Dangers facing this scenario this for three reasons

By allowing the takeover by the State of the "toxic" assets of the financial intermediaries, Paulson's plan offers potentially a good response to the current financial crisis. Everything will depend on the manner in which this plan will be implemented, because the devil is often in detail. The liquidity crisis which has survived was triggered by the doubts of the banks on the real value of the assets of the other banks.

To calculate a risk premium of an active market, it is necessary that buyers and sellers have objective to evaluate the probability of incidents on this asset. In the indescribable state of our markets and mistrust to assessment models, this common knowledge no longer exists.

However, as shown in many experimental studies, investors feel of ambiguity aversion, in the direction where to lose an asset with unknown probability is considered worse than to lose the same asset with an objective probability. This psychological trait becomes the engine of a haircut of value of these assets, as shown by different authors, including Lars-Peter Hansen of the University of Chicago or our Toulouse colleague Fabrice Collard, the inaugural conference of Chair Georges Meyer organized on this topic by the Toulouse School of Economics in Paris in early September. Assets in the assessment of the risk the more dubious undergo a premium of ambiguity which the cost is in addition to the risk premium. This premium seems to have reached astronomical levels. If healthy competition prevalent in auctions under Paulson's plan, the American taxpayer should benefit from this ambiguity premium that will decrease the prices of recovered assets.

Dangers facing this scenario, this for three reasons. First, the announced volume of redemptions in the plan is such that it can change the price of balance of toxic assets, that rise because of the significant increase in demand. Pending clarification of the form will take this request, you can also fear a hardening of the liquidity crisis, the players waiting to know how the plan will be implemented before considering any new transaction.

Second, the current holders have better information about these assets than the recipient State. This leads to the problem well known adverse selection: only holders of the most toxic assets will want to separate. The price that will emerge from the auction gives no clear indication to the market on the non-assigned assets, this will limit the beneficial effect on their liquidity.

Finally, recent events suggest that a solvency crisis adds to the liquidity crisis. Therefore, another objective of the plan could become to bail out financial institutions in poor health, which would cause the authorities to redeem their toxic above their value assets such that it can be inferred from the current market signals. In the absence of further information, it is impossible to know what will be this possible overvaluation, or what financial intermediaries it would benefit the most. To not assist less creditworthy banks, i.e. those that hold the assets derived from the most toxic credit, the State could organize auctions descending on a very heterogeneous to retrieve than the most undervalued classes asset classes by the market at a high price, are voluntarily creating a problem of adverse selection. In this case, the plan would fail to make liquid all the toxic assets. Worse, he would offer the highest bonus to those who have been most at risk, without consideration! Moral hazard, which is the source of the crisis, would be further strengthened. If the hypothesis of a solvency crisis support, another instrument, created by the Act finally passed last Friday, the participation in the capital of failing institutions, would take increased importance.