Friday, September 26, 2008

Should an equity position be an important part of the bailout?

Greg Mankiw quotes an anonymous "smart friend" to give a witheringly condescending dismissal of the popular idea that the taxpayers should get equity stakes in the firms they are helping to bail out. Here's an excerpt from Greg's "lil friend":

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."

not surprisingly Mr. Leonhardt took exception to the idea that he needs remedial training (probably didn't like the misspelling of his name much either):

Jonah Gelbach also takes issue here.

Modigliani-Miller (MM) is explained here.

My own view is the MM is a mighty thin reed on which to base an argument in this current situation (or perhaps even in any real world situation). I am not an expert on the capital structure literature, but the empirical evidence testing whether capital structure is irrelevant is far from being conclusive in MM's favor (check the introduction to this paper for example).

I actually think we'd all be at least slightly worse off if the MM theorem was taught in high school.

Here is a picture of my lil friend.


Todd McGreevy said...

Mr. Munger,
Just heard your interview on WLS radio. Thank you for your candor... the pablam on everything from NPR to "top of the hour" reading statements is enough to drive one nuts...

I am just learning of your candidacy and am very interested, will check it out.

I am hopeful that you can somehow get the following question onto the proverbial table in this so called debate about the bailout (or if you read the Wash Post or listen to W, the "rescue plan"):

What % of the $700B is actual non performing mortgages?
Assuming the Treasury is going to buy these "toxic assets" at less than face value, let's say 50 cents on the dollar, that would denote that there is $1.4 Trillion of non performing mortgages out there.

Does that make sense to anyone?

Can someone in Congress or heaven forbid in the media ASK THIS QUESTION please?

My father has done some analysis of the total number of houses purchased in the last 3 years and average values, etc... in his estimate there is at the most $100B in non performing mortgages.

He sent this to McCain's campaign and I sent it to Ron Paul's campaign... maybe Dr. Paul will get that on the table, we will see.

Meanwhile, it was reported this a.m. that WaMu had 9% of its deposits withdrawn which forced the FDIC to seize them... think about that for a minute.

The bank couldn't proffer more than 9% of its deposits that it says it has on hand, so it had to go down?

Wow. That fractional reserve banking really seems to be working well. Do you have any insight into this dynamic?

Finally, it has been reported in the WSJ that the FDIC has over 100 banks on its secret "watch list" of banks that might fail soon.

What % of banks in America is that?

I look forward to reading your blog and hopefully hearing you more on WLS.

I don't know if you can email me back via this tool, but if you would like a copy of my father's analysis please do so.

Todd McGreevy

Christoph said...

It's a bit scary to say this, given that I'm only a grad student and Mankiw is, well, Mankiw. But it seems to me that he (or his friend) is way off here. Despite his assertions, the whole point of the bailout is to overpay the assets. If not, government can just leave the buying and selling to the market. Therefore, the price the taxpayers have to pay will not increase if they demand equity in exchange. Merely the windfall for current owners will be capped. The M-M theorem requires to efficient markets; the idea of the bailout is based on the assumption that markets are failing. Thus, the two don't have anything to do with each other.

br said...

No economic model is going to convince me that it's a good idea for a government to buy (eg acquire equity in) companies, especially governments with fiat currency.

Christoph said...

br, I agree with you. On the other hand, once the government is spending money already it can just as well get something in return. Better yet in my opinion would be to keep the money in the first place.