Prisoner’s Dilemma gone awry: The Paulson Plan
Tuesday, 9 September 2008 by Joscelynn TomawSince Fannie Mae and Freddie Mac have officially been “deprivatized” my Reader is en fuego with commentary about why the plan for the government to back covered bonds didn’t work out. This is my favorite and probably the most digestible. Since the formatting is a little off for some reason, here are excerpts:
John Hempton has an interesting take on the Frannie bailout: the markets forced Treasury to take this step by being irrational. It’s almost as though there was some kind of collusion going on.
Remember the prisoner’s dilemma? Given the choice between action A and action B, action B is always preferable from an individual’s perspective, holding everybody else’s actions constant. But if everybody chooses action A, then that’s the best result of all. Here, action A is refusing to buy agency bonds at wide spreads, while action B is believing in the government guarantee and buying them. And in this case, the prisoners didn’t confess.
The bond investors kept agency spreads wide, thereby forcing a government intervention — which is an even better outcome, for them, than a government guarantee which can be rescinded at any time. Yes, the government guarantee was real — but the bond market held out, and got an even better deal. Hempton says he’s “staggered” by this — it does seem to fly in the face of the common conception of how markets work. Which probably says quite a lot about how much we really understand of how markets work.
. . . . . . . . . . . .According to this theory, Fannie and Freddie would have been capable of raising money on their own — but then Paulson went and announced that he might (possibly, maybe, hopefully not) intervene with government cash. And as anybody who saw what went down at Bear Stearns knows, when Paulson intervenes, he intervenes with a vengeance, and shareholders are left with essentially nothing.
So on top of the normal risks of injecting new capital into leveraged entities with trillions of dollars of housing exposure, there was an extra political risk that all that capital could be wiped out at any time by an executive decision at 1500 Pennsylvania Avenue.
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September 9th, 2008 at 13:21
So, did the government’s gaurantee setup bond holders and stock holders to be opposed to each other about the health of the companies? Or is this always the case?
September 9th, 2008 at 13:59
Yes, stock and bond holders have opposing interests in regards to risk taking. Stocks gain value by “risk taking” which negatively affects bond ratings by jeopardizing the firm’s ability to pay bond holders.