Are the American people really gullible enough to buy into Hank Paulson’s $700 billion bailout plan? Unfortunately, it seems so. After all, most bought into the Patriot Act in 2001 and the Federal Reserve Act in 1913. The consequences of Paulson’s bill, however, will be dire, says Dan Denning. For a start, it will involve the government buying bad debt from banksat “hold-to-maturity” prices - that is, a ways above their market price.

This from The Daily Reckoning Australia:

Paulson and Bernanke argue that the fund (likely managed by either Goldman or Morgan, for a fee, of course) should not pay low, real-world prices for the bad debt. The market price of the bad assets is what Bernanke calls a “fire-sale” price. And that is bad, apparently (don’t ever try to go discount shopping with Ben Bernanke).

As we mentioned earlier this week, forcing the banks to sell at fire-sale prices doesn’t improve their capital position. So Paulson and Bernanke have advanced the theory that the tax-payer should pay the “hold-to-maturity” price for the securities. That price, as you might guess, is much higher than the “fire sale” (market) price.

Some people like paying higher prices simply because they can. It makes them feel rich, especially when they’re paying with other people’s money.

Hang on, though. What is the “hold-to-maturity” price? No one knows! Paulson and Bernanke argue that many of the mortgages will come good once the storm passes, and that the assets the taxpayer buys today at “hold-to-maturity” price might actually be a good investment in the proverbial “long term.”

Gag.

Wretch.

Here’s what we guess will happen. The Paulson plan is an attempt at price controls. Only here, the Plan is to value the impaired asset-backed securities much higher than the market values them at. This will not create a scarcity (as is the case with price controls in the stock market). It will create a surplus! How is that possible?

As Thomas Sowell explains, “A price set above the free market level tends to cause more to be supplied than demanded, creating a surplus…It is often lost sight of in the swirl of more complex events and more politically popular beliefs.”

Translation: if the Paulson plan offers a higher price for assets than the market price, the banks have every incentive to off-load as many assets as they can. They increase the supply of assets for sale that they consider the riskiest. And why not? If someone pays you to get rid of your biggest liabilities, wouldn’t take advantage of it too? If you could sell your garbage for gold, wouldn’t all of your possessions suddenly look like garbage?

A better plan might be to slap a multi-year freeze on the valuation of the suspect assets and leave them on bank balance sheets. Just let the banks carry them on the balance sheet, Japan style, without having to mark them to market. Let them unwind the bad debts over time, rather than going out of business, or transferring the whole mess to the Federal balance sheet.

Not that we like that solution. And it certainly doesn’t address the “root cause” of the problem. The assets the securities are tied to, American homes, are falling in value. As far as we can tell, there’s no way to slap a price control on those and keep them from falling.

But the Denning Plan - leaving the toxic waste on the balance sheets of the folks who created it - seems more just than the Paulson Plan.

Source: A Violation of Public Trust