EconomicReason

One cornerstone assumption underlying the viability of the Paulson Plan is that current market prices for subprime and Alt-A products differ by a significant margin from their “hold-to-maturity” value. Reasons for the persistent differences between market prices and a “fair” value are thought to be illiquidity and asymmetric information. If this were indeed true, then the plan could actually work – by restoring liquidity, depressed prices of poor quality assets would rise to “fair” levels, bank balance sheets would heal, and the taxpayer could even pocket some nice profits.

Unfortunately, we are probably not facing a liquidity crisis, but a solvency crisis. In a short recent paper (’No recourse’ and ‘put options’: Estimating the ‘fair value’ of US mortgage assets), Daniel Gros argues convincingly that lower quality mortgages do indeed have quite a low fair value, due to the implicit put option of homeowners which allows them to just walk away from their mortgage obligation.

If we are facing a solvency crisis, then liquidity measures will not make that crisis go away. A solvency crisis can either be ended by bankruptcy, which is not acceptable in case of the banking system, or by a bailout. There is therefore no way that the US taxpayer will profit from a plan to end a solvency crisis – on the contrary, he will ultimately foot the whole bill, both directly (by higher taxes) and indirectly (by higher inflation).