...Archive for September 2008

How to recapitalize: the Semi-Swedish Solution

So, you don’t want to nationalize all the bad banks, and neither does Megan McCardle. After all, America is not Sweden, we’re heterogeneous and fractious and really gosh-darn big. American politics are nasty, brutish, and interminable — no way to run a lemonade stand let alone a bank. Okay.

Unfortunately, the private sector approach to reorganizing and recapitalizing banks, forced debt-to-equity conversions, is too harsh on creditors. Yes, it is the free-market solution, and it’s what we normally do (via the bankruptcy process) when firms are viable but undercapitalized. But, we are afraid of hurting lenders at a moment where credit markets are wobbly and a strike by lenders could be catastrophic. Okay.

Maybe these are two great tastes that taste great together. What if both the state and junior creditors could took equity stakes in reorganized firms, fifty-fifty. The former creditors would run the place without government interference, isolating management from politics and diminishing concerns of creeping socialism. Taxpayers would enjoy the upside as passive investors in ordinary, profit-maximizing businesses, and would buy shares at a bargain price (book value after very aggressive write-downs have been taken). Some creditors would still have to endure the indignity of being converted to equity, but the amount of debt that would have to convert would be cut in half (approximately), giving converted debtors a lot of capitalization bang for their buck. Junior creditors would go from owning very dodgy debt to relatively safe shares, and more senior creditors would see the value of their positions spike and stabilize as solvency concerns abate.

Here’s how this would work:

  1. Regulators would go over bank balance sheets, and come up with a very conservative account of their assets. Nothing would be carried at more than market, in-quantity bids. That’s a fire sale price? Too bad. There’s no market bid at all? That’s a zero then.

  2. Any bank that is undercapitalized on this basis, that is beneath the regulatory thresholds for an adequately capitalized bank, is insolvent. Equityholders, common and preferred, are wiped out. Sorry, Charlie. You levered up, you bought crap, you lost. That’s how it goes. I love the smell of capitalism in the morning.

  3. We choose a “well capitalized” leverage ratio, and that will tell us how much debt we’ll need to convert to equity. Here are the formulas, if I’ve got my algebra right:

    government_equity = converted_equity =
       (total_assets / (2 * target_leverage - 1))
    reqired_conversion = converted_equity - old_book_equity

    …where old_book_equity is the book value (a negative number) of the now wiped old equity.

  4. We define two classes of stock, one voting and one nonvoting but convertible to the voting shares, each with a par value of $1. The government puchases its share, by purchasing government_equity shares of the nonvoting stock at par. The government is forbidden from exercising the conversion option.

    The required amount of debt is converted to converted_equity shares of voting stock, which is distributed to creditors pro rata based on the amount of equity converted. (Equivalently, a conversion rate of required_conversion / converted_equity is established.)

  5. The firm would have the option of paying unsecured contingent liabilities that arise from contracts entered into prior to the reorganization in stock at the conversion rate established for other creditors. This has the effect of placing undercollateralized derivative counterparties where they belong, in the same boat as the most junior creditors of the firm. It’s also good from a “moral hazard” perspective — we really, really want people to take counterparty risk seriously in whatever OTC derivaties market survives this episode, but we don’t want to wipe out existing counterparties and set-off a cascade or meltdown. Counterparties to reorganized firms would take a haircut, and salutary uncertainty would be introduced in valuation schemes that too often begin by assuming away counterparty risk.

  6. If a firm is so profoundly insolvent that, even with the government capital infusion, the required debt-to-equity conversions would have to hit depositors (at banks) or claims on assets held on behalf of clients (e.g. stocks held for clients by brokerages), then the firms should be liquidated, with the government honoring FDIC and SIPC guarantees. If any such firms are systemically important, they’d have to be nationalized outright, like AIG. Half-measures can’t save such firms. (Thanks to Winterspeak for pointing out this issue.)

The aggressiveness of the writedowns in Step 1 is the core protection for taxpayers in this plan. If that’s watered down, this could become a taxpayer subsidy to converted creditors. Also, to protect taxpayers, creditors should never be able to purchase shares more cheaply than the government. Under the formulas above, that would happen when the book equity of the reorganized firm is positive, but less than regulatory capitalization thresholds. In this case, the new owners effectively get a subsidy, a wealth transfer from old equityholders, during the reorganization. This subsidy should be shared by converted creditors and the government. The formulas above allocate old book equity to converted creditors, to ensure that creditors rather than taxpayers bear prereorganization losses, and would have to be modified when old book equity is positive:

government_cash_infusion =
   (total_assets - (old_equity * target_leverage)) /
   (2 * target_leverage - 1)
government_equity = converted_equity =
   (total_assets + government_cash_infusion) /
   (target_leverage * 2)
reqired_conversion = converted_equity - (0.5) * old_book_equity

…and the government would buy shares at the same conversion rate paid by creditors, rather than at par.

Update History:
  • 30-Sept-2008, 2:20 p.m. EDT: Replaced an “and” with “as”, ‘cuz that’s what i meant.
  • 30-Sept-2008, 2:45 p.m. EDT: “abated” to “abate”

How I learned to love the Fed

I’ve written about the Federal Reserve a good deal, and I’ve been critical of its willingness to take private sector risk onto its balance sheet by swapping Treasuries for the increasingly dodgy securities produced during the credit bubble.

