Improve what bank plan?

There are laws on these matters.  Let me first refer you to William K. Black, of the author of The Best Way to Rob a Bank is to Own One:

    "Whatever happened to the law  (Title 12, Sec. 1831o) mandating that banking regulators take ‘prompt corrective action' to resolve any troubled bank?  The law mandates that the administration place troubled banks, well before they become insolvent, in receivership, appoint competent managers, and restrain senior executive compensation (i.e., no bonuses and no raises may be paid to them).  The law does not provide that the taxpayers are to bail out troubled banks."

There is no exception in this law for Citigroup or Bank of America.  If the bank is troubled, the regulators need to be on the case.  If the bank is not troubled, then why are we talking about a a bad asset rescue fund of two trillion dollars?

The administration should follow the law.  Pass-through receiverships are the legal way to resolve troubled or failed banks. They are also the proven way.  They have been used under Democratic and Republican administrations, including for the Savings and Loans under Bush I and for IndyMac under Bush II.

All other proposals are experimental and untested.  For this reason alone, even if they are well-conceived, they have the potential of failing spectacularly. There is no coherent reason to avoid the proven path, in favor of the wild experiment.  And particularly not, when the law is very clear.

Ed Leamer is a serious economist, and his detailed proposal deserves discussion.

Leamer's plan is based on a very clear factual premise, and it stands or falls on that premise.  Here is the premise: "Potential sellers suspect with great justification that the current offers to buy are undervaluing these so-called ‘toxic' assets.  To get this market to clear, we need to help the price discovery process by providing private investors some government incentives."

Leamer does not tell us what the ‘great justification' actually is. Nor does he tell us why "private investors will be better able to price illiquid mortgages, mortgage backed securities and equity investments" than the markets which are presently pricing them at rates that predict widespread defaults and that would render the largest banks deeply insolvent.  He simply asks us to accept that this is the case.

Leamer writes, "Under this approach, private investors would conduct the analysis and due diligence of prospective purchases..."  And this is the critical point. In the case of sub-prime securities, we find there is some evidence of what the due diligence will reveal.  In a report dated November 28, 2007 and entitled, "The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance,  Fitch Ratings reported on the results of a small survey of loan files underpinning relatively well-rated residential mortgage-backed securities.  Fitch found "the appearance of fraud or misrepresentation in almost every file."

The problem for a diligent private investor is obvious. How do you purchase, in good faith, mortgage-backed securities whose underlying loans, you know for a fact, are broadly tainted by fraud and misrepresentation?  And especially, how do you do this when you cannot actually examine the specific loan documents, which may not be in the hands of those selling the securities?  In the boom it was possible to rely on the ratings agencies, but who would do so now?  Obviously the ratings process was also tainted by fraud, in that the raters found ways to certify the securities without actually examining the underlying loans.  That game is finished, for sure.

There is a simple reason why the market is today valuing residential sub-prime mortgage-backed securities as trash.  They are trash. There is no way that a diligent outside investor, acting as a fiduciary, can come to any other conclusion.  And so there is no way that private investors will come in on deals, unless the government by some device guarantees them against loss.  

And in that case, the government will not be engaging in price discovery but in price-fixing. The price will then not be the market price or the "fair value" price at all, but simply the government-set price.  Call it the "bail-out price."

At the bail-out price, the government will almost surely take on major losses, since the underlying loans will still be subject to a very high incidence of default.

Leamer argues  that the "private sector is infinitely better equipped to save the financial system than the government."  I do not believe this is true. The private sector has amply demonstrated incompetence, misfeasance and irresponsibility in these matters.  That is why we are in the mess to begin with.  The right people to save the financial system are the professional regulators of the FDIC. And it goes without saying, there should be no political interference from the Treasury Department or Congress.  

But even if we accept Leamer's point, his proposal will not work unless the government removes the risk by, in effect, fixing the price.  And in that case, it will be the government-as-price-fixer and not the private sector, that will be "saving the financial system." By Leamer's own argument, that outcome is "infinitely" worse than relying that assets be marked to the private price, the market price, which is what current law and regulation require.  

As a detail, Congress did not reject the TARP because "neither the Treasury nor elected officials were able to make a clear case to American taxpayers why this plan would be effective, and at what cost, and because voters were up in arms..."  I was in the Capitol, meeting with members, for many hours on the day before the vote.  The House Republican caucus deserted the administration on TARP for a very specific reason. William Isaac, the chair of the FDIC under Reagan, who was present that afternoon, persuaded them that they could save the system simply by suspending mark-to-market accounting – pretty much as Leamer favors.  For members who hate spending public money, this was irresistible.  

It was also a piece of political serendipity, as the fact that it was the House Republicans who defeated the bill may have cost John McCain the election. I doubt that Mr. Isaac got his ideas from Professor Leamer.  But if he did,  then I have only one thing to say.  Thank you, Ed.
 

