brothers paid out nearly 11 billion a year in compensation. As best I can figure based on the number of employees and median salaries, about 1 billion of that was compensation to normal employees. The rest was presumably money taken out by top management. So: they are walking away over five years with nearly 50 billion dollars. They did that by earning abnormally high returns on investments that had a low probability of catastrophic failure. They get to keep the money they took out after the failure...it's the stockholders and bondholders who get the loss. So it seems to me they were pretty competent. If you open the piggy bank, there isn't really a point in saying people were incompetent for taking the money out. Unscrupulous yes, incompetent no.

David:

Smells like greed to me.

Not to be blowing my own horn too hard here, but none of the compensation contracts that seem to have been in force here (or in the past for that matter) bear any resemblance to the contracts that Sanjay Srivastava and I showed were optimal in a repeated moral hazard setting in our 1987 Review of Economic Studies paper. These contracts specify rewards and punishments in terms of current compensation, together with a promised future benefit in expected terms, the actual realization of which depends on how the firm performs in the future.

Cheng Wang and I also showed in a recent Journal of Economic Theory paper that it was optimal to fire a CEO if he either did very very well, in which case the promise-keeping constraint generates a golden parachute, or if he does really really poorly, in which case you boot him out of the plane without a parachute.

David: An interesting perspective and a viewpoint that I had not considered.

While I am a great admirer of Stephen and Sanjay's work...there is one key assumption in their model that appears to me to be wrong. They assume that the purpose of the incentive schemes used in practice is to solve the problem of moral hazard. Based on the evidence I cited above, I doubt this is the case. We should get shareholders to read S&S on compensation schemes and try to make sure that management does not read it.

Last night (9/23/2008) I was watching Larry Kudlow's show on NBC. He had Senator Bernie Sanders (of Vermont) on. Bernie humorously pointed out the amazing overnight "conversion" of Larry Kudlow (a free market advocate) to "socialism" now that free market has failed and these companies need to be bailed out. Exactly the same point that I have been making. Bernie phrases this much more eloquently.

Luckily I was able to find a YouTube video of the conversation between Larry and Bernie. Enjoy.

http://www.youtube.com/watch?v=Lkqb1pQrCcg

If somebody does very very well at their job, it's optimal to fire him rather than keep him on in the same position??? Why???

Well? Why?