First things first… why the government? Why not leave the dirty task to private asset management firms? Couldn’t they be brought together to buy the garbage (oops, I did it again.. meant “illiquid assets”)? Without a penny of taxpayer money??
Some have responded that, given the scale of needed intervention (see $700 billion minimum), there is not enough private cash to do the job. I actually don’t buy that. Fed data on monetary aggregates suggest that, since the subprime crisis hit last year, tons of private money have fled risky assets and are “sitting” in cash form, waiting… for what?
The right price! That’s the real problem: Despite frequent claims that prices have reached obscenely low levels, the “fair” price of the garbage (damn my Freudian slips!.. “Illiquid Assets”!) remains a question mark. This implies a huge risk for prospective buyers and a huge uncertainty for their creditors. That is, if a private firm must raise funds to buy the garbage (ok, last time, promise!), their creditors would demand prohibitive interest rates to compensate for the risk that the securities purchased are true, ugh, garbage!
So here is one advantage for Hank. Currently, the US government can get a 10-year loan at less than 4 percent interest! That’s quite an advantage—the equivalent for triple-A financial institutions is 7.3 percent (if anyone is prepared to lend ot them). In plain language, the government can afford to take on more risk than the private sector.
Gets better.. the government can hold the @#&@age to maturity and forget about short-term market risk. Not true for private financial firms, which have to mark down any short-term price declines, courtesy of mark-to-market accounting.
Finally, there is another advantage for the government: Bargaining power. The government can impose conditions on the benefiting banks, to ensure the bailout works as per my “definition” above: That is, not only get banks back to business, but also contain moral hazard and protect the taxpayer.
So how do you do that? And would the bailout in its current form do the job?
Making the banks “confess”: Challenge No.1 is to make sure banks reveal the full scale of their problem. The reason is simple: We want all the #&$age out of banks’ balance sheets, fast!
Why? Because we want the bailout to help eliminate fears about which bank will go bust next. And because we want to free-up capital for new, high-quality lending. So unless we know how much is “all,” we won’t know if banks are clean after the bailout.
But what would make banks confess? Well, the right price. If the price is too high (say close to face value), banks will happily unload their assets and even start lending again—but taxpayers pay more. But if it’s near current market levels, banks would either be reluctant to transfer the assets to the government (ergo no new lending); or take large losses and go bust (ergo zero confidence and no new lending). Taxpayers pay less, but…
Is there a middle? Could the government’s proposal of reverse auctions do the job? I’m actually not so sure—reverse auctions might encourage banks to reveal a “fair” price for the securities they’d be willing to auction. But unclear whether they would make banks auction all their junk (note the use of a synonym!).
If anything, the auctions might help banks that have already acknowledged their problems make a profit! I mean, if I were a bank and I’ve already taken (huge, fire-sale-type) losses on my junky assets, I’d rush to put those up for sale in the hope that the clearing price turns to be higher! On the other hand, if I have yet to acknowledge my losses, out of fear that my creditors will panic and run on me, I might refrain from stepping forward, unless someone (the government?) promises to recapitalize me.
Charging for “lunch”: How do you solve the problem? By offering banks incentives to step forward, while also allowing the possibility that more may have to go bust.
For example, the government could offer above-market (e.g. “hold to maturity”) prices in exchange for commitments by shareholders for fresh capital injections. And if shareholders are reluctant to put any new capital to keep banks healthy, one might as well let that bank fail, since not even its owners believe in their firm’s ability to generate adequate income in the future.
Alternatively, the government could enter in profit & loss-sharing agreements with the banks—like those adopted by Asian countries following the crisis in the late 1990s. Accordingly, banks could retain a pre-determined stake in the upside (with call options), if recovery prices ended up higher than the government’s purchase price; but also maintain a share in any further loss up to a ceiling. Other incentives could include tax breaks in exchange for banks’ recognition (and transfer) of bad assets (e.g. allowing amortization of the losses over the course of a number of years).
Worth noting that it’s unclear whether such incentives will be included in the package soon to come out of Congress. True, there will likely be limits on executive pay, which could reduce moral hazard in the future… but this is far from enough to address the urgent problems of today.
And the taxpayer? At the end of the day, the bill to the taxpayer will not be known until banks reveal the full scale of their problem. The full scale of the problem will not be known until the economic slowdown (recession?) unfolds in the coming months. The recovery value for the junk the government buys will not be known until things normalize. And, of course, even if there were a profit, can’t say I trust the future administration to send me a tax rebate in the mail.
Still, at this point, I’m ready to go with JFK’s call on that same inaugural speech:
“All this will not be finished in the first 100 days. Nor will it be finished in the first 1,000 days, nor in the life of this Administration, nor even perhaps in our lifetime on this planet. But let us begin.”
Glossary: reverse auctions, call and put options, mark-to-market, JFK.
1/ For the non-Americans among you, I am paraphrasing John F. Kennedy at his January 20th 1961 inaugural address when he famously said: “My fellow Americans: ask not what your country can do for you—ask what you can do for your country.”
Originally published at Models & Agents and reproduced here with the author’s permission.