Wednesday, September 24, 2008

Plan B: How to Restore Financial Markets Without a Bailout

In the last several days there has been an emerging consensus among well-informed analysts (like this and this) regarding the Fed/Treasury plan to bail out financial markets. It goes something this: the US financial sector faces a liquidity crisis on top of a solvency crisis. The liquidity part is that financial intermediaries (only some of them banks) are increasingly unable to meet their obligations to depositors and counterparties because they have no access to credit. Highly leveraged, they do not have the resources at hand to carry on their business. If this were the entire problem, the Fed could solve it by offering to buy mortgage-backed securities and similar assets at their actual market value. In that case there would be no bailout, just an infusion of liquidity to tide the markets over.

But there is an underlying solvency crisis: as housing values have declined, assets tied to them are no longer worth the financial obligations institutions have incurred in acquiring them. A large portion of the financial system (no one knows at this point how large this is) has negative net worth. This is why Bernanke has spoken of purchasing assets at their face rather than market value.

There are two gigantic problems with the bailout scheme, in addition to all the smaller ones. First, overpaying banks, investment funds and other financial players to the tune of hundreds of billions of dollars is an ethical and moral hazard nightmare. These people have made obscene fortunes in wild speculation; now that their bets have gone sour is it the public’s duty to cover their losses? Second, it is not even clear that the strategy will work. We don’t know how much it will take to bring the financial sector back to life, partly due to the lack of transparency that helped get us into this mess in the first place, and also to the understandable reluctance of firms to mark down all the paper that has declined in value. It may well be that between one and two trillion dollars will be needed to get the markets back on their feet, and this may exceed the financial and political resources of the federal government.

A big improvement (championed by Paul Krugman) would a buyout of the firms rather than the assets, even as an option as formulated in the Dodd proposal. Still, and especially in light of the difficulty in disentangling viable portfolios from moribund ones, the cost may be too great. It would be nice to have something completely different on the table. So read on: here is a Plan B, an alternative to bailouts that might restore a functioning credit mechanism to the US economy.

The concept: The existing approach tries to bring existing institutions out of insolvency and credit gridlock. Plan B allows these institutions to go belly up but rapidly creates a parallel financial mechanism to rescue sound assets from the rubble while offering credit to new borrowers. Rather than providing a public prop, it provides a public alternative.

The plan: Create a new publicly-financed, publicly-run enterprise; for the purposes of this description we can call it Fund US. Its initial capitalization would be provided by a Treasury issue. The amount could well be much less than the $700B (or $1.4 trillion in borrowing authority) that headlines the existing plan. This is because the fund would be permitted to leverage up to some reasonable ceiling—say six-to-one. So give it $300B as an initial allocation.

One initial function of Fund US would be to open a window for the purchase of existing financial assets at fair market value. This is not necessarily the same as the value of the moment, since, by its size relative to the markets as a whole, Fund US would be a price-maker. One possibility would be to honor prices as of September 15, before any general public plan was broached. Another, specifically for MBS’s, would be to use an algorithm based on a decline of the Case-Schiller Index to long run trend. Either way, this would protect the genuine value of financial wealth tied to housing from the cascade of defaults likely to sweep through the private sector.

The other main function would be to serve as an all-purpose financial intermediary to the US economy and to foreign interests that do business here. It would underwrite existing loans or other contracts, originate new credit and assemble a portfolio of financial assets in a manner consistent with prudent management. On the liability side, it would accept deposits and sell instruments like mutual funds and secondary debt. In other words, it would do what the current system does, subject to greater constraint.

What could assure this constraint? Here are some ideas: (1) The limit on leverage would be statutory. (2) Full transparency could be written into the legislation authorizing Fund US. All assets and liabilities would be publicly reported and all terms made explicit. (Small borrowers and lenders could have their individual identities protected for privacy purposes.) (3) There could be systems of oversight and undersight. The first would be provided by an outside board of disinterested specialists, primarily academics in the fields of accounting and finance. For the second, we might have front-line employees, who analyze and perform individual transactions, constitute themselves into a review body. This entity could give frequent public assessments of the quality of the Fund’s activities and their adherence to overall policy objectives—institutionalized, routinized whistle-blowing capacity. (4) All employees of the Fund, top to bottom, should be paid fixed salaries—no commissions or bonuses. (5) The Fund’s goals should be to maintain the value of public equity, minimize aggregate risk and have the capacity to supply credit sufficient to meet the needs of the economy. Profit maximization, returns in excess of what is necessary to supply a net worth buffer, would not be a goal.

Of course, one paragraph cannot possible provide sufficient detail to demonstrate that such an institution is feasible. On the other hand, how many paragraphs do we have at this point for the mega-bailout?

