In a front piece story in today’s NYT, Edmund Andrews warns that the bill is about to come due on the massive borrowing the federal government has engaged in.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

[...]

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

[...]

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.  The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

[...]

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation’s oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.  “What a good country or a good squirrel should be doing is stashing away nuts for the winter,” said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. “The United States is not only not saving nuts, it’s eating the ones left over from the last winter.”

Emphases mine.

This sounds ominous and unsustainable.  But Paul Krugman, recent winner of the Nobel Prize in economics, say these fears are overblown.

As Dean says, the numbers don’t fit the scare story — a decade from now interest payments will reach a level not seen since … 1992. And the market seems unworried, since long-term rates remain low.

The “Dean” is question is Dean Baker of The American Prospect.  He sarcastically titles his post, “In Just a Decade the U.S. Interest Burden Could Be as High as It Was in 1992!!!!!!!”

There is no evidence presented in this article that the rise in interest rates will place the U.S. government in a situation where it will be unable to pay its bills and no one cited in this article makes such a claim.

The article is also completely unbalanced in not presenting the views of any economist who could put the deficit/debt issue in perspective for readers.

Krugman makes the same charge but, oddly, neither of them bother to actually present a counterargument.

Andrews argues that most of the debt is in short-term loans whose price will go up as there becomes more competition for money.  He makes what strikes me as a plausible case that higher interest rates, growth in entitlement spending, and a smaller tax base will make servicing the debt very, very difficult.   Countervailing factors could offset this but neither Krugman nor Baker tell us what they might be.

It’s true that we had gloom and doom forecasts during the 1992 recession.  But we only solved those through the dual magic of the dotcom bubble and the post-Cold War defense drawdown.  It’s not likely that those events will repeat themselves.

Photo by Flickr user kandyjaxx under Creative Commons license.

Remember that plan by Obama’s pay czar to radically limit executive pay at bailed out banks? And how some of us were predicting that they’d just go to companies whose pay was not limited?  Well, it didn’t take long.

Even before the Obama administration formally tightened executive compensation at bailed-out companies, the prospect of pay cuts had led some top employees to depart.

[...]

Many executives were driven away by the uncertainty of working for companies closely overseen by Washington, opting instead for firms not under the microscope, including competitors that have already returned the bailout funds to the government, according to executives and supervisors at the companies. “There’s no question people have left because of uncertainty of our ability to pay,” said an executive at one of the affected firms. “It’s a highly competitive market out there.”

At Bank of America, for instance, only 14 of the 25 highly paid executives remained by the time Feinberg announced his decision. Under his plan, compensation for the most highly paid employees at the bank would be a maximum of $9.9 million. The bank had sought permission to pay as much as $21 million, according to Treasury Department documents.

At American International Group, only 13 people of the top 25 were still on hand for Feinberg’s decision.

Alex Tabarrok does the math and notes that 23 of 50 is “close to a majority.” He guesses, and so do I, that a few more will leave now that it’s official.

Again, the issue isn’t one of “feeling sorry” for the executives whose pay the administration wishes to limit. There’s no reason to: The ones who can are simply going to go where they can command what the market will bear. The taxpayers who are holding the bag on tens of billions of dollars in bailout loans, on the other hand, might prefer not to have to staff these companies with those who can’t find jobs at the hundreds of firms who pay more than Feinberg thinks fair.

The top earners at the top firms bailed out by the U.S. government during the financial crisis will have their pay and bonuses drastically cut. Deborah Soloman and Dan Fitzpatrick for WSJ:

The U.S. pay czar will cut in half the average compensation for 175 employees at firms receiving large sums of government aid, with the vast majority of salaries coming in under $500,000, according to people familiar with the government’s plans. As expected, the biggest cut will be to salaries, which will drop by 90% on average. Kenneth Feinberg, the Treasury Department’s special master for compensation, also intends to demand a host of corporate governance changes at those firms.

Mr. Feinberg’s ruling, expected in coming days, will provide fodder for the long-running debate about whether the Obama administration is being overly tough or overly lenient on Wall Street. An executive at one of the seven companies under Mr. Feinberg’s authority said the terms came as a shock, especially because they changed so suddenly. The compensation restrictions “were clearly much worse than what had been anticipated.”

The largest single compensation package will be less than $10 million and is destined for a Bank of America Corp. employee, according to people familiar with the matter. That is much less than Wall Street’s standard payouts for star employees. Yet some executives will still walk away with large paychecks. And some big salary cuts might skew overall numbers. Outgoing Bank of America Chief Executive Ken Lewis will receive no salary for 2009. Already, Citigroup Inc. is telling employees the net impact of Mr. Feinberg’s rulings will be minimal because the cut salary will be shifted from cash to longer-term stock grants, said people familiar with the matter.

The Obama administration gave Mr. Feinberg the job of more closely tying compensation to long-term performance, something the White House believes will help prevent employees from taking unnecessary risks for short-term gains. The administration believes skewed compensation incentives were one cause of the financial crisis.

Stephen Labaton of NYT frames it this way:

Responding to the furor over executive pay at companies bailed out with taxpayer money, the Obama administration will order the firms that received the most aid to slash compensation to their highest-paid employees, an official involved in the decision said on Wednesday.

