With the collapse of the Treasury Department’s proposed bailout plan, we have avoided, at least for the moment, a very unfair plan.
As we mentioned in our last piece on the subject, which you can read here, the bottom line of the Paulson plan is that either the Treasury was going to buy assets at the market price — in which case, there is no need for a government plan — or the Treasury would have paid more than the market price — in which case, the plan would unfairly bail out specific Wall Street interests because of supposedly “systemic risks.”
By paying more than the market price, the same people who engaged in the risky behavior — high leverage, trade with parties without confirming they had resources to honor the trade, etc. — would be allowed to extort money from hard-working Americans because the Wall Street institutions are “too big to be allowed to fail.”
Newt Gingrich said the Paulson plan, with its vesting of virtually unlimited power in the Secretary of Treasury, was “un-American” and that Paulson should resign.
Though we have dodged a bullet, it has also come out that one of the consequences of the government’s bailout of AIG may have been saving the skin of Paulson’s old cronies at Goldman Sachs. See article here. We have not solved the crisis. Robert Salomon, a really sharp professor at NYU’s Stern School of Business who has occasionally taken note of some of our work on Tesco, sent us an e-mail that pointed this out about our piece:
I must disagree though (in principle) with the main assertion that we should not go ahead with some version of the Paulson plan (although the version they’re set to vote on leaves much to be desired).
At this point, not doing anything will result in financial Armageddon. In your article, you assert that it’s not that there is not a market for the securities, just that the sellers don’t like the price. However, if the banks did sell at the “true” market price, they would all be effectively insolvent.
Imagine the consequences of having the entire banking system (many of the banks at first, not just a few, and the counterparty risk of each to the other would then bring all the financial institutions down — even the “technically” solvent ones). This would force the FDIC to take receivership for most of the system.
Their balance sheet is $42B. Do you think they have enough money to cover $10T in insured deposits, or even some fraction of that?? Then think about all the social ramifications — the mass layoffs, the decrease in government budgets, etc. It would be an absolute nightmare. And even though I agree that the $700B may not work (for reasons I plan to explain in a blog post), at this point we absolutely have to do something — even if it is only rearranging deck chairs on the Titanic. That’s how scary this event is to me. But again, that’s just my opinion. Doesn’t mean I’m right…
Professor Salomon is being admirably self-effacing; he is exactly correct. Now we would say three things in response:
- The financial institutions may all be insolvent, but they are insolvent to different degrees. We still need to sell the assets so we can know what the actual market value is, as that knowledge is the crucial information that will make going forward possible. As long as there is ambiguity as to what these assets are worth, credit will remain frozen.
- The cost of this situation has to be paid. But it does not have to be paid directly to those whose negligence and self-serving behavior got us into the mess.
- We can put $700 billion into the FDIC as well as into buying up assets.
We do not propose to do nothing. The situation is serious, but we think that allowing one person, without any real supervision, to allocate $700 billion is a recipe for corruption. We also think that it won’t solve the problem. We need to act quickly and any rational system for valuing and acquiring assets on this scale will take months to set up. So we would propose the following:
1) Avoid runs on the bank.
One way the Paulson plan fails is that it does not provide depositors with direct assurance that their deposits are safe. We would suggest that the first thing that must be done is full FDIC insurance coverage must be offered in unlimited amounts to all non-interest-bearing bank accounts. Because of the popular perception that money market accounts are 100% safe, we would provide a similar guarantee to all current money market fund deposits for one year — giving funds and individuals time to adjust their investment portfolios to match their risk tolerance. Many will choose to invest in money market funds that invest solely in instruments backed by the “Full Faith and Credit” of the United States once the risk of commercial paper is explained.
2) Change the incentives by individuals and local governments in relation to housing.
It is widely believed that there is a public interest served in encouraging home ownership. The rootedness to a community, a stake in society, etc… these are democratic interests that we can favor through a sound housing policy. If we do this correctly we can also get people buying homes again. There are three separate problems:
- The government now bizarrely encourages people to use their homes as an ATM machine. Under most circumstances, interest on a home equity loan, for example, is tax deductible, whereas the interest on the same loan taken without a lien on the house is not deductible. Many a person who has the cash to buy a house or to put a larger down payment on a house has been encouraged by their tax advisers to take out a larger mortgage in order to get the tax deduction. This is all insane. Whatever the public interest in encouraging home ownership, there is no public interest in encouraging borrowing against one’s home.
