This percentage of cash is actually pretty small and most banks are leveraged 10-15x. This is called a fractional reserve system. Because of leverage, a mere 10% decline in total assets would completely wipe out a bank. In this case we're not talking about total assets, but we're talking about a good chunk and a lot larger than 10%. For instance Citibank and JP Morgan not only have over a trillion dollars of “level 3″ assets (this means that their accounted value is based on a “model”…that is now probably overstating by at least 20%) but they also are engaged in tens of trillions in swaps. A mere 20% drop in level 3 assets or a very small percentage of decrease in swaps means they they would be wiped out.

This is why the plan has to overpay. If it paid anywhere close to market value then the banks would have to adjust the value of their holdings and it would bring their actual cash reserves to way below regulatory requirements. This is why they say the program as written doesn't address the root cause, which is that there is too little money to support too much debt.

A liquidity problem means that there is a temporary situation normally caused by fear. Let's say that there is a perfectly good bank and someone spreads a rumor that they are going bad (this used to happen all the time before the central bank, sometimes by competitors) and so everyone went to withdraw money. If the central bank gives them a temporary loan they can prove that they are solvent and their assets are ok and the crisis goes away.

This isn't a liquidity problem, this is a solvency problem. The entire world has much more debt than can be serviced. Things are going down not because of a temporary panic, but the realization that too much of the value of things is built on top of debt instead of actual money. The actual implications of this are pretty complex and I am going to write a post today I think to talk about things on a general level and focus the discussion.

The stuff at the link increases my apprehension that I'm off the road of reason, since you guys (including Mr K) are certainly smarter and more knowledgeable than me, but I can't go along with what I'm reading. For instance, from the primary link:

'â??Itâ??s easy to forget amid all the fancy stuff â?? credit derivatives, swaps â?? that the root cause of all this is declining house prices. If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it.â?
Alan S. Blinder, Princeton economist, and former vice chairman of the Federal Reserve Board of Governors, Sept 20, 2008'

This seems wrong, to me. It's declining house prices that triggered this problem, but what I think we're dealing with now is a confidence problem. If everyone knew who was exposed, due to declining prices, to bad mortgages, and how much their exposure was, those entities would suffer, and may have had to be bailed out. The problem is that no one knows, and no one wants to take the time to find out. What they want to do is to get their money into investments whose value they can estimate. That means, no one wants to have anything to do with financial institutions, because they'd have to try to compute the soundness/solvency of that institution, and no one wants to do that. Instead they'll move into treasures and commodities and anything but financials. What Paulson wants to do is to take the uncertainty away by getting rid of the need to try and estimate a financial firm's exposure, so people will go back to lending those firms the money they need to operate. This has nothing to do with the underlying price of housing. It's all about making these firms look solid enough to be good investments/borrowers.

Mr K, touches on this, but I think his argument is somewhat disconnected (I know, he was writing a blog post, not a white-paper, but still, it's what I have). First, he says,

“The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system â?? that is, convince creditors of troubled institutions that everythingâ??s OK â?? simply by buying assets off these institutions.”

Which, of course, I agree with. But, then:

“This will only work if the prices Treasury pays are much higher than current market prices;…”

Why is this true? What I can see is that that the financials will need some price that keeps them solvent. But, why does that have to be higher than the current market price, which no one really knows, anyway?

Then, he says,

“…that, in turn, can only be true either if this is mainly a liquidity problem â?? which seems doubtful â??…”

Why is it doubtful? To me all the evidence indicates that it is precisely a liquidity problem. What's the evidence that it isn't?

Then,

“…or if Treasury is going to be paying a huge premium, in effect throwing taxpayersâ?? money at the financial world.”

OK. So, what? Maybe there's something morally, even politically, wrong with doing this. But, why does that mean it won't work?

Getting back to the primary link, CR says:

“…determining price will be difficult. And what happens if a price can be determined?”

I'm arguing that this is exactly the problem; that no one wants to determine the price (e.g., the asset value). The government's job, in this case, will be to set a price, based on other than market (profit maximizing) considerations. Hence, my example of the Treasury figuring out the asset value required to keep the financial firm solvent, and buying at (or even just guaranteeing) that price. This will give the asset a solid value and will (hopefully) stop the bed-wetting about whether the firm is going to declare another write-down, or go bankrupt. The value of the underlying property doesn't matter. The house could burn down, or fall into a sinkhole. The price has to be set such that the financial firms can get back to the business of finding the next quick-buck scheme, and the government can then try to work out who's to blame, who can and cannot be punished, and how to stop the same thing from happening again without going totally socialist.

Again, thanks, for this discussion. It's certainly helping me focus!

This explains why the proposal will not work and is just a waste of money. Paul Krugman agrees. I am not as optimistic that we can prevent bad stuff from happening but if we used the same amount of money to recapitalize failed banks then it would be a much better idea.

Letting everything fall in price in any fashion will lead to a lot of deflation so we would probably enter one of the most severe recessions we've faced but the alternative would lead to massive inflation and still not put banks in a healthy situation. I seriously hope that a plan like the one I linked is adopted rather than the terrible bill as it currently stands — that bill is even worse because it gives the secretary of the treasury full power to do anything and is not reviewable by the courts or congress.

You say, “…we'll be far worse off than if we had done nothing.” What do you think will happen if we do nothing? Paulson and friends told the folks from Congress that we were looking at an absolute freeze-up of credit markets. Do you think that's an exaggeration? Do you think that the economy can take such a freeze-up without freezing-up, itself? What would be worse than that?

We know that banning short selling won't do any good. In markets that don't have it they have much more volatility and it's easier to crash. The options market is extremely important in maintaining stability and it's going to have to close unless they make an exception.

Here, the whole charade was done after the 29 stock market crash and before the bad part of the Great Depression. All the stuff — from the Fed taking junk as collateral for swaps to Congress trying to buy bad debt was done. None of it worked.

It worked to an extent Japan but as this points out that was because they had a ton of money saved. We owe $10 trillion already.

All these actions are going to make it much less likely that the people that actually have money are going to move it away from the US. Every single thing we're doing supposes that the world will destroy itself to prop up the US. That gamble is a huge one to take, and if we lose (which I think we will) then there is absolutely nothing we can do and we'll be far worse off than if we had done nothing.

The idea, here, is to Calm Everybody Down. The idea is to convince people that somebody is in charge and is doing something to reign in this panicked, sweating, snorting, runaway, steed. A slogan of FDR's administration, at the beginning, was, “For God's sake, do something!”

No one knows if shutting of short-selling will do any good. But, just about everyone (except, apparently, the folks at TMV knows that is something has to be done. If this doesn't work, they'll try something else. They, our representatives, seem determined to go down fighting, and I applaud them for it.

It's not _that_ hard, really.