The plan, for the 25 top earners at seven companies that received exceptional help, will on average cut total compensation this year by about 50 percent. The companies are Citigroup, Bank of America, American International Group, General Motors, Chrysler and the financing arms of the two automakers. Some executives, like the top traders at A.I.G., will face tight limits on their pay. In addition, the top-paid employees at all the affected companies will face new limits on their perks. The plan will also change the form of the pay to align the personal interests of the executives with the longer-term financial health of the companies. For instance, the cash portion of the executives’ salaries will be slashed on average by 90 percent, and the rest will be replaced by stock that cannot be sold for years.

But while the plan would pare compensation substantially from what the highest-paid people at the companies might have received under normal circumstances, it would still permit multimillion-dollar pay packages.

In addition, it would have no direct impact on firms that did not receive government bailouts or that have already repaid loans they received from Washington. Therefore, it is unclear how much effect, if any, the plan will have on the broader issues relating to executive compensation, income inequality and the populist animosity toward Wall Street and corporate America.

There’s the question of the fairness of setting the conditions of the bailout long after the loans were agreed to.  For that matter, there’s an equity issue in that some or most of the people whose salaries are affected may not have even been working for the firms at the time of their collapse.  But, hey, these companies took billions in taxpayer money, so they should just suck it up, right?

And, hey, the American people support this.

In the Post-ABC poll, support for federal limits on the salaries and other compensation of top executives at companies receiving emergency federal loans in the past year spans party lines. Nearly eight in 10 Democrats back the idea (79 percent support, 68 percent “strongly), as do seven in 10 independents (56 percent strongly) and more than six in 10 Republicans (62 percent support, 49 percent strongly).

If even Republicans want to screw these guys over, what’s the harm?

Well, business law professor Steve Bainbridge says we should be outraged.

The Obama administration has shown a shocking disregard for the rule of law when contract rights interfere with the administration’s ability to reorder the American economy as it sees fit.

[...]

So set aside the question of whether compensation at financial firms is “too high,” however you propose to measure it. Set aside the question of whether these troubled firms will be able to keep their best people, who presumably now will be targeted by unregulated firms like hedge funds that will be free to pay market rates.
The basic problem is here is that many (most?) of the compensation deals the Obama administration is shredding were set in employment contracts. Granted, some of those employment contracts were signed after the law setting up pay “czar” Kenneth Feinberg’s position and empowering him to review pay packages at TARP firms. But a lot of them are pre-existing contracts and it’s those contracts that are the main concern.

Feinberg in fact is trumpeting his success at forcing so-called renegotiation “even for contracts over which he did not have explicit authority.”

The bottom line thus is that Obama is having his minion coerce TARP executives and employees into ripping up contracts Obama doesn’t like so as to assuage the populist public. In doing so, Obama and his appropriately entitled “czar” are exhibiting a basic lack of respect for the rule of law.

Unfortunately, these are not isolated incidents. As I wrote back in May, they are each “of a piece with the totality of Obama’s program.”

Further, economist Alex Tabarrok questions the practicality.

There is no way this will work as advertised.  If the administration actually follows through, most of these executives will quit and get higher paying jobs elsewhere.  Executives not directly affected by the pay cuts will also quit when they see their prospects for future salary gains have been cut.  Chaos will be created at these firms as top people leave in droves.  Will the administration then order people back to work?

But, so what, right?  It would serve these companies right, wouldn’t it, to lose their best people?  I mean, aside from the fact that they owe the taxpayers tens of billions of dollars and the same leaders who are pushing this policy deemed them “too big to fail” just months ago?

Well, Yves Smith thinks this is just a “feel good” measure that will do very little.

Pay cuts falls well short of the oversight the government should be exercising (any private owner with that big of a stake would have thrown out the board and installed new management, for starters, and be all over AIG like a cheap suit). So this is an overdue, token measure to appease the public over the AIG retention bonuses that were also extended to clearly non-essential support staff, which is a clear tipoff that they were also extended to non-essential management.

Four of the companies are auto bailout related, so we can exclude them as far as implications for big financial firms are concerned.

Citigroup is an obvious ward of the state too, and the AIG argument applies there. The government should have more control there too, which does NOT mean micromanagement. When the Swedish nationalized their banks, they replaced management and set strict goals and targets, but did not interfere in operations. Bank of America may look like a borderline case, but it would be dead now had it not gotten emergency infusions. Given its credit card losses, Merrill, and Countrywide (for starters) combined with the sudden exit of Ken Lewis, it may well be in worse shape than is now perceived.

The point is that the collection of these scalps will do nothing to comp levels ex these firms. The companies that also enjoy implicit government guarantees are free to do the “heads I win, tails you lose” game of privatized gains and socialized losses. And Ken Lewis is the poster child of why these measures are completely meaningless. He sacrificed his 2009 pay, but will still collect $125 million when he departs Bank of America.

If the government is going to backstop the industry (and this isn’t an “if” anymore), it needs to limit those firm’s activities to what is socially valuable and regulate them heavily to contain risk taking. As we have said, reining in executive pay (and note there is no will to do that anyhow) is not an effective approach. Those employees who don’t like that are free to decamp and raise money in ways that do not involve the regulated firms in any way, shape, or form, save perhaps counterparty exposures on very safe, highly liquid instruments.

