The $ 700 bn requested from Congress by Treasury Secretary Paulson to buy up bad mortgage-backed and mortgage-based securities from American banks is not going to solve the crisis, although it can be part of a solution. I assume that $700 bn will allow the purchase by the US Treasury (or its agents) of at least $2 trillion worth of mortgage-related securities at face value, as it would not make sense for the US tax payer to pay much more than 33 cents on the dollar for the mortgage-related rubbish that banks have loaded onto their balance sheets. Pricing the assets punitively makes it possible to save the financial system while punishing the financial sinners at the same time. The right time to address moral hazard is always now.
But the US banks have large amounts of bad assets on their books (if not on their balance sheets) that are not mortgage-related. Basically, any financial instrument that implies significant exposure to the US household sector is dodgy and doubtful. That includes automobile loans (secured against the vehicles) and other secured and unsecured household borrowing, including, say, ABS backed by credit card receivables. There is also exposure to the business end of the construction sector, such as commercial and industrial mortgages, secured and unsecured loans to construction companies and developers etc. etc. I expect that Secretary Paulson or his successor will, if Congress grants the $700 bn request, be back for more before long. Probably at least another $700 bn, as it is unlikely that a crisis of the magnitude we are witnessing will be resolved without the tax payer coughing up at least 10 percent of annual GDP. US GDP for 2008 is likely to be around $14.5 trillion, so you can do the arithmetic.
Paulson’s proposal creates what Anne Sibert and I have called a ‘market maker of last resort’ for some of the toxic assets of the banking system. But is does not, in and of itself, solve the problem of an overleveraged/undercapitalised US financial system. To get new capital into the banks, and to reduce leverage dramatically at the same time, I propose a mandatory debt-for-equity swap for all US financial institutions. For the most junior debt (subordinated or tier one debt), 100% could be swapped for equity. For more senior debt, the share of the notional or face value of the debt that is subject to compulsory conversion into equity (preferred or common stock) would be lower. Even the most senior debt should, however, be subject to a non-trivial ‘conversion ratio’ – 25 percent, say.
This form of debt forgiveness would not extinguish the claims of the current creditors, but would convert them into equity – a pro-rated claim on the profits – if any – of the banks. It would have the further benefit of diluting the existing shareholders – a desirable action both from the perspective of fairness (I was going to say equity!) and from an efficiency point of view: incentives for a repeat of past incompetence, reckless lending and mindless investment would be mightily diminished.
The proposal amounts to a compulsory re-assignment of property rights – a form of expropriation. So be it. Extreme circumstances require extreme measures. It is time for the creditors of the banks to make a more significant contribution to the resolution of the financial crisis and to the prevention of an economic crisis.