Wednesday, September 24, 2008

Alternatives to Paulson plan

Or what needs to happen.
Mark Thoma has a summary:
1. Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer. The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly [and this leads to the "paradox of deleveraging", see Krugman's description]). By having the government trade for these frozen assets (some of which are perfectly fine) and replace them with safe, low risk or risk free assets, the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing.

That's an illiquidity problem. It's caused by toxic assets, the hidden ones freeze up the whole system since nobody wants to end up with them. Why give up cash unless the interest rate is really, really high, too high?

2. The other problem is solvency. Now, some people think that if you solve the illiquidity problem, that's enough, it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves.

Others think the solvency problem can only be solved with additional injections of safe assets - say cash or bonds - solving the illiquidity problem alone won't be enough.

I don't want to take chances, so I say (1) get rid of the toxic stuff, that helps the liquidity problems and gets credit markets moving again (they froze up severely after Lehman was allowed to collapse, that was a mistake), (2) add additional capital to help with solvency, this is extra insurance in case freeing up credit markets by solving the liquidity problem isn't enough by itself, and (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.

Use the 3R's from Naked Capitalism:
a) Recognition. We need to find out what the assets on the balance sheets of banks and other financial institutions are really worth, and what the balance sheets of the most troubled institutions look like under a regime of realistic marks.

b) Recapitalization. The US banking system needs a lot more capital. Credit losses are depleting equity capital, and deleveraging increases the required equity capital per unit of balance sheet capacity. So capital infusions are needed to avert a sharp contraction in lending.

c) Relief. In many cases, we need to restructure the loan terms of homeowners who lack the ability (or economic incentive) to service their mortgage. This isn't just in the interest of the home buyers, but it's often also in the interest of the lender (given the cost of foreclosure) and certainly in the interest of the macroeconomy (given the feedback effects between foreclosures, home prices, and economic performance)....In any case, recognition is only a start. In fact, recognition actually increases the need for recapitalization because it brings capital shortfalls out into the open. So it will be important to see how the Treasury proposal addresses this. Do they force banks to seek equity infusions from private investors in a specified time period? Do they simply "pay over the odds" for the assets (this would promote recapitalization but jeopardize recognition)? Is part of the program earmarked for the purchase of preferred stock in banks? Or is there a public/private partnership scheme such as an issuance of publicly financed puts in exchange for warrants for would-be private investors?

From Calculated Risk:
First, a recognition phase with complete transparency. Have private investors bid on some assets to establish market prices (some portion should be sold to the private investors to encourage bids), and then let the banks argue for their own valuations. Based on an analysis of these valuations, have the Treasury make an RFC type investment in the bank with a convertible debenture that would count as regulatory capital. This capital infusion would keep the banks lending (the primary goal) and the amount required would be far less than the amount needed to buy the troubled assets.

If a bank can pay off the debentures with interest - possibly because the assets perform as the bank expects, or perhaps by bringing in private capital - then there would be no dilution from the debentures. Otherwise the debentures convert into preferred shares and significantly dilute the shareholders - and then the government can sell the shares on the public market. Ideally the debt holders would take a haircut too (before the taxpayers), but that is probably too complicated. This alternative would keep the banks lending, minimize the cost to the taxpayers, and reduce moral hazard.

... the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

Luigi Zingales:
Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. ...

If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?
· First of all, there is a coordination problem.
Even if each individual debt holder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay.
· Secondly, from a debt holder point of view, a government bail-out is better.
Thus, any talk of a government bail-out reduces the debt-holders’ incentives to act, making the government bail-out more necessary.

Willem Buiter:
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.

My own 2cent alternative?
1. Financial institutions need to be recapitalized because,
2. "Toxic" securities are causing deleveraging.
3. "Bailing out" by paying "market prices" or book value for securities with tax payer money is unacceptable. Moral hazard, taxpayers should have an upside for bearing the risk, blah, blah, blah
4. Some "dictatorial" powers by Treasury will be necessary.