The (hopefully defunct) Paulson Plan has provided a come to Jesus moment. Having the Fed lend money against overpriced collateral valuations is infinitely superior having the Treasury purchase those securities outright at inflated prices. While the taxpayer is on the hook in either case, at least when the Fed lends, the taxpayer loses only if the borrower first fails. If the Treasury Secretary overpays for an asset, the original owner books the profit and the taxpayer eats the loss directly. A “quiet bailout” from Dr. Bernanke strikes me as much more equitable than a sellers’ market fashioned by Secretary Paulson.

Lending from the Fed even against worthless collateral cannot address undercapitalization of the banking sector. Neither could the Paulson Plan, unless the Secretary were to overpay for bank assets. Removing the ability and incentive to overpay on a permanent sale strikes me as a good thing. Recapitalizing the banking system will require more than easy money from the Fed. But easy money, combined with a bit of temporary forbearance on capital requirements, would help blunt the current panic, while leaving bank stockholders and creditors on the hook before any losses would be taken by taxpayers.

The big hazard of this approach is as it has always been, how to wean the banking system from the mother’s milk of Fed largesse. Many banks are insolvent, and those banks need to be identified, reorganized and recapitalized (or else liquidated). That should happen quickly — not zombie style over the course of a decade — but it needn’t happen instantaneously and simultaneously. In order to even get started, we need to have a fair endgame, a good approach to reorganizing and recapitalizing banks. I’m already on record as supporting either temporary nationalization (a la the Scandinavian model or AIG), or internal recapitalizations via debt to equity conversions. It’s possible that a combination of these two approaches, one that doesn’t give government direct control over reorganized banks and includes both internal and public sector capital injections, might be more palatable than either choice alone. That will be the subject of my next post.

In the meantime, I would support a standalone act authorizing the Fed to pay interest on deposits immediately. I would prefer that Congress impose limits on the quantity of deposits on which interest can be paid, to limit the risk and interests cost to taxpayers, but that limit could be quite loose for the moment. This approach has the advantage of getting liquidity into the banking system far more quickly than the Paulson Plan ever could have, and drawing a clear line between the liquidity and capitalization aspects of the plan. It could be implemented immediately by passing the one sentence Section 128 of the Paulson Plan in isolation (although again, I’d prefer to muck it up with a limit on the quantity of paid deposits).

Freed of its balance sheet constraint, the Fed might consider injecting funds into the banking system by purchasing a diversified portfolio of holdings in money market funds that trade in commercial rather than government paper. This would help relieve the stresses in the commercial paper market very directly, and reduce the likelihood of a disorderly adjustment in nonfinancial commercial credit markets.

Justice matters

I remain adamantly opposed to the “Emergency Economic Stabilization Act of 2008″. And I’m astonished that so many who opposed the bare-bones Paulson Plan have, however begrudgingly, risen to support this proposal. Yves Smith is right that “turning Hank Paulson’s three pager into a 110 page draft made for a nice fig leaf but made virtually no substantive difference.” There is a bit more accountability and transparency. But, there are also huge new powers for the Federal Reserve and the SEC that weren’t in the original, and were inserted with no public debate. All the rest, the equity sharing, the “installment plan”, the compensation limitations are weak, and the act specifically authorizes the Treasury to overpay for assets (that is, “at the lowest price that the Secretary determines to be consistent with the purposes of this Act”).

There has been so much talk of catastrophic consequences if we do not support this bail-out. What happens if we do pass the act — over the clear objections of the vast majority of Americans — and the depression still comes?

I think people are severely underestimating the depths of the crisis we are in. This is not a financial crisis about banks and commercial paper. It is not about the housing market. We are in an economic crisis, because America’s productive capacity is deeply out of kilter with our habits of consumption. No amount of financial legerdemain can fix that. We have to actually produce the goods and services we want to consume, or else produce current goods and services that we can trade for what we consume. Relying on the mysteries of finance to square the circle has brought us low. At best, the proposed bail-out might buy us some time to fix the underlying economics before the pain kicks in. At worst, the pain will kick in anyway, but we’ll have even less flexibility than we have now to address the real problems.

Suppose we pass the “Emergency Economic Stabilization Act of 2008″, and a depression comes anyway, and we cannot raise taxes (blood, turnips, all of that), and we cannot borrow from abroad (because our paymasters have tired of us). Sure, the Federal Reserve will print money, because the debt must be paid and the government must continue, and in a depression many prices will fall regardless, but commodities and imports will grow dear. We will know then that we want to build factories, for all the televisions and computers that used to be cheap from Asia, but that can no longer be bought with debauched greenbacks. But we won’t have the capital.

What will we say, in those dark days, when someone comes along and blames the bankers? It was the bankers, after all, who “intermediated” our vast current account deficit, who found ways of accepting goods and producing debt despite our incapacity to repay, and who enriched themselves by doing so. And then these self-same bankers threatened us with armageddon unless we paid them hundreds of billions of dollars, back when dollars could still buy steel and cement and machinery. We paid the ransom, but the hostage died anyway. How will Secretary Paulson answer their charge?