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A Correction

Please read below the excellent comment by Peter Wallison of the American Enterprise Insitute, whose postion is presented much more clearly than in a story I wrote in last week's National Journal. I made the gross error of characterizing Peter's presciption for much more forceful action by the govenrment as nationalization, when it is not. I compounded the error by bunching him in with Paul Krugman, not a happy place for a conservative to be.  No excuses here -- I screwed up, and I'm grateful that Peter has been gracious about it.  I'll resist the temptation to put his idea in my own words again, except to say that I think he has one of the more thoughtful and clear arguments for a very different approach to the bailout, and I recommend reading it.

ALLEVIATING THE FINANCIAL CRISIS:

“PLAN B”--A MARKET BASED SOLUTION

Kip Hagopian and Professor Ed Leamer[1]

February 17, 2009

Congress initially rejected the $700 billion “Troubled Asset Relief Program” (TARP) bill, presumably because neither the Treasury nor elected officials were able to make a clear case to American taxpayers why this plan would be effective, and at what cost, and because voters were up in arms over the prospect of bailing out the very people who got us all into this mess.  Before passage of the TARP bill we proposed an alternative that we thought might help attract more taxpayer and Congressional support because the risks to taxpayers would be clear and limited and because the intent and likely effects of the bill would be transparent and appropriate. 

The essential idea was a public/private partnership to purchase mortgage-backed securities and to provide a capital infusion into needy and worthwhile financial institutions.  We are now very optimistic that Treasury seems to be moving in this direction.  Here are our ideas first offered October 1, 2008.

This plan can be used as a substitute for TARP or could be grafted onto it, in which case, the Treasury and its oversight board would have additional tools available with which to address the problem.

We believe, as many others have averred, that the problem has three components: 1) A severe lack of trust in the financial markets, not just from the public, but from investors and institutions; 2) A lack of liquidity in the assets held by financial institutions, specifically mortgages and mortgage backed securities; and 3) The danger of a collapse of many banks whose solvency has and will continue to be threatened by write downs in their mortgage assets, some of which could be saved with a capital infusion.  The Treasury’s TARP plan directly addresses the lack of liquidity in the market for mortgages and mortgage-backed securities, but its effects on trust seem ambiguous.  Most importantly, it does not address directly the other, perhaps most important, problem which is an insufficient amount of equity capital in the nation’s financial institutions. 

The TARP plan might increase the capitalization of banks if the Treasury paid high enough prices for the securities, but the plan leaves ambiguous whether the Treasury would offer “fire-sale” prices, “fair market value” or some higher price.  Of course higher prices are better for the financial institutions but make the plan more costly for the taxpayers.  Another problem with the plan is the enormous amount of government capital that would be required. 

Lastly, the administering a program under TARP will require the establishment of an oversight body and a sizable new bureaucracy that will take considerable time to create and will be very difficult to run efficiently.

Is there a better way?  It’s hard to say with any degree of confidence; after all, we are breaking new ground.  Nonetheless, we are proposing herein an alternative that could eliminate or mitigate some or all of the above-described weaknesses in the Treasury’s plan.

The Goals of the Proposal

These are the basic goals we believe any alternative plan should have:

·        First, to provide, not just a market for illiquid assets, but also a market that offers prices as close to fair market prices as possible.

·        Second, to create the means by which troubled financial institutions can more easily acquire equity capital at market prices.

·        Third, to minimize the taxpayers’ financial exposure.

·        Fourth, to manage the program with the highest level of efficiency and at the lowest possible cost.

·        Fifth, to jumpstart the program so the benefits can be felt as soon as possible.

We believe all of these goals can be achieved by implementing this proposal.

The Proposal.

The fundamental principle underlying this proposed alternative is that the private sector is infinitely better equipped to save the financial system than the government.  However, due to the current crisis in confidence, the markets are frozen, in part because sellers value their assets more than buyers and in part because, in many cases selling assets will necessitate write downs in the sellers’ portfolios that will render some of them insolvent.  Potential sellers suspect with great justification that the current offers to buy are undervaluing these so-called “toxic” assets.  To get this market to clear, we need to help the price discovery process by providing private investors some government incentives.  With this as a premise, our hypothesis is that all of the above stated goals might be achieved by creating a co-investment partnership with the private sector.  Here is how it might work:

·        Purchase of Mortgage Assets:  We propose setting aside $350 billion as a pool of matching funds to be invested side by side with private investors (private equity funds, hedge funds, healthy banks, wealthy individuals, pensions funds, and other investing institutions.).  The government’s funds would be co-invested with any creditable private investor on a dollar-for-dollar matching basis.  Thus, $700 billion of capital would be available to purchase assets, but only $350 billion would come from the taxpayers. 

Under this approach, private investors would conduct the analysis and due diligence of prospective purchases, would control the bidding, and would manage the investments when consummated.  In the ideal, there would be several bidders for each asset or asset tranche being offered, thereby creating a real market for the assets.  The government’s investment would be pari passu with the private investors, thus it would be sharing the risk proportionately.  But in order to attract maximum participation from the private sector, the government would provide an enhancement to investor returns by allowing investors to share disproportionately in the gains. As a ‘straw man’, the government might accept interest only for a 10 year time period at the 10 year Treasury bond rate[2] leaving the private investor to reap all of the gains in excess of the interest paid.  The government’s interest return would be enhanced by the taxes it collects on investor profits. 