Yeah, but meaningful reform is hard and hanging a few scalps on the wall is easy and makes us feel good. But, really, as James Pethokoukis points out, our wrath here is misdirected:

If I made of list of factors contributing to the recession and financial crisis, Wall Street pay would come in around 6th, after 1) easy monetary policy; 2) TBTF; 3) US housing policy; 4) global savings glut/China labor shock; 5) Wall Street group think. Yet pay is where so much energy is being directed at this issue thanks to its populist appeal. America hates TARP so Washington needs to make amends by hammering execs at TARP recipients.

But most of those things involve government or are totally out of the hands of greedy business executives.  And it’s the latter we really want to punish.  So don’t bother me with facts.

UPDATE (October 23):  We’ve moved from the theoretical to the real in less than 24 hours: See Top Employees Flee Pay-Limited Firms.

Surprisingly few bloggers of the bloggers I read are writing about GM’s emergence from bankruptcy in a mere 40 days through a rather unorthodox process.  The background:

AP:

General Motors completed an unusually quick exit from bankruptcy protection on Friday with ambitions of making money and building cars people are eager to buy. Once the world’s largest and most powerful automaker, new GM is now leaner, cleansed of massive debt and burdensome contracts that would have sunk it without federal loans.

CNN-Money:

After a six-week trip through bankruptcy, the “new” General Motors was born Friday owned by the government and free of tens of billions in debt and shed of unaffordable brands, dealerships and plants.

The sale of the valuable assets of the old company to the new GM was completed Friday morning.

[...]

The new company retains the Chevrolet, Cadillac, GMC and Buick brands, along with most of its overseas operations.

GM also keeps about 3,600 of its 6,000 U.S. dealerships and most of its plants. But 14 U.S. plants will be closed, and the company will eliminate about 20,000 of its 88,000 U.S. employees by the end of the year as it continues to cut costs.

While the new company goes forward outside of bankruptcy, much of its debt and many of the assets it shed in the process remain in bankruptcy. It will take about two to three years for an entity known as Motors Liquidation Co. (GMGMQ) to liquidate under court supervision.

NYT:

“It’s just beginning. It’s nowhere near over,” said Keith Crain, the publisher and editorial director of Automotive News, an industry trade publication. Speaking on WJR-AM in Detroit, Mr. Crain said, “They’re going to need hard work, a lot of smarts, and they’re going to need good luck.”

G.M.’s goal, said the chief executive, Fritz Henderson, is to design, build and sell the best vehicles in the world, something that the company had forgotten.

“We deeply appreciate the support we’ve received during this historic transformation and will work hard to repay the trust and the money that so many have invested in G.M.,” Mr. Henderson said hours after the company closed the sale of its good assets to a new, government-backed carmaker.

While Friday marked the first day of the new G.M., many unanswered questions remain, including the government’s role at the company.  The federal government will hold nearly 61 percent of the new company — now called the General Motors Company — with the Canadian government, a health care trust for the United Automobile Workers union and bondholders owning the balance. By the end of the year, the government will have poured $50 billion of taxpayer money into the automaker.

[...]Senior administration officials have promised that they will not micromanage the company, despite being the majority owner and having already picked new directors, including G.M.’s new chairman, Edward E. Whitacre Jr.

The administration hopes to take the new G.M. public again next year.

CNN’s report that the bad assets will continue to go through something akin to the traditional bankruptcy process is encouraging news that I hadn’t seen elsewhere.  The idea that a massive corporation could simply sell its “good” assets to itself while leaving its debt entirely behind struck me as outrageous.  It remains to be seen what its creditors get; they’re certainly entitled to something.

Rolfe Winter makes the most obvious point:

Remember when everyone was saying that if GM filed for bankruptcy the world would end?  It didn’t.  Yeah they got lots of government help, but they were still able to divest billions of old liabilities.  So why don’t we remove the bailout facilities benefiting banks and busted homeowners and force them through the bankruptcy process?

Especially if it’s the new, pain-free bankruptcy that doesn’t ruin your credit for  seven years.

Jim Manzi, Kevin Drum, and Matt Yglesias are upset with the notion that the government might intervene to keep the automakers from unilaterally closing 2000 dealerships.   But, considering that the government actually owns GM and is backstopping Chrysler to the tune of billions of dollars, I’m not sure why they shouldn’t intervene.   Especially given that the process by which these franchises were closed was, to say the least, opaque.

Were you wondering if yesterday’s big rally was related to the Geithner plan? Well, it probably was.

The Treasury helpfully provides an example, which I reproduce here:

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Let’s flesh this out by repeating it 100 times.  So say a bank has 100 of these $100 loan pools.  And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which.  (These numbers are made up but the principle is sound.  Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)

Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.

The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece.  Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.

Half of the pools wind up worthless, so the investor loses $300 total on those.  But the other half wind up worth $100 each for a $16 profit.  $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury.  So the investor gains $400 on these winning pools.  A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.