Suddenly we will realize the cost of putting expedience before even the thinnest veneer of justice. Because in the end, Secretary Paulson will answer these charges with a locked gate and an exception to the Posse Comitatus Act. An economic depression will bring temptations to violence and radicalism. And a lot of people will look back on this decade, right up to and through the “Emergency Economic Stabilization Act of 2008″, and feel with some justice that they were royally screwed.

Now, in a deep downturn, scapegoats will be found no matter what. Maybe we really have nothing to lose by passing this badly flawed proposal, since it might prevent a depression and if not we’re all toast anyway. But, you know what? While we still can borrow valuable dollars, we could use that 700B to build infrastructure that might make the economic facts of a depression less severe. And, if we insisted that the mighty bankers actually fall now, actually take the hit that their own ideology demands of them, that just might blunt the sense that we are “us” and “them”, rather than a nation with a common struggle, when it all hits the fan. Maybe the choice we are really making here is not about financial and monetary arcana, but a choice between civic peace and civil war.

Obviously this is speculative, and alarmist, while the crises in the credit markets are acute, real, and tangible. But we really could nationalize failing banks before they take down the credit markets, while bailing out senior creditors. It has been done. The Federal Reserve or the Treasury could buy high quality commercial paper if the money markets go on strike. (That’s much less risky than buying frozen mortgage assets.) We really could invest in productive infrastructure, rather than in claims on already built subdivisions. We do have other choices, besides starting the depression tomorrow or giving Secretary Paulson what he wants.

The Paulson Plan is now the easy out. It has a lot of momentum behind it. It feels safe. But it is not guaranteed to work even in the short run, and does not address the substance of our economic problems at all. Much of the public perceives the plan as at best a kind of ransom and at worst a kind of theft. The plan might buy us enough time to put our economic house in order, in which case it would have been well worth the cost. But if it doesn’t work out that way, if the public is forced to swallow a bail-out that seems flamboyantly unjust and everything falls to pieces anyway, we will have painted ourselves into a very dark corner. In a genuine catastrophe, social cohesion matters more than anything. Surely, by now, we should have learned not to underestimate tail risk.

TARP, first public draft

So, I’m not a lawyer, I’ve gone through this very, very quickly, and I’ve got to run.

On the whole, I think this is basically last weekend’s Paulson Plan with much better oversight, more transparency, and a lot more words. Also, the Federal Reserve is given authority to pay interest on deposits, and thereby implement a “channel” or even a “floor” system of monetary policy (ht commenter RueTheDay). And, the SEC can suspend mark-to-market accounting requirments. Those are big things to slip in under the radar.

Some easy changes that would make me feel a little better:

  • Section 114 on transparency: “assets acquired” should be changes to “assets acquired, obligations assumed, or any other use of financial instruments undertaken”, so that the Treasury’s participation in derivative markets or its assumption of contingent liabilities is made public.

  • While disclosures are required for taking positions in financial instruments other than security purchases in Section 3(9)(b), there should be stronger controls, and those controls should apply regardless of whether the contracts entered into are mortage-related or not.

  • The streamlined contracting described in Sec 107(a) should be toughened. Disclosures should be public, and approval by, not merely notification to, some oversight body should be required. The Bush Administration has a poor record on “streamlined contracting”.

  • In general, a required disclosures and reports to committees under TARP should be required to be public.

Some miscellaneous bullets:

  • The House Republican’s insurance plan has been added, presumably to salve egos, but that only harms the taxpayer.

  • The equity participation portion is toothless, much less specific or meaningful than in the earlier Dodd proposal. If equity participation is your core criterion, it’s unclear to me how one could say “no deal” to last week’s plan but “deal” to this one. Yes, some kind of equity participation is broadly mandatory, but aside from general principles, the scale of that participation is wholly at the discretion of the Treasury Secretary.

  • The compensation limitation section is very complex. Tin-foil-hat me thinks that this means there are loopholes by which the Treasury could structure participation in ways that prevent these requirements from biting, but going through the different sections, I wasn’t certain that I’d hit upon the scheme. There’s a fairly broad section that would create tax penalties for those who participate via auctions, and a much less specific section regarding beneficiaries of direct purchases. Tin-foil hat me thinks that those the Treasury Secretary wants to exempt will participate via direct purchases, and these players will be subject to vague, discretionary restrictions, or will be exempt due to a lack of meaningful equity participation. But overall, this section is too complicated for me to quickly make sense of.

My bottom line:

I still dislike this proposal and hope it does not pass. However, in a way, reading this makes me feel better about Secretary Paulson’s original plan. He was at least very honest about the powers he was asking for last weekend. Here he basically gets the same thing — although the added transparency and extra oversight is meaningful! — but all the verbiage blunts the impact.


Notes:

Below are, unedited and unexpurgated, the notes I took while reading the act. They are very quick and dirty, but I gotta run. My apologies in advance.

Sec. 3 (9) — Defines “troubled assets” to. Section (a) includes not only securities, but “obligations, or other instruments” related to mortgage assets, while Sec. (b) allows

any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress

The word “obligations” in (a) means that Treasury is authorized to assume the liabilities of private parties. The phrase “any other financial instrument” in (b) is very broad, and could include entering into contracts that put taxpayers on the hook for far more than any upfront cost. It’s clear that Congress recognized the danger associated with “any other financial instrument”, and insisted on some check. I would prefer this check be stronger, at least permitting “appropriate committees” to object, not merely be notified of a trade. In any case, the non-security “obligations, and other instruments” defined in Sec (a) need to be subject to the checks and oversight defined in Section (b). Assuming contingent liabilities can create a hole in the public balance sheet regardless of whether those liabilities are related to mortgages or other assets.

