Sunday, January 18, 2009

Thoughts On Sheila Bair's Bad Bank Solution

Does FDIC's Sheila Bair's idea of using government funds to buy bad, toxic assets at banks at a 'fair value' price that is above current prices make economic sense?

If you believe that markets price assets at or close to fair value all or most of the time, then the only solution is for the government to overpay for the banks' assets. Having this idea is to align oneself with efficient, rational markets theorists.

If you believe markets can misprice assets and under or over value them for a sustained period and that the market will eventually correct itself, then purchasing the assets from banks above current prices will be the correct action. In this scenario, one sees the banks as unfairly penalized for market disruptions that are beyond their control.

If you believe that market prices are mostly right, then it is inconsistent to believe that there was a housing bubble. Then, the recent decline in house prices is a rational response to expected economic forces as yet not fully disclosed.

Bair, other government officials, many politicians, and more than a few economists believe there was a housing bubble and that house prices were not rational. Going from believing in mispriced house prices to mispriced mortgage and other bank assets is a tiny step.

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