The bank unloaded assets worth $5000 for $8400.  So the private investor gained $100, the Treasury gained $100, and the bank gained $3400.  Somebody must therefore have lost $3600…

…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless.   But no worries.  As long as the FDIC has more expertise in evaluating the risk of toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this.  What could possibly go wrong?

A couple of points. First, this is just an example to help understand how the plan would work. Hence the numbers and any percentages derived from them are likely to be completely bogus. What is important to take away from this is the qualitative aspect of the post. That is, there is still significant potential for a downside for the FDIC and ultimately for the taxpayer (yes, the FDIC is funded by the banking industry, but if they get into big trouble I have little doubt that the taxpayer will be put on the hook).

This is probably as good a reason (or one of the reasons) for the rally yesterday. As the guys on Wall Street ran this by their number crunchers it became apparent that this plan could offer a very nice deal for distressed financial institutions.

The author of that post, Nemo, has more here as well.

In Part 1, I gave an example of how a private investor could buy some loans for $8400, ultimately realize $5000 on them, and still earn a 16.7% profit. Milo Minderbinder would be proud. The loser would be the FDIC, which is interesting because the FDIC is financed not by the taxpayer but by the banking industry — or at least, it has been so far. So even if the FDIC needs to tap their new $500 billion credit line to make good on tons of bad loans, in theory they will eventually repay the Treasury by exacting higher insurance premia from the banking industry.

Thus Part 1 could be read as a transfer of wealth from good banks to bad banks and private equity. Assuming Treasury actually demands repayment on the credit line and does not just write it off…

Well, great. A transfer of equity from good banks to bad banks. Gee, if you were a good bank what would you be thinking at this point? Time to get the f*ck out of Dodge? How to quickly become a bad bank?

Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing. Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer. Color me skeptical, especially with regard to the Fed.

Me too.

Tim Geithner takes to the pages of WSJ to flesh out his Plan for Bad Bank Assets.

Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

To my non-economist mind, that sounds eerily remniscient of the Troubled Assets Relief Program (TARP), the $700 billion plan passed last October to prop up the frozen financial system by buying, well, troubled assets.   Granting, arguendo, that the Bush administration, which ran the first part of TARP, was evil and incompetent and the Obama administration is all sweetness, light, and omniscience, why would this work any better the second time around?

I know remakes are all the rage but usually they involve movies that 1) were successful at the box office and 2) were made long enough ago that teenagers haven’t already seen them.   By contrast, TARP was a veritable Ishtar and is barely out on DVD.

The economist mind of Brad DeLong leads him to support the package, given the alternatives.  The John Bates Clark Medal and Nobel Prize-winning economist mind of Paul Krugman thinks this is too little, too late.  This makes DeLong nervous but not enough so to change positions.

DeLong offers an amusing but obviously incomplete list of Four Groups of People into which the world is divided.  For example, neither Krugman nor I fit into any category.   He also offers a handy dandy Geithner Plan FAQ.  Krugman thinks it’s a nice try but ignores some salient downsides.

This point, especially, strikes me as right:

[I]t’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

Or to put it another way, Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.

That doesn’t sound like a good idea.

Update (Alex Knapp) Regarding the moral harzard of TARP 2.0, I believe that John Cole has put it best:

If this were a medical emergency, it appears it would look something like this:

The Illness- reckless and irresponsible betting led to huge losses
The Diagnosis- Insufficient gambling.
The Cure- a Trillion dollar stack of chips provided by the house.
The Prognosis- We are so screwed.

That’s about right.

Update (Steve Verdon): Maybe we can call them Patriot Loans or Big Penis Loans. I’d like to note that I was noting this possible policy several weeks ago. In other words, Geithner is going back to the original Paulson Plan.

As for James’ question as to why this would work this time around it could be argued that the original Paulson Plan was never implemented. The TARP funds basically became a ginormous slush fund that was given or forced on financial institutions. Forced for those financial institutions that are still sound and didn’t need a bailout. Why? Well if the slush fund gave money only to troubled financial institutions then you’d know precisely what financial institutions were troubled and many investors might be inclined to go ahead and dump those stocks now rather than latter. Nothing like having your own government pull the wool over you eyes.

I do have to admit that I find it amusing that now that it is “their guy” (i.e. Obama) who is making this pitch Brad DeLong likes the plan and Krugman merely thinks it is too little too late. I’d be curious to know their initial views on the plan back when it was the Paulson Plan not the Fluffy Bunny Loan Program.

Eric Posner has a Slate piece offering a novel plan for “renegotiat[ing] all those bad loans at no cost to the taxpayer.”

The solution to this problem is for the government to force renegotiations to occur. A simple plan could do this. The plan would give all homeowners who live in a ZIP code where house prices have dropped more than 20 percent the option to have their mortgage reduced to the current market value of the house. In exchange, these homeowners would yield to their lenders 50 percent of the future appreciation of the house. To avoid any gaming and future moral hazard, both the current and the future value of the house will be determined by multiplying the purchase price and the variation in the housing price index. So if you bought your house for $300,000, and the average house in your ZIP code has lost 20 percent of its value, then your new house is assumed to have a value of $240,000. If your mortgage was $280,000, now it is $240,000 (the new value of the house). You are no longer underwater.