Sec. 101 (d) — Requires publication of

(1) Mechanisms for purchasing troubled assets.
(2) Methods for pricing and valuing troubled assets.
(3) Procedures for selecting asset managers.
(4) Criteria for identifying troubled assets for purchase.

Good.

Sec. 102 — Not only authorizes, but requires the Secretary to start a program to provide Federal insurance of troubled assets, if the core TARP program is implemented. I have a great deal of respect for the House Republicans for having slowed down this train, and still harbor some hope that they may stop it. But adding this insurance program is positively harmful. It increases the potential cost to taxpayers, if actuarially estimated premia turn out not to cover the cost of the claims. The "concession" the Republicans have insisted upon ended up creating a new potential hole in the taxpayer balance sheet. Two wrongs don't make a right, and two bad programs don't help the taxpayer. We'd be better off without this section. The insurance program creates a loophole by which taxpayer money can be given away, and th resulting losses blamed on good faith bad estimates. (Justin Fox points out that while the program is mandatory, the actual extension of guarantees is at the Treasury Secretary's discretion. I'm less confident that guarantees won't be offered than Justin is.)

Sec. 104 — The members of the newly defined "Financial Stability Oversight Board" are all members of the Executive Branch, with the exception of the Federal Reserve Chair, who is appointed by the President. WTF? There should be significant Congressional representation on this committee. The era of trusting the executive branch to do the right thing is long passed. Having only "reports and recommendations" sent to Congress is insufficient. It let's this committee set the options and determine the range of reasonable debate, just as Paulson and Bernanke did to us last weekend.

Also, it is insufficient that the reports and recommendations of the Oversight Board (which include financial statements, justification of prices paid, etc.) be sent to Congress. They should be made public.

Sec. 106 (d) — Requires that at least 20% of any profits be transferred to specific funds. That's dumb. These assets are being purchased from the General Fund of the Treasury. The General Fund of the Treasury should be made whole. If Congress wants to support the "Housing Trust Fund" or "Capital Magnet Fund" it should do that in separate legislation. Let's try to make the taxpayer whole, and then worry about make use of all our profits.

Sec. 107 (a) — Permits a "streamlined" contracting process under which ordinary checks on Federal contracting can be circumvented, if the justification for the circumvention is submitted to various committees. Given the plum jobs this act could create for financial intermediaries, and the degree to which precedents for extortionate compensation can be found in private sector contracts (2 and 20, anyone?), I am deeply uncomfortable with this. The Bush Administration has not won the public's trust with respect to no-bid contracting. "Streamlined" contracting should require more than notification, but active approval by some third party, and notification that contracts have been awarded through the streamlined process should be public, along with full details of the contracted arrangement.

Sec. 111 — This is the section containing the vaunted restrictions on executive pay. I cannot quicky understand or summarize it, as different rules apply for firms accepting direct purchases, participating in other ways, "golden parachutes", etc. I am suspicious that in all of this complexity there is room for the Treasury and firms to structure their participation in such a way as to evade the restrictions and penalties defined in the act. But I don't have the time or legal experience to think about all of the different what-ifs, and how this very complicated section of the act might apply.

Sec. 112 — Permits the Treasury to take "troubled assets" off the hands of foreign central banks, if the assets were issued by financial institutions that have defaulted. Whoa! What's this all about?

Sec. 113(2)(b) — The Treasury is specifically authorized not to purchase at the lowest price possible, but to purchase "at the lowest price that the Secretary determines to be consistent with the purposes of this Act". That's comforting.

Sec. 113(d) — While in general the Treasury has to acquire warrants or debt from participating firms, this section is much weaker than the "make whole" requirement reported in the Dodd proposal. The Secretary has complete discretion over the terms of these arrangements

(i) to provide for reasonable participa-
tion by the Secretary, for the benefit of
taxpayers, in equity appreciation in the
case of a warrant, or a reasonable interest
rate premium, in the case of a debt instru-
ment; and
(ii) to provide additional protection
for the taxpayer against losses from sale of
assets by the Secretary under this Act and
the administrative expenses of the TARP.

That's it. There are no teeth, nothing that says if a firm fobs an asset off and forces a serious loss on taxpayers, the Treasury will achieve a claim on the firm sufficient to make it whole.

Sec. 114 — Market Transparency. The good part:

To facilitate market transparency, the Secretary shall make available to the public, in electronic form, a description, amounts, and pricing of assets acquired under this Act, within 2 business days of purchase, trade, or other disposition.

The bad part: buying "assets" doesn't begin to cover all that TARP is permitted to do. What about the obligations or contingent liabilities it assumes? Those should be made public as well.

Sec. 115 — This is the part about the size of the TARP's balance sheet, including the celebrated "installment plan". It retains the huge loophole that restrictions apply to the size of TARP's balance sheet "outstanding at any one time". That is, Treasury could spend more money than these limitations seem to imply by purchasing and then reselling assets at a loss, then purchasing more. There are restrictions elsewhere, suggesting that Treasury must either hold-to-maturity or sell when it would be most advantageous to the taxpayer, but that leaves a whole lot of wiggle room. Treasury can always purchase, then claim to have revised its valuation and sell "advantageously" at a loss.

