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Earlier today, Greg Maniw posted a three-point defense of the Paulson bailout plan from someone to whom he referred only as "a smart friend". I want to address point 2 of Mankiw's friend's argument:
2. "Taxpayers will be better off if Treasury gets warrants."
This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again,assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.
For a smart guy, Mankiw's friend is making a pretty dumb argument. Sure, if everyone has the same information, then an asset with a value of $10 will cost $12 if it's required that a $2 warrant comes with it. But that totally misses the point. Based on what I've read, it appears that if everyone understood what these assets were worth, there wouldn't be any need for a bailout: the bailout is necessary because people with capital are scared witless that anything they buy will just be crud. Folks like Mankiw are constantly reminding us (and they're often right) that there's no reason to think government has better information than private parties. So how will Hank Paulson or his agents know any better than folks risking their own money?
In more concrete terms, the right way to think about the equity issue is as follows. (I'll abstract from debt-deflation spiral issues, which are no doubt important but are beside the point for this discussion.) Suppose a bailee has two assets, each of which has face value of one unit. However, actual value and face value diverge, say because the underlying security may default. The first asset is actually worth $10, and the other is actually worth $9 $8. The Treasury can't tell the difference, but the bailee can.
Now suppose the Treasury declares that it is willing to pay $10 for one asset with a one-unit face value, with no equity transfer required. The bailee will certainly prefer to sell Treasury the $8 asset, as it will profit by $2. The bailee now has $10 in liquid capital, and Treasury books a real, long-term loss of $2.
Now suppose that Treasury insists on getting warrants whose value is an increasing function of the loss Treasury books when it sells off the bailee's assets. Let's suppose for simplicity that the warrants' value have expected value equal to the difference between the price Treasury pays the bailee and the price for which Treasury sells the asset. Now if the bailee hands Treasury the $8 asset for $10, the bailee will expect to pay $2 later in warrants, so the bailee and Treasury each break even, though the bailee gets liquidity in the short run, which is the point. On the other hand, if the bailee hands over the $10 asset, then there will be no warrants issued later, since Treasury won't lose anything on the deal.
In this example, the use of warrants has (1) gotten liquidity to the bailee, (2) made the bailee indifferent between transferring the two types of assets, and (3) ensured that Treasury doesn't get stuck with an adverse selection-induced loss. The moral of the story is that the use of equity claims makes truth-telling incentive compatible.
This is an example of simple mechanism design, a topic that is well understood by many microeconomists, no doubt including many smart friends of Greg Mankiw's. Obviously the real world is much more complicated than the simple example here (which I emphasize I took from Mankiw's smart friend). But the idea that the MM-type argument Mankiw's smart friend makes is at all relevant to a world full of informational asymmetries strikes me as bankrupt, tough to credit, and more than a little deflating.
7 comments:
Two problems with your argument:
1. Just a typo. Your $9 was supposed to be $8.
2. If the Treasury knows that one asset is worth $8, and the other is worth $10 (but doesn't know which is which), why would the Treasury offer $10? Since it knows it will be given the $8 asset, it would only offer $8.
You can make your argument work if you assume: the Treasury knows the total (or average) value of the assets; but does not know the value of the least valuable asset. But that is a rather stretched assumption.
anonymous:
thx for point 1 -- i'll fix the typo.
on point 2, the whole issue is that treasury *doesn't* know the value of any particular asset. that's why coming up with a revelation mechanism, warrants in this case, is necessary.
one other point, anon, concerning your view "But that is a rather stretched assumption".
i'm not sure if you're a professional economist (i'm not lobbing an insult/compliment here -- i just don't know). so it's worth my pointing out that such information asymmmetries are a core part of modern economics. the presumption in a situation like this one SHOULD be asymmetry, not symmetry.
i wrote my post for other economists, which is why i didn't emphasize this point, but perhaps i should have been clearer on this issue.
The bigger reason is not asymmetric information; it's that the government will not be paying the market price for these securities anyway. They are worth too little -- in their real, fair market value, not just their fire sale value. It would very likely inject too little capital to prevent a severe liquidity crunch and recession.
It's not like these securities are worth $10, and that's what the government would pay, but when you add warrents that are worth $2, so now the government will just have to pay $2 more, and so it gets them nowhere. The government was never going to pay $10 for these securities in the first place. They were going to pay like $20 for securities that were only worth $10 if they didn't want to take a big risk of disaster. If you add the $2 of warrants, it's better becasue the firms still get the $20 of capital that's necessary, but at least the government would now get $12 of value in return instead of just $10 -- It cuts down on how much the tax payers are giving away to the current managers and shareholders.
The best thing of course would be just that the government buys these companies for what they're really worth -- about zero -- then they inject the funds, buy the securities, etc., and then sell the companies back to private buyers for a far higher price. Then the tax payers get the whole benefit, not the existing shareholders and managers.
Mankiw's a well trained and intelligent economist. He knows this. Why does he deceive for the Republicans? Well, I've listed reasons in the past which I'll reprint here:
There are several reasons why an economist might intentionally mislead for the Republicans:
1) There are relatively few successful university economists who support the Republicans, so there is much less competition for plum and high paying jobs in Republican administrations and propaganda tanks. Becoming a Republican crony can mean a lot of money and/or a very high level government jobs, like Mankiw's job as Chairman of the Council of Economic Advisors in George W. Bush's administration. He's also currently a fellow at the American Enterprise Institute. Mankiw has a strong incentive to please the Republicans by misleading for them.
2) He may be an extreme Libertarian, and very willing to mislead for that cause, even if he knows it hurts total economic, scientific, and medical growth greatly, and embarrasses him professionally.
3) He may be very Plutocratic, and very willing to mislead for that cause, even if he knows it hurts total economic, scientific, and medical growth greatly, and embarrasses him professionally.
4) He may have Slipperyslopeaphobia -- for details see my blog post.
5) A well intentioned reason, he may think he can affect change to the historically disgraceful and brain dead Republican party better from the inside than from the outside, and in order to stay inside he can't displease those in control too much.
Honestly, I can't really see what the problem is. The financial firms we are going to buy these "assets" from are, for all important purposes, bankrupt. That is why we have to bail them out.
But if they are bankrupt, then the value of their equity warrants is $0. So it doesn't make any difference.
To anonymous:
The value of their equity warrants is zero or very little now, but after the government infuses $700 billion, buying their toxic assets for much more than they're really worth, then those warrants will be very valuable. Without them, the current management and stockholders will get the whole benefit, with none going to the tax payers.
Yeah, okay, bad phrasing on my part. I shouldn't have implied that it didn't matter either way.
To be clear, I think Gelbach's original post is right. Modigliani-Miller means nothing here. While M-M implies that the value of a warrant will be included in the price the share sells for, this occurs whatever the price it sells for.
So, yes, if the "value" of the share is $8 and the warrant is "valued" at $2, then the share will sell for $10.
But so what? If the share sells for ten cents (and includes a warrant), then the "value" of the warrant will also be included in that ten cents.
So what is the value of the warrant then? Is it $2 or is it some fraction of ten cents?
This is why the argument of Mankiw's "smart friend" is so dumb. He seems to think we want to acquire these assets. We don't. We want to establish values for them. Equity warrants help ensure that this is what we do, rather than just shovel money at finance.
Forcing the finance companies to determine their future value with, or without, certain assets is exactly what we are trying to accomplish.
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