For the homeowner, this is a very attractive proposition. Suppose he has a $300,000 mortgage on a house he bought for $350,000 but today is worth only $200,000. With the plan, he will receive a $100,000 reduction in his mortgage in exchange for giving up a portion of the future appreciation of the house should that happen. Using the tools of finance theory, we can calculate the value of the “option” that the homeowner gives to the bank. Assuming an 8 percent annual volatility in house prices and an 11-year tenure in the house, the option is worth $36,000. The homeowner loses $36,000 from the lost future appreciation but gains $100,000 in the reduction in mortgage debt: a good deal. The homeowner also has a good incentive to maintain his property. If the homeowner adds a bathroom, he reaps the full benefits of this addition when he sells the house. Although he must pay the bank 50 percent of the increase in the price of the average house in the ZIP code, he keeps any additional return if his own house appreciates more quickly than the average house because of the new bathroom.

This does strike me as a better solution than the Obama Plan.  It is hardly, however, without moral hazard.

What of those of us who put down a substantial down payment and so are not “under water”?  Our houses have still depreciated in value but, because we were responsible, our outstanding loans are still secured.  Meanwhile, our neighbors, who bought a house they couldn’t afford, are rewarded with a free $100,000 or $200,000 or whatever.  In essence, our down payment would have been stolen from us by the government.

Having already wasted billions of our tax dollars, GM and Chrysler are back. But don’t worry, they’ve got a plan:

General Motors and Chrysler, two flagships of traditional American manufacturing, reported yesterday that the decline of the U.S. economy has outpaced their bleakest expectations of just two months ago, forcing them to significantly boost their request for billions of dollars in government aid.

The companies said they plan to cut an additional 50,000 jobs worldwide, drop as many as six brands and shutter 14 plants in an attempt to survive one of the deepest recessions in decades.

Once-popular lines such as GM’s Hummer and Saturn will be spun off or, failing that, eliminated. Saab is up for sale. Chrysler will stop production of the PT Cruiser, Aspen and Durango by the end of the year.

“Today’s plan is significantly more aggressive because it has to be,” GM chief executive G. Richard Wagoner Jr. said. “We have taken stronger actions; we needed to.”

The automakers yesterday said they may need as much as $21.6 billion in additional loans — $5 billion for Chrysler and the rest for GM. The requests announced yesterday come on top of $17.4 billion the companies received in recent months.

Now . . . let me get this straight.

The only reason to bail out these failing companies is to save the jobs of its workers during dire economic times when it would be even more difficult than normal for them to find new work.   Yet, they’re going to cut at least 50,000 jobs anyway.

And their plan for saving the company is to announce ahead of time that cars they’re trying to sell now will soon go out of production, which means the companies won’t be making spare parts for them, which means no one who isn’t an idiot will buy one of them.

Further, if the idea is to cut costs and they’ve figured out that the Aspen, Durango, and PT Cruiser are unprofitable why not stop making them now?

Explain again why we didn’t just let the companies declare bankrupcy and do this restructuring without taxpayer money?  Which, by the way, might happen anyway:

GM said it might need as much as $100 billion in financing from the government if it were to go through the traditional bankruptcy process. Rick Wagoner, GM’s chairman and chief executive, said the bankruptcy scenarios are “risky” and “costly” and would only be pursued as a last resort.

Chrysler’s plan said the company would likely have to file for Chapter 11 protection if it doesn’t get additional loans from the government and concessions from unions, creditors and dealers. It said it would need $24 billion in financing if the company were to file for bankruptcy. But company officials said in a conference call that they believe a Chapter 11 filing is “not necessary” for Chrysler’s survival.

You’ll forgive me if I’m less than confident in their prognostication skills.

UPDATE:  Dave Schuler adds,

As of this morning GM’s total stock valuation is $1.33 billion. The estimated value of GM’s assets is something like $30 billion. GM is literally worth more dead than alive.

If the objective is saving the jobs of GM’s workforce, here are two alternatives. GM’s 181,000 U. S. employees could buy the company. That’s something like $7,500 per employee. Or maybe some sort of debt for equity swap could be arranged. Heck, I think the U. S. government should lend GM’s employees the money to buy the company, perhaps on a need basis. Then if GM’s workforce think they can do a better job than GM’s current management they could do anything they cared to.

That certainly makes more sense than simply throwing good money after bad.

Update (Steve Verdon): It should also be pointed out that bankruptcy does not automatically mean that the company ceases to exist or that jobs are terminated immediately (i.e. not all 181,000 will be out of work). If the problem with GM, for example, is bad management and a bad business plan that bankruptcy can clear out the rot and possible save the company. Granted it might be in a leaner form (i.e. we might still lose those 47,000 jobs), but at least the American tax payers isn’t going to be at risk for tens of billions of loans to a company where the management has made a series so bad decisions.

After hedging bets with talk about “controlled bankruptcy,” the Bush administration has decided to give the Big 3 loan guarantees that could not pass the Senate.