There's a lot of verbiage in this section about the procedure by which Congress could refuse the second $350B installment. The details are beyond my comprehension or interest, but broadly, by default Treasury gets the second installment unless it is specifically blocked by action of Congress.

Sec. 128 — Though there's no indication of what this is about in the plain language of the act, this is a stealthy acceleration of the Fed's ability to pay interest on deposits (ht commenter Rue The Day).

Sec. 131 — It looks like someone didn't like that the Treasury's guarantee of money market funds made use of the Exchange Stabilization Fund.

Sec. 132 — The SEC can suspend mark-to-market accounting requirements.

Sec. 134 — Recoupment... a ridiculous kick-the-can down the road, after 5 years we'll bill participants in the program for any loss. Right.

Sec. 310 — Looks like some kind of tax relief for losers on Freddie and Fannie preferred.

Going political

I really hate to disagree with Kevin Drum. He’s thoughtful, moderate, level-headed, smart. He’s the kind of guy who is, on balance, usually right. So, it makes me nervous to read his recent post, Pass the Effin Bill.

I don’t know if the financial universe will blow apart if Asian markets open tomorrow night and there is no bail-out in sight. I do know that the TED spread may not be telling us what we think it is, that the current proposal has almost nothing to do with the stressed out corporate paper market except via the catch-all term “confidence”, and that the timing of bank failures is largely at the discretion of the FDIC. I accept the principle that it is worth bearing significant costs to insure against even uncertain catastrophes, but other than cries of inchoate pain from anything labeled financial, I have yet to hear a compelling tale of why we should be confident that this expensive ounce of prevention will actually work. Hope is not a plan, and neither is discomfort.

Of course the people advocating the Paulson Plan have the capacity to create pain that might be perfectly avoidable. Yes that’s cynical. But that’s honestly where I am. Not only do I not have confidence in the solvency of the banking system, I don’t even have confidence that important players in both the public and private sectors wouldn’t use the tools at their disposal to create a little pain, until they bully the public into giving what they want. I know, I know, give me my tinfoil hat. But, if you believe the advocates of the Paulson Plan, major financial institutions would be insolvent if they marked their assets to current (um, “fire sale”) market bids. That’s not what their balance sheets say. If it’s true, investors and the public at large have been lied to for months by the leaders of the institutions to which we are expected to trust our life’s savings. And they want us to help cover that up. So, I’m cynical.

Anyway, for better or for worse, I was finally moved to do get political and write my representatives in Congress. I hope this was the right thing to do. For whatever it’s worth, here’s what I wrote:

September 27, 2008
To:	Representative Ben Chandler
Senator Jim Bunning
Senator Mitch McConnell
Re:	the “bail-out” (Fax transmission, 3 pages including this page.)

Like many voters, I feel helpless and angry as an astonishing bail-out of our corrupt and obsolete financial industry wends its way through the Congress. I am a new resident of Kentucky, have lived here for just over a year. The three of you are now my voice in Washington.

I am a doctoral student in finance at the University of Kentucky. I am not the world’s foremost expert in anything, but I am making the study of financial markets my vocation.

The legislation submitted by Secretary Paulson last weekend, if passed, would have been an astonishing arrogation of unchecked power. I fear for the United States of America that the proposal was even considered by the Congress, and described as “a good foundation” by Senator Schumer. After his crass attempt to assume near dictatorial power, I have lost my trust in Secretary Paulson. I believe this financial industry insider must be kept on a very tight leash for the few months he has left to help his friends and former colleagues on Wall Street.

I do, however, believe that we face a financial emergency, and that the Congress could play a constructive role in resolving the crisis in a manner that protects taxpayers and the general public and ensures that those responsible for our financial collapse bear most of the costs. I think there are two workable paths, one fully public and one fully private. I am open to both approaches. But I am adamantly opposed to a "public / private hybrid" solution, because frankly, I don’t think even our most well-intentioned public officials can avoid being milked and hoodwinked by the world’s greatest dealmakers. Either the Federal government should take over failing institutions, as it has taken over the insurance giant AIG, or the barrier between the public purse and the private banks should be made impermeable. The first thing that any legislative proposal should do is remove the gun that bankers currently hold to the head of our nation: the threat of disorderly bankruptcies. All systemically important financial firms should be subject to a controlled procedure in the event of insolvency, and should only have access to ordinary Chapter 11 reorganization or Chapter 7 liquidation after regulators have vouchsafed that such a filing would not imperil the nation’s financial system. Similarly, a petition by a creditor for involuntary bankruptcy should trigger the same regulatory review.

