Gulp! The $2 trillion gamble

It appears that we, the taxpayers, are betting $2 trillion dollars and the next 10 years on the right answer to this question of what the nation's housing stock is worth: (a) the banks made lousy loans and leveraged their exposure, so that their assets are now worthless (b) the housing market seized up, but the houses that the loans went for are eventually are worth something

Paul Krugman believes that the answer is (a) and that unless the government bites the bullets, wipes out the banks' existing shareholders and installs new management with a clean slate, we are hosed.   He explains here:

Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.

On the other hand, the Obama administration believes that the answer is (b).  They are planning to put up capital, get it managed by financial managers (who themselves put up a 20% stake) and hold the mortages, if necessary, to maturity.  Brad DeLong explains here:

The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

The newspaper accounts, not surprisingly, are worthless -- you'd do better to get the bottom-line from experts than from journalists imperfectly channeling experts and laboring under some illusion of balance.

What do I think? I think it's a huge, huge gamble.  However, the US population is growing; people highly prefer single-family homes and the quality of childrens' education is tied highly to real-estate. So, in the next 3-5 years, we'll burn through the surplus of homes.  Nothing we've seen indicates that the homes themselves are shoddy -- there hasn't been any epidemic of corrupt home inspectors to go with the corrupt appraisers, mortage brokers, lenders and insurers.  So, I'm hoping that the Obama administration is correct, and that (in DeLong's words):

At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.