The White House has decided to come to the rescue of General Motors and Chrysler by providing them with $17.4 billion in low-interest loans to keep them afloat, ABC News has learned. The money for the loans will come from the Troubled Asset Relief Program fund, signed into law this fall to bail out the financial industry. The president will provide $13.4 billion in short-term financing in December and January and plans to make another $4 billion available in February, provided it can reach into the second half of the $700 billion TARP fund to do so.

[...]

Bush and other administration officials publicly worried in recent days about the need to avoid an uncontrolled bankruptcy by the two car companies. “This is a difficult time for a free-market person,” Bush said Thursday. “Under ordinary circumstances, failed entities, failing entities should be allowed to fail. I have concluded these are not ordinary circumstances, for a lot of reasons… We got to the point where if a major institution were to fail, there is great likelihood that there’d be a ripple effect throughout the world, and the average person would be really hurt.”

Treasury Secretary Henry Paulson told a business forum in New York Thursday night it was too risky to simply let the automakers fail. “When you look at the size of this industry and look at all those that it touches in terms of suppliers and dealers& it would seem to be an imprudent risk to take,” he said.

[...]

Treasury Secretary Paulson will administer the plan until Jan. 20, at which point there will be another “presidential designee” to oversee the loans under the new administration. If the companies cannot prove they are financially “viable” by March 31, the loans will be recalled and the money returned to the Treasury. The White House is also calling for no dividends for stockholders until the money is paid back, and stipulating that the government can block transactions over $100 million.

The facts that this is overwhelmingly opposed by the American people, was killed in the legislature, and that the TARP funds were allocated for an entirely different purpose were apparently not major factors in this decision.

The Fed cut their lending rate to zero.

A surprised Wall Street bolted higher Tuesday after the Federal Reserve’s historic decision to further slash interest rates and provide broad support to revive the troubled economy. The Dow Jones industrials surged 360 points, or 4.2 percent, and broader indexes jumped more than 5 percent after the central bank said it will use “all available tools” to jump-start the economy. It also set its target for the rate at which banks lend to each other to a range of zero to 0.25 percent, the lowest level on record.

This record may be tied but I predict it’ll never be broken.

The public opposes bailing out the Big 3 automakers by a wide margin because they believe the companies are responsible for their own failure and doubt that their going bankrupt will hurt the economy, a new WaPo-ABC poll finds.

Overall, 55 percent of those polled oppose the latest plan that Chrysler, Ford and General Motors executives pitched to Congress last week, on par with public opposition to earlier, pricier efforts. But with 42 percent support, the new request for up to $14 billion in emergency loans has more backers than previous proposals to secure up to $34 billion in loan guarantees. But as with the earlier bids, those who strongly oppose the measure greatly outnumber those who are strongly supportive.

Opposition to the automaker bailout is fueled by the widespread perception that the companies themselves are responsible for their predicament, not the faltering economy. In the new poll, three-quarters of Americans said Detroit’s woes are mainly the fault of its own management decisions, and a sizable majority of those who blame the front office object to government help.

Nor have Detroit’s Big Three made significant progress persuading the public that bankruptcy proceedings would deepen the broader economic slowdown. Sixty percent said it would make no difference or would be good for the economy if one or more of the companies were forced to restructure under the protection of bankruptcy laws.

This is an example of public opinion polling at its most useless.  What the public has here is attitudes, not opinions.   The world’s best economists can only make educated guesses as to how a bailout — or the lack of one — will impact the economy; the general public — myself included — haven’t the foggiest clue.

Now, I happen to think the bailout is a bad idea.  Then again, I thought all the bailouts were a bad idea.  Whether I was right is unknowable.   They clearly didn’t “work,” if the object was to stop the freefall of the stock market, boost consumer confidence, and get credit flowing again.  But it’s entirely possible that things would be calamitously worse had we done, as I counseled, nothing.

The bottom line is that we’re making this up as we go along.  The House approved the bailout and a majority in the Senate purportedly favored it but a strong minority stopped it using procedural rules.  It looks like President Bush will circumvent that result by use of the giant slush fund created to bail out the financial sector.  I’ve got a strong guess that Chrysler and GM will fail, anyway, but nobody really knows.

Senate Republicans killed the bailout deal worked out between President Bush and congressional leaders that had previously passed the House.  NYT:

The failure to reach agreement on Capitol Hill raised a specter of financial collapse for General Motors and Chrysler, which say they may not be able to survive through this month.

After Senate Republicans balked at supporting a $14 billion auto rescue plan approved by the House on Wednesday, negotiators worked late into Thursday evening to broker a deal, but deadlocked over Republican demands for steep cuts in pay and benefits by the United Automobile Workers union in 2009.

The failure in Congress to provide a financial lifeline for G.M. and Chrysler was a bruising defeat for President Bush in the waning weeks of his term, and also for President-elect Barack Obama, who earlier on Thursday urged Congress to act to avoid a further loss of jobs in an already deeply debilitated economy.

“It’s over with,” the Senate majority leader, Harry Reid of Nevada, said on the Senate floor, after it was clear that a deal could not be reached. “I dread looking at Wall Street tomorrow. It’s not going to be a pleasant sight.”

AP:

Republicans, breaking sharply with President George W. Bush as his term draws to a close, refused to back federal aid for Detroit’s beleaguered Big Three without a guarantee that the United Auto Workers would agree by the end of next year to wage cuts to bring their pay into line with U.S. plants of Japanese carmakers. The UAW refused to do so before its current contract with the automakers expires in 2011.