The Congress should choose either a private sector or public sector approach to managing the failure of systemically important firms. A private sector approach should follow the principles outlined by University of Chicago Professor Luigi Zingales. [See http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf] All of our financial firms are "asset rich" — they have plenty of money, it’s just that they have too much debt. They can be rendered liquid and solvent by requiring some creditors to accept equity in the firms in exchange for their debt claims. This is a perfectly fair outcome: People who lent these highly leveraged companies money knew or ought to have known they were taking a risk, and capitalism requires that lenders every bit as much as stockholders take responsibility for the soundness of the firms in which they invest. Unless these firms are quite profoundly insolvent, most creditors should take only a small haircut on the value of their debt, and could profit over time if the firms recover. Even the thorny issue of derivatives and other contingent liabilities can be addressed in this fashion: Firms that undergo a “fast-track reorganization” would be given the right to pay these obligations in the form of $1 par value preferred stock (the structure of which would have to be defined by Congress). Counterparties to derivatives transactions would undoubtedly prefer cold cash to company stock, but at least these contracts wouldn’t become fully worthless, as they would have under ordinary bankruptcy. Since counterparties would take only a haircut rather than a total loss, debt-to-equity conversions would help minimize the likelihood of cascading defaults on derivative contracts, the dreaded "CDS meltdown".

A public sector approach the problem would be to let the controlled failure of AIG serve as a model for systemically important financial firms. The banks that are today failing took on huge and foolish risks. (That "everyone was doing it" is a schoolboy’s excuse, not acceptable from people entrusted to manage trillions of other people’s money.) If as a consequence of their poor decisions, they now need money from the Federal government, we should demand that the taxpayer take effective ownership of the firm in exchange for the support. Regulators could then ensure a reorganization that promotes systemic stability while minimizing taxpayer costs, following which firms could be reprivatized in small, conservatively financed pieces that would no longer be "too big to fail".

Both the private sector and the public sector approaches presented here are workable, protect taxpayers’ interests, and avoid rewarding malefactors of great wealth with gargantuan public subsidies. The hybrid approach at the core of the Paulson Plan will result either in a serious cost to the taxpayers, or in future inflation as the Federal balance sheet is stretched to the breaking point and people lose confidence in US Treasury securities. (With a high enough rate of inflation, the Treasury can definitely turn a paper profit on any trash it buys from Wall Street, but that paper won’t be worth much. We could avoid a lot of foreclosures if we devalued the dollar by 50%.)

I am an independent voter. At the Presidential level, the Republican Party has already lost my vote. The last eight years have been catastrophic for the country, and accountability demands a change of party in the White House. At the Congressional level, however, my vote is up for grabs. Frankly, your response to the current financial crisis is my litmus test issue.

If there is any way I can be of service as you work through these difficult issues, I would be very honored to help. I thank you for your time and consideration.

Sincerely,
/s Steve Waldman

Real capitalists nationalize

Brad DeLong made my day:

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

  • grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship

  • requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury

  • requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

  • grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

…It’s time for the Democrats to pass a nationalization in the taxpayers’ interest bill and dare Bush to veto it.

There’s a beautiful irony here. The superficially private-sector-friendly Paulson Plan is likely to entail socializing losses and undermining the incentives that give capitalism its efficacy and its legitimacy. Outright nationalization, on the other hand, may look like a Commie statist plot, but strengthens the “invisible hand” in the long run, as long as the nationalization is temporary.

To understand the paradox, go back to Zingales’ excellent essay. Under ordinary circumstances, when firms can’t manage their debt, Chapter 11 reorganization is an excellent means of preserving market discipline while preserving the “going concern” value of the enterprise. Unfortunately, bankruptcy is a slow and uncertain process. In the current crisis, the insolvent enterprises are so large, numerous, and interconnected that financial markets might self-destruct if we “let nature take its course”.

Temporary nationalization could serve as a kind of fast-track bankruptcy. Creditors, counterparties, and customers would have some certainty that firms in conservatorship would continue to function, and most could expect to be made whole (although the state could and should force haircuts or debt-to-equity conversions on the some junior claimants). Stockholders and incumbent management would be unceremoniously booted from nationalized firms, creating a strong incentive for companies to avoid the state’s tender mercies if at all possible.

Besides reassuring counterparties, nationalization provides an opportunity for the government to restructure firms prior to reprivatization with an eye towards reducing systemic risk. “Too big to fail” firms can be sold off in pieces, rather than merged into superbehemoths with a government-arranged subsidy, as is the current fashion.

Of course, nationalization does represent a “taking” by the government of private sector assets. The salutary effect with respect to market discipline has to be weighed against a corrosive effect on property rights. But if the terms under which firms can be nationalized are reasonable and carefully spelled out, especially if nationalizations generally occur where firms otherwise would have fallen into bankruptcy, the harm to property rights would be minimal. Also, procedures and timetables for reprivatizing or liquidating nationalized enterprises would have to be built into the plan.

Nationalization is a hard sell politically. Small government, free-market types naturally have a problem with the Feds coming in and taking over stuff. But counterintuitive though it may be, overt nationalization is more consistent with the principles of a free market than covert government subsidy. Real capitalists nationalize.

Update History:
  • 27-Sept-2008, 2:oo p.m. EDT: Changed “let nature taking its course” to “let nature take its course”. Fixed spelling of “mericies”.

Why did Friday come early this week?

Okay. So now I reveal myself for what I am. A conspiracy theorist, a nutcase, a crank.

But tell me, why did Friday come early this week?

Isn’t it a tradition for bank reorganizations to be announced after market close on Friday nights? Isn’t part of the reason for that to give markets time to chill out, think a bit, notice that the ATMs still work and the branches have not been demolished, to let the sun rise and shine for a whole two days, in order to diminish the possibility of people freaking out?

