The proposal to create a government-financed agency to take the most toxic assets (such as subprime and Alt-A RMBS) off the balance sheets of the US banking system is not unexpected. The US Treasury is in fact already running a pilot scheme for this twenty-first century version of the RTC; it has been stepping up direct purchases of Fannie and Freddie mortgage bonds in the last couple of days.
But the scale of the additional proposed scheme (which I shall refer to as the Toxic Asset Dump (TAD, to mirror the TAF run by the Fed), which could easily reach $ 1 trillion or more, is likely to be much larger than the Treasury’s outright purchases of GSE mortgage-backed securities. Together with the US government’s blanket guarantee of the $3.4 trillion money market mutual funds (backed up initially with $50 billion of Exchange Stabilisation Fund resources), the socialisation of financial sector risk in the USSA is proceeding apace. We can expect a similar proposal for a publicly funded TAD in the UK before long.
Whether it will help or hurt long-run macroeconomic stability depends crucially on how it is designed and managed. Two features in particular will be crucial to the long-run financial health of the US economy
(1) Pricing. The price at which the illiquid assets will be acquired by the TAD will be crucial for its effect on future bank behaviour. Prices should be higher than what the banks that own these assets now can obtain in the market, but as far below their fundamental value as is consistent with the survival of these banks. This is both to protect the tax payer and to create the right incentives for future risk taking by the banks. Punitive pricing is therefore essential. If the banks and their shareholders don’t complain loudly about expropriation through under-pricing, then prices are too high.
Since those managing the agency are unlikely to have much of a clue about the fundamental value of these illiquid assets, the TAD should arrange reverse auctions as price discovery mechanism. I recommend a reverse Dutch auction as a particularly effective mechanism to transfer value from the banks to the tax payers.
(2) Political asset stripping.Many of the assets that will be sold to the TAD will be residential mortgage-backed securities or even residential mortgages. Unlike the commercial property that made up much of the assets liquidated by the RTC during and following the Savings and Loan crisis of the 1980s and early 1990s, the residential mortgages on the asset side of the TAD’s balance sheet will be at great risk of politically-motivated value evaporation. The pressure to ‘restructure’ or ‘renegotiate’ (i.e. to forgive (at least) in part) the individual residential mortgage debt acquired directly or indirectly by the TAD will be hard to resist. Indeed, the Democratic majority in Congress may well make the inclusion of such a mortage debt forgiveness feature a condition for supporting the scheme.
I think this would be unwise. The punitive pricing of any assets acquired by the TAD should discourage future reckless lending by the banks. Requiring the individuals who took out excessive mortgages to live with the consequences of their actions is the best mechanism for discouraging future reckless borrowing by would-be home owners. They were consenting adults. There is no efficiency or fairness argument for the tax payer to cough up resources to enable those who borrowed too much in the past to continue to live in houses they can no longer afford. Individual over-leveraged home owners also don’t constitute a threat to systemic stability.
Undoubtedly, populist blood vessels will be popping at the thought of banks getting bailed out while Mr & Mrs Middle America are having their unaffordable property repossessed, but I’m nor running for office, fortunately. The right time to address moral hazard is always now.