The breakdown left the fate of the auto industry — and the 3 million jobs it touches — in limbo at a time of growing economic turmoil. General Motors Corp. and Chrysler LLC have said they could be weeks from collapse. Ford Motor Co. says it does not need federal help now, but its survival is far from certain.

The blogospheric discussion, naturally, is mostly about the politics of this. While unequivocally believing that killing this boondoggle was necessary, my political instincts mirror Jeff Fecke’s: “Evidently the Republican Party likes being a Southern regional party. Because they wouldn’t be doing this if they ever hoped to win Michigan, Ohio, or Pennsylvania ever again.” (His post title: “Republicans to Detroit: Drop Dead”) He issues a refrain that I expect to see echoed in the coming days, if not years: “[B]ack when we passed the financial bailout, do you remember Republicans hand-wringing about how we had to ensure that the companies significantly cut white collar compensation at those banks? … The GOP saw this as a golden opportunity to screw over unions and blue collar workers, and as such, they’re managing to screw everyone over.”

His counterpoint is Stacy McCain, who’d like to punish Republicans who backed this deal. But he’s dead right here: “After so much bad economic news, it’s good to see real progress. (And if you don’t understand why GM’s bankruptcy is good news, you don’t know anything about economics. Or bankruptcy.)”

Others are all over the map.

Chris Bowers sees this as evidence that, “While Obama is personally very popular, this popularity has not, as of yet, altered the legislative outlook on some key priorities.” Sandy Levinson reaches the same conclusion independently but thinks it’s time to amend the 20th Amendment, further moving up the inauguration of new leaders because “It is, frankly, indefensible that lameducks have the power to block this bill from coming to a vote. . . . There is also no reason in the world to delay the seating of newly elected representatives and senators beyond a week after the election.” That’s probably true. Newly elected presidents need time to put together a team; not so much new Members of Congress.

Digby: “So, the Republicans are saying that if the Democrats don’t agree to destroy the unions, they will block any loans to Detroit, and allow the auto companies to fail. And even that might not be enough to stop them because this wrecking crew seems have decided that the country needs to understand that if they vote for Democrats the Republicans will make them pay by ushering in another great depression.”

Robert in Monterey titles his post “Yacht Party Decides to Let Ship of State Sink” and focuses on the antics of California Republicans.

Sarah Binder is more tactical, observing, “All of the eight Michigan Republicans who participated in the vote supported the bailout. Indeed, Republicans from Rustbelt states were disproportionately (though not surprisingly) more likely to vote with the auto manufacturers, even controlling for ideological predispositions.” The upshot? “The geographic concentration of the domestic auto industry in the Rustbelt radically limits the industry’s voting power in the Senate.”

Former Clinton Labor Secretary Bob Reich is simultaneously reasoned and hyperbolic in making a similar point: “There’s a new Civil War going on when it comes to automaking in America. Japanese, Korean, and German automakers are now building 18 auto assembly plants in the United States, none of which is unionized. . . . So there’s no reason to suppose the good citizens of Kentucky, Tennessee, or Alabama are particularly excited at the prospect of handing over their taxpayer money to competing firms and their workforces.”

Pat Garofalo thinks the Republican alternative amounts to “union busting” and contends that “The UAW has already conceded to help the Big 3 manage their financial troubles. New innovations — not a lower-paid, uncared for workforce — will help Detroit get back on its feet.”

Doug Mataconis offers disdain for both sides, observing, “Not only is the Corker plan a bailout, it’s also an even greater imposition of state corporatism than anything we’ve ever seen before. It would give the Federal Government, represented by a self-described ‘car czar’ unprecedented control over a huge segment of the American economy, and anyone who thinks that power will be surrendered easily is kidding themselves.”

Hilzoy: “[A]fter years of being willing to spend money on whatever George W. Bush and their lobbyist friends wanted, after supporting Duke Cunningham’s and Tom DeLay’s buddies in the style to which they had become accustomed, now they decide to prove that they care about fiscal responsibility. In the middle of the worst downturn in half a century. Thanks a million.”

Of course, failing to adhere to their principles has been rewarded with ballot box calamity two election cycles in a row. Why not try something new?

Ed Morrissey congratulates Senate Republicans and snarks that, “Most of them, and a few Democrats like Baucus and Tester and Blanche Lincoln, must have read their Robert Byrd Pocket Constitutions and realized that the federal government has no role in bailing out out private enterprise with taxpayer money.”

Bowers’ counterpoint, though, is also valid: With a Democratic president and increased Democratic majorities in both Houses, any bailout that passes six weeks from now will likely be shorn of the sops to conservative sensibilities necessary to get Bush and House Republicans on board.

Image:  Mike Licht, NotionsCapital.com’s photostream under Creative Commons license.

Roughly three in five people who got bailed after failing to pay back home loans are back in trouble in short order according to a shocking government report.  (Well, shocking to government officials.  Otherwise, entirely predictable.)