So, here is today’s news cycle. Red State Republicans react to a unprecedented popular outrage among their constituents and refuse to get with the program. It is leaked that President Bush solemnly opined, “If money isn’t loosened up, this sucker could go down.”

Was he standing at the teller window with a note about a bomb when he said that?

And, for good measure, the government announces “by far the largest bank failure in American history” with less than 16 hours to market open.

That loud noise, was that the sound of a single gunshot? Have the robbers killed a hostage, to show that they mean business?

Yes, the irony is delicious that Paulson’s plan has for the moment been scuttled by the ideologues that his party has cynically nurtured, by the base that the business wing of the party always thought they could play. And yes, the House Republicans’ alternatives, as reported by Justin Fox, are laughable.

But that doesn’t explain the sequence of events this evening. Nor does it excuse the fact, that if a legislative response to the crisis was so critical, a single deeply flawed proposal was thrown at the Congress a week before adjournment, under terms that basically said “pass this, or else”. It is surely coincidental that the plan was the most generous and least disruptive policy possible to industry from which Secretary Paulson hails.

No, I am a nutcase. These are all public servants doing their very best for the American people in a difficult situation. We need to pull together, rise above politics. Our leaders would never manipulate markets to frighten and punish the public so that we fall into line. That could never happen in the United States of America.

I am dark. Secretary Paulson could have offered any number of proposals to help ensure that this collapsing house of cards is a controlled demolition. He and Dr. Bernanke had months to put together policy options, long months between the fall of Bear and the fall of Lehman to create orderly processes for disorderly events they knew could come. At the last moment, they offered one option, a particularly unpersuasive plan imperiously presented as a fait accompli. When Congress balked, they relented and offered a few crumbs so that the people we elected could nibble at the edges without altering the core. And today, when it looks like those crumbs might not have been enough, we have the largest bank failure in American history, announced, oddly, on a Thursday night.

JPM, BOA, and Citi: The new big three

Manhattan, 2008 = Detroit, 1979?

How many of readers believe these behemoths, our new saviors, could survive the present crisis without unprecedented Fed liquidity support and the pending Treasury solvency infusion? What would have come of Citi and its famous SIVs had it been without a too big to fail option?

Now, after a series of deals, several of which involved the government stripping liabilities of and privatizing assets, these commercial bank holding companies are the new kings of Wall Street, the white knights of our financial crisis. What lessons have been learned? Is it better to be canny and prudent in business, or to have Robert Rubin on your board and Timothy Geithner in your rolodex?

Detroit’s big three had a near death experience, and learned that by working the government, they could survive and sometimes even prosper. Working the government meant especially throwing their very bigness around the political system to get subtle little perqs, twists and loopholes in, say, well-intentioned environmental regulations, to keep them going and give them an edge over far superior competitors elsewhere in the world. GM has got to be the most insolvent going public concern in the history of the world, with -$57B in shareholder equity, but the beat goes on, with $25B in new government loans to the big three currently in the pipeline (and $25B more demanded). Imagine an alternative history in which these firms had painfully reorganized in 1980, their plants and assets taken over by lean new competitors with the fear of death in ‘em, desperate to learn from and best their rivals everywhere.

Barry Ritholtz is exactly right.

We now have a new big three, each intimately connected to the government monetary and regulatory establishment, and each profoundly too big to fail. They won’t abuse the that position, say, to strangle or absorb innovative competitors, would they? Cherish the thought. Thank goodness for the Borg. Who else could have eaten WaMu-Bear-CW-Merill? J.P. Morgan / Washington Mutual / Chase Manhattan/ Chemical Bank / Bear Stearns / Bank One / Manny Hanny, you’re my hero!

To those of us who do believe that, despite this decade’s toxic experiments, good financial innovation is not only possible, but desperately needed, this looks like the beginning of a new dark age. All the wrong lessons are being learned, as we muddle through an acute crisis by ratifying past idiocies, reinforcing ill-gotten inequalities, and consolidating where we ought to be cutting up.

All is not lost though! There is a scrappy new upstart to really shake up the Wall Street establishment! What was its name again? Oh, right. Goldman Sachs.

What was wrong with the AIG model?

I’m feeling unhelpful, because I’ve complained bitterly about the Paulson Plan and been cool towards the Dodd Plan, but my own suggestion was an obvious nonstarter. We mustn’t offend the delicate sensibilities of creditors, or God forbid give them a haircut. So, really, what would I suggest?

I wonder, what was wrong with the AIG / GSE model? The government has already published a pretty exhaustive list that includes the systemically important and potentially vulnerable financials along with many other firms — the “no short” list. Suppose Congress passed a law providing for fast-track reorganizations modeled on AIG. Firms on the “no short” list would be required to consult with the Treasury prior to any bankruptcy filing, and listed firms would be presumptively eligible for an AIG-style bailout. During an insolvency, the government would take warrants on 79.9% of firm stock, in exchange for a loan or preferred equity infusion sufficient to cover obligations to creditors during an orderly wind-down or reorganization. Existing management would be replaced, and government auditors would examine firm accounts to ensure that there were no “fraudulent transfers” precipitating the bail-out. Any such transfers discovered between the listing of the firm and the reorganization would be criminalized, and prosecuted vigorously. Listed firms would have a fiduciary obligation to the government as well as shareholders, such that “gambling for redemption” near insolvency would also place firm managers in criminal jeopardy.

