Thursday, March 13, 2008

Brainstorming About 'Bailouts'

DealBreaker tips us to this WSJ story:

At a lectern in a room of venture capitalists, Silicon Valley executives and professors at the Stanford Institute for Economic Policy Research last week, Larry Summers, former Treasury secretary and now Harvard professor and hedge-fund adviser, was at his gloomiest.

In the audience, Myron Scholes -- Nobel laureate in finance, veteran of the Long-Term Capital Management hedge-fund debacle and now chairman of his own hedge fund -- was listening and scribbling on a yellow legal pad. His conclusion, one gaining momentum, is that the government eventually will spend a lot of taxpayer money to clean up the current credit mess and prevent economic catastrophe....
...Mortgages and other bank assets aren't worth what banks thought. The losses erode the banks' capital cushion. Bank leverage, described in last week's Capital column, magnifies the effect.

In response, banks either (A) reduce lending and sell assets or (B) raise new capital on terms that dilute existing shareholders. Provided they can find investors willing to bet that bank assets eventually will be worth more than they are today, shareholders tend to prefer option A, the smaller bank. But that market solution could destroy value and produce a crippling credit crunch. Society prefers option B, hence exhortations from Messrs. Paulson and Summers for banks, Fannie Mae, Freddie Mac and others to raise capital....MORE

To which DealBreaker responds:

...The great fear, apparently, is that banks will reduce lending and sell assets. "But that market solution could destroy value and produce a crippling credit crunch," David Wessel writes. Of course that's nonsense. Selling assets does not "destroy value" it reveals it, by providing a market price for the assets sold. All of the bailout solutions basically amount to attempts to avoid this price discovery.