Two additional elements of Plan B are required to complete this brief sketch. First, Fund US would not be a chartered monopoly. Any financial institutions that survive the ongoing shakeout can compete against it, as can startups. Indeed, because of its lack of incentive for aggressive marketing on both sides of the ledger, it may eventually evolve toward being a financial intermediary of last resort. This would be fine. Second, for competition in this market to be constructive, new regulation must be extended to all players along the lines currently being discussed. In particular, limits on leverage and transparency requirements should apply to all intermediaries, whatever their institutional morphology.

I will not make any great claims for Plan B. Its details require much more working out. There is also a valid concern that it may not be possible to get a massive new institution up and running before existing credit channels freeze up. It would have been much better to have developed a public fund slowly and carefully during the pre-crisis phase, but who was thinking this far ahead? I am less bothered by the ideological objection to a public institution taking on the functions of private firms and competing with them. To take one example, more than half of all the assets in the German banking system are in public and cooperative banks. Germany isn’t utopia (and one of its state banks was mauled because it indulged in dubious US assets), but it is, along with China, the world’s leading industrial exporter. It runs a huge trade surplus with the US, largely due to the strength of its small and medium-size enterprises. Small firms in Germany are global players because they have the same access to capital as big ones, something that can’t be said for the US. This is not to say that we should copy the German template, just that there is no reason to assume that public financial institutions can’t support a successful modern economy.

Plan B is offered to you as a stimulus to creative thinking about the current imbroglio. I would be interested to find out if it can withstand scrutiny.


Myrtle Blackwood said...

I've rephrased your proposal Peter. Is this an accurate rendition?

- Allow insolvent institutions to go belly and publicly take over their functions. This time with statutory limits on leverage and full transparency. Buy assets at fair market value rather than value at the moment. Be a price maker.

Remove the incentive for aggressive marketing in the economy by subjecting the same regulation that this new institution has to all players.

Institute institutionalized, routinized whistle-blowing capacity:

- provide oversight by an outside board of disinterested specialists, primarily academics in the fields of accounting and finance.

- provide undersight from (perhaps) front-line employees, who analyze and perform individual transactions, constitute themselves into a review body. This entity could give frequent public assessments of the quality of the Fund’s activities and their adherence to overall policy.

- pay fixed salaries to all employees.

- Drop the goals of profit maximization and excess returns.

- serve as an all-purpose financial intermediary to the US economy and to foreign interests that do business here.

Allow surviving financial institutions and startups to compete against this new body. Facilitate its evolution toward being a financial intermediary of last resort.

Peter Dorman said...

Kind of, Brenda, but I would foreground the basic idea: provide liquidity through the purchase of distressed assets at the going (highly marked down) price, but otherwise allow existing private banks, funds etc. to choke. Meanwhile, scale up a public general-purpose financial intermediary to perform the functions of the failed institutions. Impose proper regulations on the whole system. The finer points about the public fund are just for the purpose of convincing skeptics that we can do a much better job of honesty and sound judgment.

Myrtle Blackwood said...

Australia had a national bank for decades. It was also the Central Bank for a time. This arrangement seemed to work reasonably well.

Then it was privatised in steps by the Australian conservative Lib-Lab party between 1991 and 1996. Things fell apart (in general) afterward.

"In 2002, the Commonwealth Bank came under fire by the Wilderness Society for its 16% stake in the controversial woodchipping company Gunns Limited, which is involved in the logging of old growth forests. The Commonwealth Bank has retorted that it does not itself hold any direct investment in Gunns Limited, but instead has invested in Gunns through its funds management businesses, on its behalf.[4] The Wilderness Society claims the Commonwealth Bank is the second biggest shareholder in Gunns, and at a Gunns shareholder general meeting in August 2003, the Commonwealth Bank has used its shareholder voting rights to vote against a resolution which would have stopped the company from destroying old growth forests[5].

Commonwealth also owns an 8.2% share in the Hazelwood power station[6], the most carbon intensive power station[7] in Australia and the industrialised world.

It would be appropriate for the central banks to become fully public and stay that way. I can't see any logic in such an entity being private in the first instance. How can the public have any democratic control over the running of government if their government has lost control of the currency? How can regulation of the financial sector take place when the very same people causing catastrophes are running the central bank?

The Big Mook said...

Some insight into how fast the US government can put together an institution.. I was at the SBA disaster office after Katrina. The office ramped up from a crew of 800 loan officers to over 4,000 in a matter of days. There are thousands of US government trained loan officer in reserve for natural disasters. Why not put us to work on the wall street made disaster?