A Better Way to Use That $700 Billion

Even though the deeply flawed bailout bill appears to be moving relentlessly towards passage by the House, it hasn’t deterred pundits and experts from coming up with better alternatives. Since the smart money expects this so-called “Mother of All Bailouts” to be another chapter in a series, it’s worth keeping tabs on these ideas, since some of them may actually see the light of day.

This “Bailout 2.0” idea comes from Morris Goldstein at the Peterson Institute. It in essence recommends that the powers that be spend some hard dollars to do price discovery and ascertain how damaged the big players really are, It then sets forth a plan for recapitalization, which includes having companies suspend dividend payments, That is more important than it might seem. Banks pay $400 billion a year in dividends, so suspending or reducing them would help a great deal in shoring up the system.

From the Peterson Institute:

Fortunately, there is still time to agree on a modified TARP…. That plan should deal with four key aspects of the current difficulties: illiquidity for certain mortgage-backed securities, undercapitalization of the financial sector, an interruption in the flow of credit to households and nonfinancial businesses, and a rising foreclosure rate that threatens to produce a downward overshooting of housing prices.

Rather than spend the entire $700 billion on government-financed purchases of troubled assets and aim for a purchase price (based on hold-to-maturity arguments) that is significantly above recent market prices, the Treasury should conduct auctions for only about a fifth of the authorized amount (say, $150 billion). That ought to be large enough to establish greater transparency about the fair market value of such assets. Such transparency should in turn make it easier for counterparties and bank supervisors to evaluate the balance sheets of financial institutions and to distinguish healthy from less healthy ones. Better credit assessment is a prerequisite for reducing excessive hoarding of liquidity. Trying to “tilt” the results of the auctions in either direction is a mug’s game: A “low” price will provide little relief to banks’ balance sheets while a “high” price will make it less likely that taxpayers can avoid a significant loss from such asset purchases and their subsequent resale. Since the government needs to promote both financial stability and to minimize costs to the taxpayer, it should let the (auction price) chips fall where they may.

Once the auctions are completed in an expeditious way, the authorities should have regulators and supervisors apply a uniform set of standards and make a fresh evaluation of the solvency and capital adequacy of all systemically important financial institutions that are currently subject to federal regulation. Those institutions that are found to be undercapitalized in light of the tougher market scrutiny now directed at all large financial institutions should be encouraged to make up at least half of that capital shortfall by reducing or suspending dividends and by raising additional capital from the market. Those institutions that were confident that they can do this would then apply to the TARP for a “matching” capitalization loan that would make up the other half of the capital shortfall. In exchange for this loan from the TARP, the participating institution would agree to grant the Treasury warrants so that taxpayers could share the benefits of any subsequent improvement in performance.

In addition, the participating institution would agree to expand its lending to households, to nonfinancial businesses, and to other financial institutions so that the flow of credit in the economy could be revitalized. This would make the link between Treasury assistance and a resumption of private lending more predictable and assured than with the design of the existing TARP. In cases of severe undercapitalization where the institution was not able to raise capital from the private markets (at sustainable interest payments), a capitalization loan from the TARP could also be requested, but the terms of Treasury assistance would be more onerous—akin to the recent Treasury loan to AIG (with a penalty interest rate, a pledge of all assets as collateral, and a dominant share of the existing equity going to the Treasury). If that institution subsequently failed, a search would be undertaken for a stronger institution to purchase and assume the “good” assets and liabilities from the TARP, while the “bad” assets would be transferred to the TARP for subsequent resale. Because recapitalization of the financial sector is a pressing priority, up to $350 billion of the TARP’s authorization should be allocated for such a purpose.

Last but not least, the remaining $200 billion of the TARP’s resources would be made available to restructure troubled mortgage loans that were in danger of imminent foreclosure. This could be done by contributing funds to one of the existing government mortgage restructuring programs (with its existing eligibility requirements) or by setting up a separate but equivalent mortgage restructuring operation within the TARP itself. As noted earlier, the aim here would be to relieve some of the downward pressure on housing prices exerted by a sharply rising rate of home foreclosures (expected to hit roughly three million units this year). A decline in the foreclosure rate would also have positive feedback effects on the market value of mortgage-backed securities. And with a significant share of the TARP’s financial resources allocated for foreclosure prevention, any perception of “unfairness” as between treatment of Wall Street and Main Street would be reduced….

