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Are Paulson and Bernanke Fear-Mongering?



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I wrote a post called “Irresponsible Folly” on Monday that harshly criticized House Republicans who voted against the bailout. Within about two hours, I received over 250 emails, almost all critical of my views (topping the previous record for negative emails received after my critical “Wilma Jennings Bryan” post about Sarah Palin’s acceptance speech). The vast majority of these emails were civil, intelligent and principled. Almost half of them asked some version of what I consider to be an excellent question: “How do we know that we really are at risk for a financial catastrophe if we don’t pass a bailout?”

Contagion — a cascading series of defaults resulting in a loss of confidence in financial institutions, and therefore in a severe economic contraction that hurts just about everybody, whether they were responsible or irresponsible about debt – is the catastrophic scenario that Paulson and Bernanke are asserting is a real risk for us. There are different levels of potential pain. It looks like we’ve moved past the “only the foolish get burned”, and “only the foolish plus rich speculators get burned” levels. The next level is a serious recession in which normal policy tools and the normal operation of the market can correct things. The next level is something like the Great Depression, or full-scale contagion. The true nightmare scenario (yes, even worse) is a loss of confidence in the ability of the U.S government to make good on its obligations. This would result in a run on the dollar, which is to say a run on the big bank called the U.S. government based on a loss of confidence by investors, both foreign and domestic.

This is all easy to say, but what are the odds of any of these negative scenarios occurring?

Let’s start with the observation that we had an almost perfect natural experiment on Monday to measure equity market reactions to a reduction in the probability of a bailout. The widely-tracked Dow (a stock market index that is a very imperfect proxy for the U.S. stock market) lost about 780 points yesterday. That is a really bad day, but on a percentage basis, not even in the top 10 worst days in the history of the Dow. Further, if you look at the Dow minute-by-minute through the day, it opened down, then traded very steadily until 1:30PM when vote results started to come in, then fell off a cliff, and was down about 540 points from 1:30PM to the close. It’s impossible to isolate reliably the impact of any single piece of information in one of these exercises, but I think it’s a fair guess to say the market (or, more precisely, the Dow proxy) lost about 500 points when it integrated the information that the bailout bill had not passed. Reasonable confirmation of this estimate is that as confidence rose during the day Tuesday that a bailout will, in fact, be passed, the Dow went up by about 500 points. To compare this to a random big number, this represents a loss Monday and then a gain back Tuesday of a little more than $700BB of market value.

Now, the probability that the bailout will be made into law sometime soon was not 100% Monday morning, and was not 0% Monday night. In fact, I think most observers believe that some plan somewhat like the modified Paulson plan is more likely than not to pass sometime soon. To pick rough numbers out of the air, let’s assume that the odds of passage dropped from 9-in-10 to 3-in-4 on Monday afternoon when the bill failed. The reduction in odds of passage would have gone from 90% to 75%, or been reduced by 15%. So the market went down about 500 points in response to a 15% reduction in odds of passing. (In addition to being wild guesses for numbers, this is a gross simplification of the real market calculus of the degradation of the probability cloud of possible outcomes, e.g., odds of passage at all, odds of specific worse kinds of bills passing, increased time-at-risk while the debate continues, etc.) So a crude estimate of the reduction in equity value attributable to certain failure of the bill is something like 500 / 15%, or a 3,300 point decline in the Dow. Apparently Paulson and Bernanke have put forth an estimate to congressional leaders that the equity market impact of not passing legislation to address the debt crisis would be “3,000 to 4,000 points”. So far, then, they seem to be doing OK in the prediction department.

How big would a 3,300 point drop in the Dow be? That’s about a 30% decline versus the Dow at 1:30PM yesterday — from 10,907 to 7,607. It would also be about a 50% decline vs. the peak of last July. How bad would that be? That’s a really severe bear market, but not necessarily disaster. The Dow dropped 22.6% in one day in 1987, and there weren’t exactly armies of Joads wandering America in 1988. It’s possible that even if this occurred, we would muddle through with a typical recession, or in an extraordinarily sunny case, no recession at all.

So what’s the big deal then — on what basis could we justify such a huge market intervention if even the bad case just isn’t that bad? Remember that this decline would not be the catastrophe; it would be the bet of the stock market about the odds-adjusted loss in expected future collection of money (from the perspective of equity holders) from businesses. Part of this decline would reflect the loss in expected value from the odds-adjusted impact of the normal recession scenario, and part would reflect the odds of a true Great Depression-style scenario.

How can we estimate a way to break-out these odds? Bear markets come and go, but there were four huge bear markets for the Dow in the 20th century: 1906-1907, 1912-1914, 1928-1932, and 1972-1974. In each of them the Dow declined around 40% in the first two years (a little more in the 1928-1932 case). Three of the four then stopped declining. In the 1928 – 1932 case, it kept going for two more years, ultimately declining more than 80% from its peak, and signaling the Great Depression. 25% of these mega-bear markets didn’t find a floor, and just kept going down. Given the amount of poorly understood debt permeating the U.S. economy right now in combination with ongoing collapse of the real estate bubble, the mechanism by which a 50% decline from July 2007 to October 2008 could continue and expand into full-scale contagion is quite clear. Once this gets going, it would be extraordinarily hard to stop.

So a very rough guess is that if we do absolutely nothing about the credit crisis, we are running something like a 25% chance of a true catastrophe at the level of the Great Depression. I’ve gone through the assumptions of my analysis; you can play with them at leisure, but I think you’d be very hard put to end up with an estimate that is less than 10% or greater than 50%.

Each day they leave this problem unaddressed, Congress is basically flicking a lit match at a lake of gasoline. But, hey, it hasn’t caught fire yet, and maybe we’ll stay lucky.



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