Temporary routinization of AIG-style bailouts would put skittish creditors at ease. Although Treasury would retain the right to opt out and permit a traditional bankruptcy, the default course of action would make creditors whole. Equityholders and management of listed firms would have a strong incentive not to take the government up on the bail-out if they have any prudent means of avoiding it, since they would lose nearly everything. Taxpayers would own the firms they rescue, and would enjoy the upside of successful reorganizations or divestitures.

Like all the bailouts, this scheme rewards the moral hazard of creditors, and I hate that. There is the danger that it would not be temporary, and that promised regulation to restrain leverage would never materialize, leaving only a subsidy to future blackmailers. Still, I think it’s a lot better than silently and opaquely recapitalizing firms without replacing management or forcing at least shareholders to take a hit.

AIG-style bailouts would stigmatize firms that take advantage of them, as any form of bankruptcy does, but many firms do successfully reorganize from bankruptcy, and the stigma would be well deserved. The process would be transparent.

That many firms would not survive their brush with insolvency in anything like their original forms is an positive. I strongly agree with Barry Ritholtz, quoted in a piece by David Leonhardt:

If Chrysler had collapsed, [Ritholtz] argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.”

If we do end up with a gentle, behind-closed-door bailout of financials, I’m afraid that in twenty years, we may view lower Manhattan the same way we see Detroit today. What Wall Street needs is what it has delivered to so many other industries, a dose of Schumpterian creative destruction, to make room so that better things may rise up from the ashes.


p.s. I do hope to rise to Dani Rodrik’s challenge and be concrete about what “better things” might look like, but, alas, my bitter obsession with the looming bail-out takes priority.

p.p.s. Since the government has stormed the commanding heights anyway, does anybody else think it’d be a good idea for some bureaucrat to declare a ban on dividend payments for all firms on the “no short” list? This would have the effect of helping troubled firms preserve cash, while softening the hit individual firms would take if they announce dividends cuts. Firms on the list would have no choice, and only a small minority of “no short” firms are in crisis, so there should be no stigma.

Paulson’s vacuum cleaner?

Commenter “geee” asks a very good question:

[W]ould banks and other financial institutions be allowed to act as conduits to hedge funds selling these securities?

Given that Ben Bernanke has conceded that it is the government’s intention to purchases assets at a “hold-to-maturity” price rather than at a price near market bids, banks favored by Paulson could earn a nice living serving as a market-maker to any entity in the world holding bad paper. Bank buys “toxic” asset from hedge fund, individual, foreign government, whomever, for something above the market bid and then resells to Treasury for the “hold-to-maturity” price, earning a nice spread. All those “blockages” in the financial system might start flowing real fast, into as well as out of our poor sclerotic banks.

This adds to concerns expressed by others that banks would acquire bad mortgages and structure new assets eligible for “hold-to-maturity” sale. (The plans do have language specifying “originated on or before”, but it is ambiguous whether that refers to the mortgages or the securities that wrap them, and there is a big loophole, see below).

A related concern is that the Treasury would purchase assets that are simply inappropriate. Both the Paulson and Dodd plans now permit the purchase “any other financial instrument, as [the Treasury Secretary] determines necessary to promote financial market stability.” The term “financial instrument” covers a lot of ground. In particular, I am uncomfortable with the prospect that the Treasury might take over third parties’ contingent liabilities, as the Fed did when it acquired a book of derivatives from Bear Stearns. (The Fed is at least somewhat shielded from liability by its holding company, Maiden Lane LLC. As far as I know, the Treasury would not be.)

With all the world nervous about counterparty risk, having the US government become a “risk-free counterparty” would undoubtedly soothe nerves, but it could put tax-payers on the hook for indeterminate payouts in a bad scenario. Suppose a hedge fund or non-US insurer that has written a lot of CDS protection goes down, and the dreaded counterparty cascade does occur? I don’t think the Treasury should be in the business of trying to insure the 60+ trillion dollar CDS market. (Yes, that’s notional, but blown counterparties mean questionable netting, so liabilities in a bad scenario could become a significant fraction of notional even on a hedged book.) Nothing in either of the major proposals forbids the Treasury from going down that road, and there are all kinds of reasons, some public-spirited and some corrupt, why it might. There needs to be hard and fast language forbidding positions in financial instruments on which losses are not limited to the upfront cost of purchase.

I don’t mean these to be very constructive suggestions. I still don’t like either plan, though I’d much prefer Dodd to Paulson. But in any plan, there have to be controls on what sort of positions can be taken, including when the asset was last restructured, when ownership was most recently transferred, and that the Treasury’s liability must be strictly limited.

While I’m on this, I want offer a shout out to Calculated Risk for continuing to push on transparency. I cannot believe that the government may trade nearly a trillion dollars of assets on my behalf, and I may never learn exactly what it did. I would never invest in a “rocket science” hedge fund whose manager refused to disclose what he was up to. It looks like I may end up paying taxes to one. There is a lot about this plan that really has me angry, but the shrouded-in-shadows aspect more than anything else has me wondering whether this is still America. A Congressional oversight committee is not enough. Investors with 700 billion dollars under management at the very least deserve the frequent statements that any retail brokerage would issue, enumerating and detailing the performance of all assets transacted.