In sum, if they act quickly and in a spirit of bipartisanship, there is still time for the US administration and the Congress to make something positive emerge from the delay in passing TARP legislation. Without changing the ultimate objectives, a revised and improved TARP bill can be designed and agreed upon that will increase the liquidity of mortgaged-backed securities, while allocating more resources (than did the original TARP) both to recapitalization of our financial institutions and to mitigation of rising home foreclosure rates. If Congress wants to rebuild market confidence rather than destroy it, it needs to get its act together.

How to restructure the mortgages needs to be worked out in more detail. Frankly, I have yet to see anything better than the idea of letting bankruptcy judges modify mortgages. Despite the hue and cry about interference in private contracts, judges already do precisely those sort of mods in commercial bankruptcies. Mortgage experts I know say they are mystified at the banking industry’s refusal to play ball, since the impact on servicer economics would be favorable. The mavens surmise that banks are pushing back because the net effect would be to force them to mark down mortgages they carry on their books sooner.

Jonathan Weil at Bloomberg reminds us why better ideas like the one from the Peterson institute will not see the light of day, at least until a new Administration holds the reins:

That brings us to this question: Why would a smart guy like Hank Paulson — the former boss of Goldman Sachs — advance such a dumb, shady plan? Let us count the reasons:

No. 1: It delays our national reckoning until after the presidential election.

Paulson first floated a bailout Sept. 18, at the very hour when shares of Goldman Sachs Group Inc. and Morgan Stanley looked like they might go into a death spiral. It’s not so much a bailout, as it is a timeout. He had to follow up with something, anything, to stop the freefall from resuming. It didn’t have to make sense.

So it doesn’t. The plan is about creating the illusion of stronger financial institutions, not strengthening them.

The banks know this. Otherwise, they would have stopped charging each other near-record rates for three-month loans by now. The reason they haven’t is because they’re still afraid their customers — other banks — might go broke.

No. 2: The reckoning will be worse than you can imagine.

If Paulson were serious about recapitalizing rickety U.S. banks, he would infuse them with hundreds of billions of dollars of fresh government money, in exchange for ownership stakes. And if he wanted to create market liquidity for all those troubled assets on their books, he would be ordering banks to disclose everything there is to know about them, so Mr. Market could figure out their present value.

He can’t let that happen. Not now. If everyone could see how much the toxic waste is worth, the writedowns would be so huge that many banks would have to be declared insolvent.

Better to let the next administration deal with the clean- up. The trouble is, the longer the government waits to address the banks’ lack of capital, the worse it gets, barring a miracle.

No. 3: He’s helping his friends.

Is there any doubt? Let’s see.

As of yesterday, Morgan Stanley Chief Executive John Mack owned 2.75 million shares of his company’s stock, valued at about $67 million. If Mack can get Morgan Stanley to trade reams of sketchy paper for billions of dollars of our Treasury’s cash, without diluting any of his stake in the company, who benefits?

Paulson would have us believe it’s you.

No. 4: There’s an excellent chance the Congress will pass it. Leave someone else to figure out the costs another day.

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  1. Anonymous

    I think The TARP Boondoggle is just a politically engineered time bomb that is exploding just before elections, with no other intent, other than to confuse voters.

    1. The 2008 U.S. House of Representatives elections will be held on November 4, 2008, to elect members to the United States House of Representatives to serve in the 111th United States Congress from January 3, 2009 until January 3, 2011. All 435 seats are up for election.

    2. As provided by the United States Constitution, each of the 435 members of the House of Representatives represents a district and serves a two-year term. House seats are apportioned among the states by population. The 100 Senators serve staggered six-year terms. Each state has two senators, regardless of population. Every two years, approximately one-third of the Senate is elected.

  2. bg

    At cubscouts today I polled every adult present. A venture capitalist, a test pilot, a corporate attorney, a retired dot com guy, and a business exec. Everyone was fully informed on what congress was doing, and everyone was appalled.

    How does congress think they can get away with this?

    Party does not matter.

  3. EvilHenryPaulson

    Against my better judgement, I’m going to predict the TARP (as passed by the Senate) will not pass Congress.