·        Infusion of Equity Capital.  The above approach should reestablish market prices for whole mortgages and mortgage-backed securities, but there is no assurance that fair-market-value prices will be high enough to keep the balance sheets of financial institutions sound.   In fact, the establishment of market prices for certain assets may result in the holders having to mark down other assets in their portfolio to reflect the newly determined fair market value.  This is required by accounting rules.  Marking assets down could render these institutions insolvent and it is likely that many financial institutions will need to seek new equity capital for this and other reasons.   Like the public/private partnership for the purchase of mortgages and mortgage-backed-securities, we propose that the government be prepared to offer to the private sector the same terms for risk and profit sharing.  Accordingly, the government would receive the 10-year bond rate of interest (plus taxes on investor gains) and private investors would receive the balance of any gains reaped from these equity investments.  The government fund available for equity infusions might be $50-100 billion which, when matched with the private sector would provide $100-200 billion to recapitalize the banks and other financial institutions.

Advantages of the Proposal

          We believe this proposal has several advantages relative to TARP.  They are as follows:

·        The plan includes a provision for infusing equity capital into the financial system, which will almost certainly be needed to shore up some of the banks and other financial institutions.

·        In comparison with a newly assembled team of Treasury officials and consultants, we believe private investors will be better able to price illiquid mortgages, mortgage backed securities and equity investments and better able to determine which firms should be saved and which should be allowed to go under. 

·        In addition to superior investment knowledge and better incentives in the private sector, the personnel infrastructure for making these decisions is already in place and there is no need for the government to invest in an expensive new Treasury bureaucracy.

·        Because the infrastructure is in place, efforts to produce needed confidence, liquidity and solvency will be accelerated.

·        By involving the private sector, the amount of taxpayer exposure will be limited to $400-500 billion, but the amount of capital available to accomplish the Treasury’s objectives will total $800 billion to $1 trillion.  This should make this approach much more palatable to members of Congress.

This concept is likely to result in prices paid for the troubled assets that are much closer to fair market value than the Treasury plan, largely because it will produce more bidders with the expertise necessary to properly value the assets.   It is possible, however that prices would slightly exceed fair market value because of the disproportionate profit sharing arrangement  (which is the equivalent of a government subsidy).   But considering the state of the financial markets, buying assets at slightly higher prices will be better than buying them under market.

[1] Mr. Hagopian is a co-founder and general partner of Brentwood Associates, a venture capital and private equity investment firm which, together with is successor firms manages about $3.5 billion.  He has over 30 years of venture capital and private equity investment experience.  Professor Leamer is the Chauncey Medberrry Professor of Global Economics at the UCLA Anderson School and is the Director of the UCLA Anderson Forecast.

[2] Alternatively, the government might take a small share of profits—say 10%--to compensate for possible losses on some asset purchases.

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Based on his speech and the accompanying fact sheet, it appears that the principal money element of the Geithner plan for rescuing the banks involves the creation some kind of public/private partnership to buy the banks’ so-called toxic assets. Involving the private sector will make the problem considerably worse, and a recognition of this is probably one of the reasons that it landed with a classic dead cat bounce on Wall Street. The apparent reason for enlisting private investors is to get them make the pricing decision, and is an excruciatingly bad idea. The reason that Congress appropriated money for TARP was that the American people as a whole have a powerful interest in returning the banks to financial health. The pricing decision, as everyone has noted, is fraught with political problems. If the assets are bought at too low a price, the banks will be weakened further; if they are bought at too high a price, it will be unfair to the taxpayers. Once private investors are brought into the picture, the question is no longer what will benefit the American people, but what price will be low enough to compensate private investors for the risk they will be taking. That’s looking at the issue in the narrowest possible way, and raises serious questions about the Obama administration’s—and particularly Geithner’s –willingness to take responsibility for what they were elected to do. As President Obama famously told the Republicans in a stimulus meeting, “We were elected.” Yes, indeed, they were elected, and it’s now their responsibility to take the political heat that will be associated with buying the assets at a price that the banks will sell them. The Bush administration, to its discredit, backed away from this responsibility. That’s one of the reasons that there is an Obama administration. The government—the Treasury department—should have only one interest: returning the banks to financial health. If assets are valued at their discounted cash flows, they can both be profitable to the government and help the banks. All other courses will prove fruitless, particularly nationalization. When we watch what Congress did on executive compensation for the banks that take TARP funds, we can only imagine what will come later: loans to the car companies, no loans to companies that outsource, low interest loans to green companies, the potential list is endless. The only good thing about the compensation restrictions that were included in the Stimulus package is that they taught the Obama administration how irresponsible Congress can be when they are responding to an angry public. It’s unlikely, after this experience, that Obama will venture into the swamp of nationalization. Eventually, the Treasury will realize that a public/private partnership to buy assets from the banks is a dead end, and eventually the Obama administration will turn to buying the assets, but by then the delays that will flow from the Geithner’s lack of fortitude and resolution will have allowed a great deal of unnecessary damage to the economy.

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