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The wrong kind of bail-out?
September 22, 2008
An excellent column by Sebastian Mallaby looks at the unfolding Fed-Treasury plan and finds it wanting:
The plan is being marketed under false pretenses. Supporters have invoked the shining success of the Resolution Trust Corporation as justification and precedent. But the RTC, which was created in 1989 to clean up the wreckage of the savings-and-loan crisis, bears little resemblance to what is being contemplated now. The RTC collected and eventually sold off loans made by thrifts that had gone bust. The administration proposes to buy up bad loans before the lenders go bust. This difference raises several questions.
The first is whether the bailout is necessary. In 1989, there was no choice. The federal government insured the thrifts, so when they failed, the feds were left holding their loans; the RTC’s job was simply to get rid of them. But in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice. It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks. There are cheaper ways to stabilize the system.
In the 1980s, the government did not need a strategy to decide which bad loans to take over; it dealt with anything that fell into its lap as a result of a thrift bankruptcy. But under the current proposal, the government would go out and shop for bad loans. These come in all shapes and sizes, so the government would have to judge what type of loans it wants. They are illiquid, so it’s hard to know how to value them. Bad loans are weighing down the financial system precisely because private-sector experts can’t determine their worth. The government would have no better handle on the problem.
In practice this means the government would make subjective choices about which bad loans to buy, and it would pay more than fair value. Billions in taxpayer money would be transferred to the shareholders and creditors of banks, and the banks from which the government bought most loans would be subsidized more than their rivals. If the government bought the most from the sickest institutions, it would be slowing the healthy process in which strong players buy up the weak, delaying an eventual recovery. The haggling over which banks got to unload the most would drag on for months. So the hope that this “systematic” plan can be a near-term substitute for ad hoc AIG-style bailouts is illusory.
I’m a little reluctant to second-guess the proposal put together by Bernanke and Paulson because I don’t know everything the Fed knows about the fragility of the credit markets and the urgency of the case. But I agree that the RTC analogy is wrong, and the column is surely right about the problems the Fed-Treasury plan faces. The article goes on to mention separate alternative proposals by Charles Calomiris and Raghuram Rajan. Both stress the need to recapitalise the banks. Calomiris would do it through government purchases of equity, Rajan through mandatory rights issues and a prohibition of bank dividend payments.
You can read fuller statements of these interesting proposals here and here on Martin Wolf’s FT economists’ forum. (Be sure to read Willem Buiter’s comments on each article as well.) These ideas definitely have attractive features–but, to put it mildly, they are not without difficulty and involve complications of their own. For instance, Rajan says:
I suggest restricting the rights requirement only to well-capitalised entities. This may seem like penalising shareholders of well-performing companies. But in fact these are institutions that could use more capital very profitably in buying underpriced assets, and taking over weaker financial companies. Authorities could also reward these companies by facilitating acquisitions, possibly through favourable tax treatment. By contrast, forcing weak companies to issue rights risks tanking an already fragile share price, and is not a risk worth taking at this juncture.
Agreed: but how do we define a “well-capitalised entity” for the purposes of this mandate? If the bar is set too low, the “risk not worth taking” in that last sentence comes into play. Calomiris says:
To ensure that MPS [Matched Preferred Stock–his proposal for government purchases of equity] is only supplied as truly needed from a systemic standpoint, and to limit any abuse of the taxpayer-provided subsidy, the private sector would also be required to act collectively to help recapitalize undercapitalized banks, and share the risks associated with recapitalizing banks.
Specifically, to qualify for MPS assistance from the government, a bank would have to first obtain approval from “the Syndicate” of private banks (including the major institutions who would benefit from the plan as well as others who would benefit from the reduction in systemic risk) to commit to underwrite common stock of the institution receiving MPS in an amount equal to, say, at least 50 per cent of the amount of MPS it is applying for (at a price agreed between the Syndicate and the bank at the time of its application fro MPS). The Syndicate would share the underwriting burden on some pro rata basis. To support that underwriting, the Syndicate would have access to a line of credit from the US government (and from other countries’ governments, if non-US banks participate in the MPS system)… For banks participating in the MPS plan that are based outside the US, foreign governments would have to provide the MPS investments. Presumably, those foreign governments would also provide the credit line commitment to the syndicate for its underwriting of common stock.
Much as I like this plan in principle, I don’t think I would celebrate simplicity as one of its chief virtues.
It will be interesting to see whether Congress insists on a debate of these and other alternative strategies, or concentrates merely on larding the Paulson-Bernanke approach with additional subsidies for distressed home-buyers.
I am happy to see that Congress is resisting the pressure from the Bush Administration to immediately agree with its proposal which seems to permit any Treasury Secretary to decide what he (presumably) wants to do with a $700 billion slush fund.
