Monthly Archives: September 2008

by Ricardo Caballero and Pablo Kurlat

Hank Paulson’s $700bn “bailout” plan unleashed a flurry of alternative proposals, as most people recognize that time is running out. There is an urgent need for a significant intervention to break an accelerating downward spiral that is threatening the very survival of the financial core of the world economy.

Most proposals, including the one just agreed to by Congress, have in common a few general principles. First, they recognize the need to recapitalize the financial system and to improve the liquidity of several key asset and insurance markets. Second, there is agreement on the need to protect taxpayers by giving the government a share of the upside as well. Third, most see moral hazard as a reason to limit the extent of intervention and, in particular, to punish shareholders. Not doing so, the argument goes, would make future crises more likely as it would encourage the financial sector to repeat the excesses that caused the crisis in the first place.

We share the first two “principles” but are less persuaded by the third one. The main problem of the standard moral hazard view is its disregard for the incentive problems it generates within crises. In real life, unlike in many of our models, crises are not an instant but a time period. This time dimension creates ample opportunity for all sort of strategic decisions within a crisis. Distressed agents have to decide when and if to let go of their assets, knowing that a miscalculation on the right timing can be very costly. Speculators and strategic players have to decide when to reinforce a downward spiral, and when to stabilize it. Governments have to decide how long to wait before intervening, fully aware that delaying can be counterproductive, but that the political tempo may require that a full-blown crisis becomes observable for bickering to be put aside. Each of these agents is in the game of predicting what others are likely to do. In particular, the likelihood of a bailout and the form this is expected to take, change the incentives for both distressed firms and speculators within the crisis. These incentives are central, both to the resolution of the current crisis as well as for the severity of the next crises. 

By Lawrence Summers

Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. There are hugely important tactical issues regarding the deployment of these funds that the authorities will need to consider in the weeks and months ahead if the chance of containing the damage is to be maximised. I expect to return to these issues once the legislation is passed.

In the meantime, it is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs. 

By Ronald P. O’Hanley and Charles. J. Jacklin

Critics of the government’s financial rescue plan are rightly concerned about taxpayers getting stuck with a $700 billion tab that benefits Wall Street bankers.  No plan can be successful if it unduly enriches any of the participants at the expense of the taxpayer.

But does this rescue plan really need to be a ‘bailout’ in order to be successful?   Not if it is structured properly and strikes the right balance between protecting taxpayers and encouraging participation by the financial industry.  Remember how we got here: an increase in credit risk, a decrease in liquidity, and increased ambiguity of valuation.  The Treasury plan will not eliminate credit risk, and taxpayers should not bail out companies that made bad decisions.  However, Treasury can increase liquidity by increasing demand and can reduce ambiguity by providing transparency. The best way to do so is to put in place a reverse auction that can help lift the entire market.

Traditional auctions have one seller and many buyers competing on price.  But in this situation, there is likely, at least at first, to be only one buyer (the U.S. Treasury) and many potential sellers (all the banks holding these toxic securities).  Through such a reverse auction, these sellers would propose to the Treasury – and ultimately any other buyers willing to come into the market as co-investors – the lowest price they would accept for their eligible securities. This will help protect taxpayers from overpaying for these securities. 

By Jeffrey Garten

Even if the US’s massive financial rescue operation succeeds, it should be followed by something even more far-reaching – the establishment of a Global Monetary Authority to oversee markets that have become borderless. 

by Larry Kotlikoff and Perry Mehrling

The credit crisis is two problems not one, both a liquidity crisis and a solvency crisis, but they are interrelated problems and so too must be the solution.  We can solve both problems at the same time by having the government sell credit insurance policies of all kinds, and accept preferred stock as payment.  The credit insurance will set a floor on prices, and so restore liquidity.  The preferred stock issue will recapitalize banks that suffer from an eroded capital base on account of asset value writedowns.

Problem one is the crisis of liquidity.  One way to think about this dimension of the problem is that everyone wants to sell the assets and no one wants to buy, so the price of the assets is beaten down below fair value.  Another way to think about it is that everyone wants to buy credit insurance and no one wants to sell, so the price of insurance is bid above fair value. 

by Daniel Gros and Stefano Micossi

The US financial system is being nationalised. The piecemeal approach followed so far had clearly not been working. Hence the US political system is working overtime to reach a bipartisan agreement on a systemic solution. The centrepiece is already known: the US government is going to buy $700bn (€480bn, £380bn) of the so-called “toxic” assets. More measures are certain to follow as the banks will require recapitalisation to the extent that they make losses. As a result, the US government will soon own a large share of the US banking system. If the details are generous enough, this should be sufficient finally to restore orderly market conditions. Can Europe be far behind? 

by Simon Johnson and James Kwak

The government plans to bail out the banking sector by buying up to $700bn (for now) of “impaired assets” … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay “fair market value”, which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a “fire sale” and proposed paying “hold-to-maturity” prices. But what does this mean? 

by Gilad Livne and Alistair Milne

The credit crisis has had a seismic impact on the global financial landscape. A central reason is an unforeseen interaction of fair value accounting rules and the illiquidity of structured credit products. Firms are required to mark to market their large portfolios of structured credit products, but for most of these products there is no longer any functioning market. Instead, as has happened on several occasions, we observe cumulative death spirals, in which the only prices that can be used for valuation are based on the fear that a Lehman or similar large firm will implode, and thus forced to sell a large structured credit portfolio. Mounting fears bring about large mark to market losses, increase counterparty margins, and bring about the very implosion that is feared in the first place.

Clearly recapitalisation of the banking sector is needed. But this malign interaction of accounting rules and illiquidity actually creates an opportunity, making it possible to substantially recapitalise the banking sector at little cost either to taxpayers or to bank shareholders. We believe this can be achieved through a direct solution to the trading paralysis, the setting up of a specialised exchange to allow a large number of traders to exchange information and views on the value of the underlying structured credit products and conduct trades at fundamental not fire sale prices. Prices established in such an exchange will provide more reliable valuations than those emerging from current bilateral over the counter trading and restore much of the banking net worth that has vanished in recent months. 

by Martin Wolf  

By Luigi Zingales

When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity: the old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debtholders can agree to cut down the face value of debt, in exchange for some warrants. Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well-established approach not used to solve the financial sectors current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector. But at what price?