Please oppose the TARP

Let me see if I can write this without spit flying out of my mouth.

Executive summary: Transferring $1 trillion into the banking system, without regard for the discipline of the market, is about the worst idea I have ever heard.

(As an aside, if they stick with the “TARP” acronym, I ask everyone reading this to head to your favorite blog and tell them it stands for “Taxpayer A**-Rape Program”.)

(As another aside, it could easily be $1 trillion, because $700 billion is merely the limit for assets held at any one time.)

“To restore confidence in our markets and our financial institutions, so they can fuel continued growth and prosperity, we must address the underlying problem.” – Henry Paulson, September 19, 2008

As Calculated Risk points out today, the “underlying problem” is not mortgages, or MBSes, or CDOs.  The underlying problem is misallocation of capital, particularly in housing.

Let me take a quick detour.  How much is a house worth?  I do not mean how much can you sell it for; I mean how much is it worth?

There are at least three ways to think about the value of a house:

  1. The cost of an annuity that pays sufficient cash to let you rent it in perpetuity (occupant’s perspective, cash purchase).
  2. The amount you can borrow such that your interest payments are equal to what it would cost to rent it in perpetuity (occupant’s perspective, borrowed money purchase).
  3. The cost of an annuity that would pay the same amount you could get by renting it out in perpetuity (investor’s perspective, cash purchase).

I am leaving off details like maintenance, because they do not affect the point.

In a free market, all of these would give the same answer.  Of course, housing is not a free market, thanks to the mortgage interest tax deduction, which makes perspective (2) give a higher answer than the others.

But all of these perspectives — indeed, any rational definition of value — will depend almost entirely on two things:

  1. Present and future rents
  2. Present and future interest rates

Of course, these are unknowable with precision because they depend on the future.  But based on any reasonable estimates for either, house prices in recent years have far outpaced their values.  And although the market can be extremely inefficient in the short run, it is almost always quite efficient in the long term.  House prices correcting to house values is inevitable.

If… and this is a big “if”… If government really wants to throw money at the “underlying cause” of the problem, it must retroactively improve these capital allocation decisions; that is, it must increase the value of housing.  How?  By increasing rents.  How do you increase rents?  By increasing people’s ability and willingness to pay; i.e. by increasing their real salaries; i.e., by increasing the value of their labor.  In short, you must enact policies to foster vibrant local economies, full of healthy, well-educated, productive workers driving on good roads, using advanced technologies, and relying on stable and secure energy sources…

Does buying toxic mortgage instruments from banks do any of these things?  No.  In fact, it simply rewards the firms who are best at convincing the Treasury to overpay for garbage, replacing market discipline by political whim.  The housing bubble was the worst failure of capital allocation in the history of capital allocation, and this plan will reinforce it. This is a direct transfer of wealth to the banks at the expense of everyone else; good for (some) banks, bad for the nation.

Moreover, if the government borrows $1 trillion to buy purely financial assets quite possibly worth zero, what will that do to long-term interest rates?  Answer:  It will drive them up, which in turn drives the value of houses down.

This plan is literally the worst idea I have ever heard.  Do not just take random bloggers’ words for it; go read what the real economists are saying.

Then fax, call, or Email your Senators and Representative.  Keep the opening short and to the point: “Please vote against Hank Paulson’s Troubled Asset Relief Program.”  Elaborate from there.  And hurry, because there is very little time.

11 comments to Please oppose the TARP

  • Just e-mailed mine! For all the good it will do.

  • diek

    OK, Nemo, so far I like what you’ve written but this one strikes me the wrong way.