    In any event, the problem with the government purchasing a broad set of securities from many different institutions by construction requires one to rely on nothing more than one’s faith in the Secretary of the Treasury.

    In truth, I am by now sick of the bailout discussion because at its very best I view the plan as procrastinating until a solution is agreed upon aka an expensive way of buying temporary calm.

    Every economic proposal is just like masturbation, the more they do it the more they think believe it’s the real thing. Meanwhile Paulson is out there fucking away and silently accepting of his limitations

  4. Anonymous

    Suggest you have some cash on hand, in your possession, to carry you through a month or two of bills and necessities. It won’t hurt anything to be prepared for events unknown or out of your control.

  5. bookman4

    i like the categorization of this plan as a timeout, rather than a bailout. it doesn’t do anything to fix the systemic corrosion within the financial system, but it does buy time for other, more effective measures to be developed.

    let’s hope that time is used wisely.

  6. Anonymous

    Why can’t the CDS contracts all just be voided?

    Are they still using these?

    Who is regulating this beast that is eating the worlds banks?

    Fiat currency needs to be destroyed from time to time. Is that what we are witnessing? Has the exponential growth hockey sticked up and the only plan is to destroy a large percentage to start fresh?

    There are agendas within agendas and my intellect doesn’t even recognize the players anymore. I do know the hard times will be harder than my worst imagination.

    I have no idea what I will do when my kids start going to bed hungry night after night. No idea.

  7. Anonymous

    The state of California is the biggest of several governments nationwide that are being locked out of the bond market by the global credit crunch. If the state is unable to access the cash, administration officials say, payments to schools and other government entities could quickly be suspended and state employees could be laid off.

    Plans by several state and local governments to borrow in recent days have been upended by the credit freeze. New Mexico was forced to put off a $500-million bond sale, Massachusetts had to pull the plug halfway into a $400-million offering, and Maine is considering canceling road projects that were to be funded with bonds.

    California finance experts say they know of no time in recent history when the state has sought an emergency loan of this magnitude from the federal government. The only other such rescue was in 1975, they said, when the federal government lent New York City money to avoid bankruptcy.

    “Absent a clear resolution to this financial crisis,” Schwarzenegger wrote in a letter Thursday evening e-mailed to Paulson, “California and other states may be unable to obtain the necessary level of financing to maintain government operations and may be forced to turn to the federal treasury for short-term financing.”


  8. Nude

    I posted this in another blog’s forums, but here’s my theory:

    I think the plan is to allow mark-to-fantasy until the Treasury can get it’s new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.

    Forcing everyone to open their books at the same time would only ensure insolvency of every institution, leaving no one behind to fill the void. They don’t want a panic that would result in a total destruction of the system.

    But creating mega-banks via shotgun weddings, preventing short-sellers from forcing their hand, increasing the FDIC insurance coverage, redefining FAS rules, and passing this bailout bill gives them time to maneuver. If they can make a few key insitutions viable, even if only a skeleton crew, it might prevent the entire system from being taken down by cascading cross defaults. Look at the institutions that have been helped: AIG, WaMu, Countrywide, Wachovia, F&F, and recently both Goldman and General Electric have been endorsed by Warren Buffett. I think Bear Sterns caught them off guard, sent them a wake up call, if you will. I think Lehman was allowed to fail to test the weaknesses, see where the fault lines lay in the overall structure. It’s just a theory, I admit, but the actions being taken by a number of different agencies makes me believe it is co-ordinated dismantling.

    Anyone else think this might be valid?

  9. Richard Kline

    I strongly concur with Goldstein’s proposals two and three involving bank system recapitalization. I’m tepid on his first proposal: $150 is a helluv a lot to spend to get price discovery. Why the Guvmint could simply take the Bear Stearns Junk Fund, put it on the market, and see what it fetches. The most the public would lose in getting price discovery would be $29B.

    I’m not at all sold on Goldstein’s last proposal, however. Set aside $200 ‘to support mortgages entering foreclosure?’ How, do pray tell, except by giving mortgages free money to make up for lost equity or buying their mortgages at face and then writing them down with the public taking the loss? Nyet; non; fuggedaboudit. The government absolutely _should not_ intervene to support the value of individual homeowner’s mortgages.

