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. Read more

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. Read more

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? Read more

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. Read more