The chorus of statements that “there is no alternative” is starting to lose resonance now that others, including those cited by Mr. Crook, are in fact presenting alternatives.
The forced debt-to-equity conversion suggested by Prof. Buiter is appealing since it permits all existing banks to operate with new equity and little debt while shareholders and lenders to the banks themselves will absorb the losses - assuming there are any - over time as the assets behind the mortgage liabilities are gradually liquidate. Ultimately it is the liquidation of the housing collateral on an “orderly market basis” that will determine any ultimate realized losses or gains although gains are unlikely.
As usual it is astonishing to see the very institutions that are heavily guilty of essentially fraudulent activity, e.g. investment bank packagers of mortgage-backed securities that are a major cause of the currrent “crisis”, aggressively solicit the expected business from managing the securities acquired by the federal government, along with vulture funds that specialize in “distressed” debt that are looking for bargains. The potential for gross self-dealing on the legislation to create a fund is simply too great.
The alternatives mentioned, plus others that will surely be proposed shortly, have to be considered.
Posted by: Wendell Murray | September 22nd, 2008 at 7:23 pm | Report this commentThe Democrats should also stand firm and refuse to accept any package that does not let bankruptcy judges adjust mortgage interest rates that are due to reset to much higher levels, since many of the resets were agreed to only because of fraud on the part of the lenders.
They should also insist on limits on pay for Wall Street executives. There is no reason for the Democrats not to stand firm on these two issues of basic equity and justice. They hold all the cards. If they cannot play them, what use is the Democratic party at all?
Posted by: algasema | September 22nd, 2008 at 11:36 pm | Report this commentNot possible to legislate compensation but Congress can change the tax code to dramatically increase the marginal tax rate at successively higher levels of income so the wasted resources on grossly excessive compensation will either go to public coffers or not be paid at all. More likely the latter.
Unfortunately, from the sounds of the current political jockeying the slush fund will be created - unnecessary and essentially outrageous - but the Democrats will merely demand their portion of the funds to satisfy their constituencies while the Republicans give theirs all back to those who caused the original problem of course. All while fleecing the average taxpayer who foots the bill but in total reaps none of the rewards.
No courage among Democrats.
Although I consider Newt Gingrich a classic windbag on any topic, I agree with him on his opposition to this proposal. He thinks some Republicans will not agree. The pressure on Republican Congressmembers is enormous to “go along” however, so I doubt there is sufficient courage among Republicans either
Posted by: Wendell Murray | September 23rd, 2008 at 12:01 am | Report this commentDear Mr. Crook - See Karl Denniger’s videos on what Paulson has been and is currently up to, a peak at the treasury secretary’s hidden agenda, as he tries to convince our reps to let him hook his siphon to our future economy, to suck us and our kids and their kids dry, http://www.fedupusa.org/.
Mr. Denninger’s common sense plan: First we have to re-establish trust in the markets by 1. balance sheet transparency 2. give all banks 6 months to reduce their leverage (some are at 80:1!) to 12:1 and 3. credit default swaps - put these on a regulated exchange and null out the bad ones.
Posted by: Maggie Knowles | September 23rd, 2008 at 5:12 pm | Report this commentAs many are saying in D.C. : the sub-prime debacle is just 250 billion dollars, the other 450 billion dollars is the amount of debt-insurance-bonds-stock-futures-swaps that A.I.G. holds over many Hedge-Funds like a sword, and these Hedge-Funds are the biggest stockholders and bondholders in key Military-Security and Intelligence Contractors in the Iraq-Afghanistan War and elsewhere, that’s what we are bailing out: the War Machine, which the Hedge Funds will “outsource”, move-out, slide out and drag out to Bermuda, Cayman Islands,Gibraltar ,Switzerland and other safe tax exempt shelters, isn’t wonderful ?
it’s the Military Contracts what they are after, and to move them out of the country, to run the War like an international operation,tax-free and oversight-free, amazing,eh?
and the Politicos in D.C. talking about terrorism overseas !
Posted by: financialtools1 | September 23rd, 2008 at 5:43 pm | Report this commentCC is at the intersection of politics and economics in Washington? Now that the FBI has been called in to investigate a.o. AIG, Fan & Fred , and Lehman Bros too? there must be near-panic on Wall Street, that fascinating hotbed of gossip and rumour. Who knows what else about who else the FBI investigators will hear / discover during their investigations. I assume the sales of copies of the FT have soared.
P.S. Who instigates an FBI investigation? The Secy of State for Justice.