    And regarding Goldstein’s point thus: “Mortgage experts I know say they are mystified at the banking industry’s refusal to play ball, since the impact on servicer economics would be favorable.” Here is the skinny on that, Mo: the banking industry has been waiting FOR ALL OF THE LAST YEAR for the government to step in and buy their crap paper at par to face or close thereunto. The industry has stalled because _they expect to be bailed out._ On the day after it is made clear that this will not be done, they will become mighty damn happy to do renegotiations. I’m dead serious in that observation. Paulson’s proposal has been the industry’s ‘Masterplan A’ for over a year, and the Bullrush Bailout is the means to get this rolling. —Which is all the more reason to oppose this scam.

    Oh, and it is utterly indefensible for any firm selling bad mortgage paper to Paulson to pay dividends. That amounts to, essentially, a direct transfer of public money to equity stakeholders of, in many cases, insolvent firms on the fiction of passing on bad assets. Of course, given the way the Pigout Proposal is written _the government has no recourse if dividends are paid_, and Paulson is absolved before the fact. Looting, to call it what it is. The shareholders can’t loot their own firms on the way out the door, since many of them are way underwater and can’t sell bad paper for cash equivalents, so they are asking for a Free Fund day to loot the Treasury to make themselves whole.

    —And our elected confiscators are only too happy to rush to hold the door open for them on their way out with a wheelbarrow full of T-bills.

  10. fresno dan

    Roubini believes that if current rules and accounting standards were applied, most banks and “shadow” financial institutions would be insolvent. I tend to agree.
    There was the theory that the world was “awash” in capital – I tend not to believe that (it was all money created by leverage) – but even if there was, would you reinvest in a bank that had lost 10, 30, or 70% of your investment?

  11. Hughson

    The more I read about this the more it resemble a cancer patient whose cancer has grown so much so that cutting out will surely kill the patient. The chemotherapy (i.e. $700B Bailout) wil serve to prolong the inevitable. In the case of humans you would say it it worth it since it gives you sentimental value to last days you spend with patience but in this case the Chemo cost is better spent else wehere than to prolong this situation. This will only give the people still invested in this market time to sulvage whatever they can.

  12. FairEconomist

    Well, Goldstein’s plan is a vast improvement over the Paulson plan. I think all four arms would help, although I think the price discovery of the first arm will be weak. We are not going to know the real values of these mortgage securities until the price declines are over and the resulting foreclosures have been done and worked out. At present the final prices, default rates, and times to default are all extremely uncertain. The market is just an opinion averaging system; it doesn’t make magic pixie dust; if nobody knows what’s going to happen the market doesn’t either. However, these securities are highly illiquid and the way it’s working out we will end up paying for most of them anyway so a well-constructed plan to pay a fair market price for some of it is a good idea.

    If we want confidence the Paulson plan is not the way to do it. Adopting a bad plan over intense public resistance makes Congress politically illegitimate and shows they have poor judgement with our money. That’s not the way to inspire confidence. If Congress worked across party lines to adopt a constructive, fair, and well-considered plan with wide public support *that* would inspire confidence. You don’t respond to a major crisis by making the only institution possibly able to cope with it morally and financially bankrupt.

    @Nude: I agree they’re trying to patch things over and delay Armageddon. I don’t see, however, any plan or intent to use the spare time to fix underlying problems. Bear fell apart 6 months ago; have they done anything about the derivative and CDS tangles that forced them to save Bear? No. It is coordinated; but remember these agencies are all arms of the same administration except the Fed and Bernanke by choice is working very closely with Paulson. Coordination is what you should expect from this crew.

    @Richard Kline: The ultimate choice for the mortgage owner is to keep the current occupant there at a price he can pay or to sell for foreclosure prices. In many, many cases the first is higher than the second and it’s just dumb to foreclose. The anecdotal evidence I see on there forums is that mortgage servicers are not acting on this and so buying and reworking will be a substantial net benefit to the country.

    Where foreclosure and firesale is inevitable servicers appear to be delaying that too which also means their actions are a major net minus for the country, as the time lost is pure waste and delays the eventual price discovery. So right now buying up the underlying mortgages and managing them intelligently (which is going to include a lot of principal forgiveness) would be a big boost to our long-term prospects.

