Wednesday, March 25, 2009

Paul Krugman Is Right!

You didn't expect me to ever write that, right? But as it happens, he provides a pretty good explanation of why the Geithner plan represents a big government hand-out to investors participating in it.

A "nonrecourse loan" BTW, is a loan where your risk is limited to losing the asset which the loan was meant for. The creditor cannot demand that you compensate him if the value of that asset is lower than the value of the loan. In this case, this means that since the nonrecourse loan provides 85% of the financing, your potential loss if the return surprised on the downside is only 15%. But in case the return surprises on the upside, your potential gain is unlimited.

Meaning that even though the expected value of the asset is really only $100 from the point of view of the overall economy, the expected value is $130 for investors-and -$30 for the government using Krugman's illustration. The exact expected value would be smaller or greater depending on how big you assume the potential fluctuations are, but the bottom line that the plan represents a subsidy will hold as long as it is assumed to be possible that the asset could decline more than 15% in value. And you'd have to be pretty naive to think that no mortgage vacked security could fall more than 15% in value.


Blogger Ke said...

Krugman is not right. Although he condemns the plan, he condemns it for the wrong reasons. He's advocating for "qualitative" easing by buying up all toxic assets with federal money and doesn't like Geithner's plan because it is somewhat "market-based".

If Krugman was in charge, he would probably be much worse than Geithner.

7:12 PM  
Blogger stefankarlsson said...

I think I was very clear that he was right about Geithner misleading people when Geithner claimed that his plan didn't represent a big government subsidy to selected rich investors and that the plan would solve the financial crisis.

That however of course certainly doesn't mean that Krugman's alternative solutions are good, but these alternative schemes wasn't the topic here.

11:22 PM  
Blogger Ke said...

You were very clear, Stefan. My apologies. I just get irked whenever "Krugman" and "right" are in the same sentence.

1:25 AM  

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