Posted by: J.J. | September 24th, 2008 at 10:56 am | Report this commentJ.J., the FBI is part of the Department of Justice, nominally subject to the Attorney General, but for a very long time, semi - independent in reality. This was particularly true under its legendary and much hated (especially by liberals like myself) director, J. Edgar Hoover, who became so powerful by the simple expedient of collecting dirt on people to use as blackmail that even Bobby Kennedy, JFK’s brother and Attorney General, was afraid to fire him.
Hoover, by the way, hated and despised Martin Luther King and did everything possible to undermine him - giving a lot of grist to the conspiracy theory mill since, of course, King was eventually assassinated (along with Robert Kennedy, not to mention JFK himself).
Now, a more responsible and respected (yet still hardly apolitical) FBI has been reportedly investigating mortgage lenders for fraud for at least a year. This is why, with all due respect for Ted’s post under one of Clive Crook’s other recent articles, it is very hard to buy the notion that the subprime meltdown was due to all those scheming, conniving, immigrant, African-American and elderly borrowers who took advantage of the naive, trusting lenders. Ted blames the mortgage brokers.
Which side, exactly, were these mortgage brokers working for? With his stated many years of experience as a real estate attorney at title insurer, Ted certainly knows the answer to that question better than anyone.
Posted by: algasema | September 24th, 2008 at 1:34 pm | Report this comment“real estate attorney and title insurer”, not “at title insurer”. Algasemia runs rampant in the morning (and during the rest of the day as well).
Posted by: algasema | September 24th, 2008 at 1:37 pm | Report this commentAgasema. Who is Ted? Who is in charge at the FBI? I’m just wondering if the great rush to get the USD700B rescue package approved by Congress is connected with the fact that
the appearance of the FBI on Wall Street was maybe known to be imminent? But maybe I’ve been watching too many old movies on TCM?
Algasemia. Dnot’t wrory, Algy, Im not feelg too clevr today either. It’s probibly the weather.
Posted by: J.J. | September 24th, 2008 at 1:55 pm | Report this commentMst be the wethr, J.J. I aggree. With regard to the FBI on Wall Street, maybe some of the executives rumored to be under investigation might eventually need the bailout in order to post bail?
Posted by: algasema | September 24th, 2008 at 7:24 pm | Report this commentalgasema. You are probably right that at least some of the bailout might be used as you suspect.
Btw, I have just watched Paulson live on CNN in a continuation of the same topic, but he clearly said, imo, that the ASSETS which will be bought up using the USD700B will later be bought by “private investors” (sic), and so the banks will be recapitalized. Did I understand Paulson right?
As the USD700B bailout will be at the cost of the US taxpayer, the US taxpayer could do a direct deal with the banks and cut out the “private investors” as follows:
In exchange for each “bailout”, the “state” will receive shares to the same amount in each “bailed out” bank/financial institution?
Then the state can be represented on the boards of these bailed-out financial institutions.
Such “state watchdogs” are quite usual in Germany for example; they don’t always prevent
Posted by: J.J. | September 24th, 2008 at 8:40 pm | Report this commentsalaries are paid to themselves or to their colleagues on the boards, i.e.
the catastrophes, but they have certainly ensured that no astronomically high salaries (as in Wall Street) are paid to directors/the management. And the question of massively-overpaid managers is part of the current debate, is it not?
Apologies! The last para. in my msg of 8.40h, shd read as follows:
Such “state watchdogs” (representing the interests of the state i.e. the taxpayers) are quite usual in Germany for example; they don’t always prevent catastrophes, but they have certainly ensured that no astronomically high salaries (as in Wall Street) are paid to the management/the directors. And the question of massively overpaid managers is part of the current debate in the USA, is it not?
Posted by: J.J. | September 24th, 2008 at 8:49 pm | Report this commentOne plan which is actually working in this market is worth considering.
The plan consists of not buying the bad securities but giving the financial institution a loan on tough terms to enable them to clear up their own mess, It also includes taking warrants on the equity of the financial institution. If Congress grants authority to make such loans where needed, I think that the demand will turn out to be substantially less than $700 billion.
This is the plan as offered to and accepted by Goldman Sachs, from Berkshire Hathaway. I think of it as the Buffet plan, even though he (”not in pro bono mode”) would rather see Berkshire Hathaway profit from the Paulson bail-out.
Posted by: David Heigham | September 25th, 2008 at 4:35 pm | Report this commentThe government should not purchase the “Bad Debts” that banks have accumulated voluntarily. Rather, it should “Loan” the bailout money to the banks to allow them to have liquidity to make future loans. Thus the Federal Govenrmnet would receive a reasonable rate of return on its investment (using terms as it did with AIG) and the banks would be forced to address the toxic loan issues that they generated.
Posted by: David Mitchell | September 26th, 2008 at 1:57 pm | Report this comment