  13. Matt Dubuque

    Matt Dubuque

    Perhaps one modification that could be made to the proposed law allowing BK judges to modify mortgage terms would be to limit their discretion to the single family residences of homeowners.

    This proposed revision could help garner more votes in the Senate.

    For example, yesterday I was told of a California resident in bankruptcy court who, as a security guard making around 12 dollars an hour, had used hyperleveraging to buy 3 homes in New York, 2 in Texas, 4 in Nevada and 2 in California.

    He has now thrown himself at the mercy of one of our local bankruptcy courts.

    Although I am a firm believer in this proposed increase in discretion for bankruptcy judges, I don’t feel this particular person should escape liquidation of his scheme.

    So perhaps for homeowners only….

    Matt Dubuque

  14. Francois

    Yves and several posters comment about the lack of serious proposals to fix, or at least try to fix the mortgage side of the problems we are facing right now.

    Yet, Barry Ritholz suggested the 30-20-10 solution recently. It make sense, doesn’t try to protect everyone and it’s Mom just for the sake of it, and appears to minimize disruptions in the marketplace.

    The essence of the proposal:
    “In doing so, let’s recognize several truths regarding the current housing situation:

    • Home prices remain elevated;

    • Artificially propping up home prices is counter-productive;

    • Home owers (No equity, 100%+ debt) who are in houses they cannot now, and never could afford, are going to have to move to homes or apartments they can afford;

    • The banks that made these bad loans to unqualified borrowers should suffer writedowns;

    • Taxpayers should not have to bailout borrowers who are in over their heads, or lenders that made these bad loans.

    If we use these as our preliminary facts and assumptions, we can craft a response that is rational, effective, efficient and requires very little taxpayer money. This means, however, that there are still several million people that are in the process of moving from living in a mortgaged home to moving to a rental property or a purchased property they cannot afford.

    This is what is required to help normalize prices and supply.

    Instead of the massive Paulson bailout plan, let’s consider a different type of solution, one that can be effectuated by a combination of policies and actions via Congress, banks, and private equity, with the loan servicing industry participating.

    I call it the “30/20/10” solution to the credit crisis:

    30: Takes up to 30% of any current delinquent mortgage and separates it from the “main” mortgage; it goes into a 2nd, interest free-balloon mortgage, and stays on the books of the present mortgage holder;

    20: The plan’s goal should be saving at least 20% or so of the current delinquent and potential foreclosure properties; Of the 5 million homes that may be late in making payments, (the first step along the road to delinquency, default and foreclosure) the process should make 20%, or 1 million homes eligible;

    10: The Balloon payment comes due in 10 years, and will be treated as a 2nd mortgage, with interest charges only accruing as of October 1, 2018; it can be refinanced or paid off in full.”

    There are many more details in the original post.

  15. FairEconomist

    Perhaps one modification that could be made to the proposed law allowing BK judges to modify mortgage terms would be to limit their discretion to the single family residences of homeowners.

    You don’t understand the law. BK judges can already cram down absolutely any loan except primary residence mortgages. They have always been able to. They were able to cram down primary mortgages too until the government started enforcement of a law prohibiting cramdowns for primary residence mortgages only, in the ’90s. The change was supposed to reduce mortgage rates, but had no benefit whatsoever.

    Besides being good policy for a crash like this, cramdowns will make BK law consistent for all loans and return us to a time-honored and proven practice.

  16. SlimCarlos

    @ Yves

    Thanks, I went and looked at the IMF report detailing 124 bank crisis since 1970. My thesis is that when an economy gets too far underwater in terms of debt, it is almost axiomatic that reflation/devaluation follows. The report does not cover this. However, I do know that the Argentina Peso fared poorly over the time frames listed here. Ditto for the Brasilian Real. I am not a keen historian of what goes on in Djibouti, but I can’t imagine we saw a rush into their currency when the bank crisis happened there.

    Can you cite one exsmple, apart from Japan, when reflation/devaluation did not happen? Can you even cite a balance of statistics to suggest that this won’t happen this time around?

    If the history so clearly leans in this direction, how come nobody is talking about it?

  17. DG

    “…$400 billion a year in dividends…”

    Any source on this? I remember reading somewhere it was 40 billion.

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