    First of all I would postulate that there is no single cause that can be singled out for this mess (with maybe the exception of Alan Greenspan) because the entire system had to evolve to the point where it was teetering on the brink of self-destruction. Low interest rates, return-seeking investors fresh from dot-com type expectations and a “trees grow to the sky” mentality, unregulated financing methods, the lifting of leverage limits, poorly thought out valuation models for illiquid assets, giant bonuses for fee-based revenues on these products, and oh yeah, houses were the vehicle this time. The houses play a minor role here although the most visible to most people, IMHO. It could have been pet rocks if the financial industry invented RBSs (rock-backed securities) and sold endless CDSs on rock mortgages. The whole thing is one big positive feedback loop carefully constructed over a period of at least 10-15 years to generate maximum income for everyone in the loop while it keeps spinning, and we know what happens with positive feedback loops when they run out of headroom. Bam, toast.

    So now we have a problem. We never should have had this problem if anyone — SEC, Fed, administration — had been paying any attention at all. But we are past that point. Like you, I hope to see those that did the stupidest things really, really suffer for them.

    I think we are going to see a few phases of this thing play out:

    1) Paulson’s plan will meet resistance in Congress, due to some good and some bad reasons. It is not obvious what it will look like or when it will be passed.
    2) Given the apparently extraordinary lack of capital flow, we have a really serious problem. Capital must flow or quite rapidly we will have some really severe impacts such as smaller companies shutting down, payrolls not being met, runs on the bank, etc.
    3) We really don’t know what prices Paulson is thinking of paying for this toxic waste. I think a lot depends on that. Setting a floor for prices will allow mark to market to start working again. This may be the single most important element of the plan. Again, it depends totally on whether Paulson approaches this as a “floor” price or a premium price. I sure hope the former.
    4) This may be one of those times when anything that can be grudgingly agreed to by all is much better than a better solution that isn’t.

    I also think house values *must* be calculated differently from rents, simply because of the “terminal value” of that leveraged asset. With normal leverage of 80% at the time of purchase, a holding period of 10 years, an average CAGR of a home’s price at 6% (most are higher even over long historical periods), and a discount rate of 4%… the house would sell for 21% more in present value than its purchase price. That is a big kicker to the rent stream.

  • diek —

    You and your CAGRs…

    Thank you for the comments. I will be spending most of today on airplanes, so I will not have time to respond properly until tomorrow. And it will probably take the form of a “causes and proposed solutions” post. But let me briefly address a couple of your statements.

    Why did you stop at 10 years to get a current house value premium of 21%? Why not 20 years or 30 years or 50 years? Perhaps because 49%, 81%, or 169% (respectively) as a premium would sound ridiculous? Talk about the “trees grow to the sky” fallacy!

    Two questions. Question 1: Over the long run, price-to-rent ratios (a) grow, (b) shrink, or (c) stay the same? Question 2: Over the long run, rents grow (a) faster, (b) slower, or (c) at the same rate as incomes?

    The answer to both is (c), of course. Over the long run, nominal house prices grow at precisely the rate of inflation. See any of Robert Shiller’s papers addressing this question (example).

    The value of any financial asset, always and everywhere, is the free cash that can be extracted from it from now until the end of time, discounted back to the present day. I stand by my valuation assertions.

    “Capital must flow” or we will see severe impacts? I would say “capital must flow efficiently” or at least “capital must flow into investment” instead. Pure consumption — which is what shelter is — cannot possibly form the basis for long-term economic growth. You, and the Congress, seem to think that “something, anything is better than nothing”. But that is not true. Deliberately MIS-allocating $1 trillion of capital is considerably worse than doing nothing. Not only does it not address the underlying issue, which is capital allocation itself, it actually makes it worse. At best, this plan will prop things up temporarily and push the problem down the road. But it will ultimately make it more acute.

    I know that I am wrong sometimes. This is not one of them.

  • jus me

    Nemo –
    Can you use your madd perl skilz to add the CRVIX (the CR Visitors IndeX) to the “Self-Evident” blog?
    As a graph?
    Lotsa folks would like that….