So here goes and these are presented as a menu of choices for the financial institutions.
1. Financial institutions should turn over whatever security they want to unload to Fed/Treasury for a loan a la IMF loans to countries in crisis. Part of the problem with having to pay "market prices" for the securities is the following:
There are private investors willing to buy these troubled assets right now, but the banks do not want to sell at those prices. Why? Some banks believe the assets are worth more than the current bids (it all depends on future house prices, and different banks and investors have different projections). And many banks are unwilling to accept the current bids because the banks would then be insolvent. (From Calculated Risk.)
With a loan, financial institutions can realize some gains and be given an opportunity to buy back the securities. The size and terms of the loan of course as in all bailouts are the details that can break any plan. With a loan, there is a risk that the firm will still become bankrupt which means that federal regulators will be appointed to monitor how the firm is run (i.e. IMF surveillance).

2. The financial institutions can turn over the "toxic" securities to the Fed/Treasury at zero cost to the taxpayer. The tax payers bear all of the risk. The firms are required to recapitalize by issuing additional debt/equity. Hence, some dictatorial powers are necessary.

3. Financial institutions can opt out and recapitalize on their own by issuing security and debt. Yes, this dilutes the interests of current debt holders and shareholders but it seems like fair is fair in bailouts. After all, countries who ask for IMF loans get all kinds of conditions dictated to them and this is nothing in comparison to IMF conditionalities.

4. Financial institutions who opt out should bear the risk of being nationalized. Debt holders will take a large haircut, equity holders will be wiped out, and all current top executives ousted with no pay. In addition, current executives bear the risk that the government will take legal action to recover losses by the institution through legal action. here is a precedent in Enron, but then Enron engaged in criminal activities. But if financial institutions do not accept any of the above shouldn't they be charged for reckless endangerment of the "foundations of capitalism?" (Already, Fannie Mae, Freddie Mac, AIG and Lehman are under investigation for possible fraud.) Again, the necessity of some dictatorial powers to "knock some heads" together. Yes, I realize that this threatens the "very foundations of capitalism" but then doesn't any massive bailout do the same thing? For all we know, this already is the end of American capitalism as we know it.

These proposals address mainly recapitalization. It doesn't guarantee that deleveraging will be halted with these steps. Again, the IMF tactics of raising interest rates to stop capital outflows is my analogy. Therefore,

5. Fed/Treasury should be given the power to call a moratorium on marking to market. See Thomas Palley via EV. Mark-to-market makes sense when the market is able to assess information but in a panic and with possible herding and informational cascades it makes more sense to suspend marking to market.

Brad Delong has a good recap of how policies should work. He would disagree with every single one of my above proposal. (I.e. This isn't the time for a morality play or punish someone for their excesses.)

Hmm, the proposal is sounding a lot like a rant. So here's another one:
Unfortunately, with a Wall Street man in charge of Treasury it is unlikely that such proposals will even be considered. At the end of this year, Paulson will be looking for a job and he doesn't want to be pariah among his kind. And I'm not the only conspiracy theorist:
From Bloomberg:
Goldman Sachs Group Inc. and Morgan Stanley may be among the biggest beneficiaries of the $700 billion U.S. plan to buy assets from financial companies while many banks see limited aid, according to Bank of America Corp.
``Its benefits, in its current form, will be largely limited to
investment banks and other banks that have aggressively written down the value of their holdings and have already recognized the attendant capital impairment,'' Jeffrey Rosenberg, Bank of America's head of credit strategy research, wrote in a report dated yesterday, without identifying particular banks.
Many banks may not participate in the Troubled Asset Relief Program because they haven't had to write down as much assets under accounting rules, meaning decisions to sell into the program would cause them to lose capital, Rosenberg wrote. Investment banks operate ``under a mark-to-market accounting model while commercial banks hold assets at cost until realizing a loss (or until they reasonably expect one),'' he wrote.

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