Recent data suggests that many borrowers who received help with mortgage modifications earlier this year tended to re-default on their payments, a top U.S. banking regulator said on Monday. “The results, I confess, were somewhat surprising, and not in a good way,” said John Dugan, head of the U.S. Office of the Comptroller of the Currency, in prepared remarks for a U.S. housing forum.   “Put simply, it shows that over half of mortgage modifications seemed not to be working after six months,” he said.

[...]

Dugan said recent data showed that after three months, nearly 36 percent of borrowers who received restructured mortgages in the first quarter re-defaulted. The rate of re-default jumped to about 53 percent after six months and 58 percent after eight months, Dugan said, without providing an explanation for the trend.

Explanation?  Bad credit risks don’t stop being bad credit risks?  That’s lawhawk’s guess, too.

Can it be that these people should never have been homeowners in the first place? Maybe the problem really is home owners who should not be owning a home in the first place? What happened to income verification?

Bruce McQuain, too: “Sometimes a stiff is just a stiff.”

Tyler Cowen thinks it interesting but provides no conclusions.  His commenters, though, provide some useful inputs.

Links via Memeorandum and Google Reader.   Photo via taberandrew under Creative Commons license.

Remember that emergency bailout, wherein the world would come to a complete halt if the government didn’t buy up all the bad loans? Hank Paulson says “Never mind.”

Treasury Secretary Henry Paulson, AP/YahooNews Photo

Treasury Secretary Henry Paulson says that the $700 billion government rescue program will not be used to purchase troubled assets as originally planned. Paulson says the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to resume more normal lending.

He announced a new goal for the program to support financial markets, which supply consumer credit in such areas as credit card debt, auto loans and student loans.

Now, I don’t know whether this is a better idea than the original plan — although it does come closer to passing a common sense test. But it’s hardly confidence inspiring that they were saying “Trust us” on the absolute urgency of doing precisely the opposite weeks ago.

Further, while I presume the bailout legislation gave Paulson substantial leeway, it’s more than a little frightening that he’s going to spend a quarter trillion dollars in a way totally contrary to the way they were designated by Congress. Something’s not quite right about that.

The widespread rumors of a government bailout of Fannie Mae and Freddie Mac have already had dramatic consequences, perhaps creating a self-fulfilling prophecy. Iain Dey and Dominic Rushe, writing for The Times of London, note that, “The two companies lost almost half their market value last week as rumours of a government bail-out swept the stock markets, hammering share prices around the world.”

Julie Creswell of the NYT notes that many have seen this coming for years.

Among them is Jim Leach, a Republican former representative from Iowa, who began arguing two decades ago in Congress that the government-chartered mortgage companies, Fannie Mae and Freddie Mac, were unfairly insulated from the real world. They were not subject to the same financial standards and tax burdens as their competitors, he warned, and if they ran into trouble, an implicit government guarantee to back them up meant taxpayers would be left with the losses.

The size of the problem is enormous.

Today they own or guarantee about half of the country’s $12 trillion in mortgage debt, so the free fall of their share prices last week amid concerns that they were undercapitalized has created chaos for Wall Street and Washington.

The dominant role Fannie and Freddie play today is no accident. The companies, Wall Street firms, mortgage bankers, real estate agents and Washington lawmakers have built up an unusual and mutually beneficial co-dependency, helped along by robust lobbying efforts and campaign contributions. In Washington, Fannie and Freddie’s sprawling lobbying machine hired family and friends of politicians in their efforts to quickly sideline any regulations that might slow their growth or invite greater oversight of their business practices. Indeed, their rapid expansion was, at least in part, the result of such artful lobbying over the years. And as Fannie and Freddie grew, so did the fortunes of Wall Street, which reaped rich fees from issuing debt for the two companies, as well as the mortgage and housing industries, which banked billions of dollars as the housing market boomed.

UCLA business law professor Steve Bainbridge has been warning about this for years, too. He points to some analysis from LAT Market Beat columnist Tom Petruno:

[I]t is triggering worries that would have been unthinkable even a year ago — including that the U.S. Treasury’s debt might lose its AAA credit grade because of heavy blows to the nation’s fiscal health from the housing mess.

[...]

Because of their size and importance to the mortgage market, it’s inconceivable that Fannie and Freddie would be allowed to fail. But an outright takeover of the companies by the government, as some experts have suggested, could frighten foreign investors — who are big lenders to the Treasury — by, in effect, adding the companies’ $5-trillion debt load to the Treasury’s massive debt of $9.5 trillion. Nationalizing the companies “would put the full faith and credit of the Treasury at risk,” [Allen] Sinai [of Decision Economics] said. “It would make foreign investors think hard about buying U.S. Treasury debt.”

Bainbridge sees a “worst case scenario” in which “Foreigners abandon the dollar for the euro, dumping treasuries. The collapse of foreign investment in Treasuries makes our massive current account deficit unsustainable. At which point, things really go to pot. “  Uh-oh, indeed.

What’s not clear to me, even in the case of a government absorption of Fannie and Freddie, is why we’d add an additional $5 trillion in “debt” by so doing.  Sure, we’d be adding some unknown amount of risk.  But, presumably, the overwhelming majority of people will be paying back their home loans.  So, isn’t most of that $5 trillion, then, an asset?