  • jus me —

    That is a very interesting idea. I will see what I can do…

  • worried


    Do you believe that we are now in a crisis?
    Do you believe we have been deliberately placed in this crisis for some purpose?
    Do you believe this crisis needs a solution now or do you want face down the perpetrators regardless of the consequences?

    Unpleasant though it must be it seems we are in a crisis that requires action.

    You were pretty calm about Goldmans 10 trillion in derivatives but it scared me.
    Last week the system appeared to be about to seize up and i think we can agree that once it really gets going in an implosion rather than just seizure it would be difficult to resolve it?

    Last week it appeared that many of us totally began to panic. I took some very unusual actions to financially protect myself and i am living in Finland.

    On the one hand Paulsons actions seem very harsh and dictatorial but on the other hand as a none American if he can get these powers i will be relieved and feel the system will work this thru somehow. Lehmans for example did a bunk out of Europe at short notice leaving counterparties high and dry. Nobody is going to trade with americans unless the US authorities show they are willing to ensure such things do not happen in such a disorderly manner again. I had two bank accounts in entirely different banking alliances in opposite world hemispheres that both got exposed to Lehmans losses last week. If one of the main US banks fail it will get increasingly ugly.

    Just sayin

  • Nemo,

    Oh, come on. It’s just the government’s money; they can always print more :)

    Actually, I have a short series of blogs ranting about this stuff as well:


  • diek

    re: houses, that wasn’t really the emphasis of my comment, but in answer to your questions:

    1) I picked 10 years because that’s reasonably in the range of the average holding period for an owner-occupied house (it’s probably more like 7 years)

    2) I personally am not enamored of Shiller at all. I think he spends way too much time promoting himself by causing shock. His home price bubble numbers are usually the highest and most volatile because he seems to focus on reporting data selected for that purpose. In the first chart on the page you linked to he fails to show home price indexes on a semi-log scale which would show a very different picture, such as Norway’s home prices undergoing a similar boom to ours, among other things. And then in that same article he places a quick marketing message for the housing price derivatives he co-invented (and I assume gets a cut from). He just has too many markings of a showman for me. Sorry. I kind of like dry Census data myself.

    3) While I don’t have good rationale for it, I would be hesitant to agree that home prices must follow inflation. There is a strong sense of desirability and exclusiveness of home ownership in the US.

    Did you happen to note that Warren Buffett, who has been right (although years early) on all this, supports Paulson’s plan?

  • diek —

    Let’s just say I do not accept any argument whose conclusion is that the value of your house is 21% more than what you paid for it no matter how much you paid for it.

    But suppose I did grant there is some special premium to owning the house over renting it. (I don’t, but suppose I did.) Then that “ownership premium” would have to be a one-off addition to the value, not an addition to the long-term growth rate of the value. Otherwise, the “ownership premium” itself would have to grow forever in REAL (inflation-adjusted) terms, which is impossible.

    Now, even if there is a one-time “ownership premium” over what the “discounted rent” model implies, that does not actually change anything about my argument or my conclusions. Unless you believe hurling $1 trillion at bad banks somehow increases that “ownership premium”.

  • “How do you increase rents? By increasing people’s ability and willingness to pay; i.e. by increasing their real salaries; i.e., by increasing the value of their labor. ”
    The best way, though, would be to restrict new construction. The misallocation of capital caused builders to construct more housing units than we have people who want them. The solution, if our goal is to keep housing expensive, is to allow population to grow faster than housing units.

    I’m surprised we haven’t heard this proposed yet and sold as a program to limit suburban sprawl and protect our farmland.

  • jus me

    Hi Nemo –
    I know I’m being annoying, but I wonder if you make a CRVIX page, maybe without the graph?
    Can you poll the CR visitor count, say every 5 minutes, (or half hour or …), date & time stamp it, and post it as a text list?
    It would be interesting to capture the information, later on you or others could graph or slice & dice the data.
    But it would be nice to start capturing the data.
    Annoyingly yours,
    jus me

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