- Equally, one of the biggest obstacles to home ownership is high real estate taxes. Yet the federal government encourages this by allowing full deductibility of real estate taxes. The truth is that real estate taxes should only be used to cover housing-related expenses — perhaps the fire department or that portion of the police effort that goes to protect property. Some people decide to have a lot of their assets in a house, some people decide to have only a small percentage of their assets in a house. This is a personal preference and should not affect the amount they pay for, say, supporting a community hospital. Although this is a local decision, by changing what is deductible and what is not, the federal government creates a strong political constituency for changing local taxation.
- Though there is a public interest in encouraging the ownership of a primary residence, there is no public interest in encouraging larger homes or ownership of vacation homes. Allowing deductions on million-dollar mortgages and real estate taxes on multiple residences encourages things we have no reason to encourage.
The solution is to First, protect all current homes owners under the current status quo, then Second, announce that for all new home buyers, neither mortgage interest nor line of credit interest nor real estate taxes on home ownership would be deductible. Instead, there will be a flat tax credit given to those who own their primary residence.
We haven’t been able to quickly get the exact average cost to the federal government of our current policies, but the average price of a house in America is around $250,000. If the average person has an 80% mortgage, that would be $200,000. At 7% as an example, that would be a deduction of $14,000 a year. If the taxes are 1.5% of value, the taxes might give a deduction of another $3,750, so the total available deduction would be $17,750. If the average person paid a third of his or her income in taxes — most pay much less — the value of the deduction would be about $6,000 a year.
In lieu of deductibility for mortgage interest and real estate taxes, if we offer every homeowner a tax credit of $6,000 a year, indexed automatically for inflation, we would encourage home ownership while discouraging people from carrying mortgage debt, discouraging states and municipalities from taxing residential real estate and no longer incentivizing people to buy larger houses and vacation homes.
This would provide a permanent basis for a sound housing policy.
3) Offer short-term incentives to get the housing market going.
Rather than give money to financial institutions to overpay for housing related securities, better to give money to people to buy houses and thus increase the value of the same paper. Basically, it is understood that every time the government undertakes a project for the public good — say building a highway — some lucky people — say property owners adjacent to the highway — may benefit disproportionately. That is OK, but that doesn’t mean it would be OK to just give money to those same property owners.
Equally, in pursuing a policy of encouraging home ownership, some holders of mortgage-related paper will benefit — that is entirely different than Secretary Paulson deciding to write a check to particular companies.
If, for the rest of 2008 and 2009, we offer a one-time $10,000 tax credit to anyone who becomes a first-time home buyer, we would provide a big psychological boost to the housing market as people would feel an urgency to buy a home, now, before the tax credit expires. Family members would see a compelling reason to help their loved ones get into a house now, etc.
4) Re-definition of insurance.
Ben Stein — of Ferris Buehler fame — wrote a brilliant column on this crisis:
…the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett.
One of the reasons we can’t just bail out Wall Street is that in a very real sense these institutions and the people who run them defrauded the public. If one has $100 billion in mortgage-related securities and one enters into a credit default swap to protect against the decline in value, one will present financial statements showing those mortgage securities as being worth par. But if the Wall Street firm was negligent — or chose not to look too hard — and, in fact, the counter-party to that credit default swap didn’t have the assets to guarantee performance on the deal — those financial statements that constituted the earnings part of the P/E ratio were really fraudulent.
So every person who bought stock in those Wall Street firms was really hoodwinked.
It is important to understand that AIG, for example, has hundreds of insurance subsidiaries and, to this day, all seem basically sound. Why? Because selling insurance, by law, requires insurers to meet capital requirements, post collateral, etc. But a small subsidiary of AIG working out of London sold hundreds of billions of dollars of “insurance” against the decline in value of mortgage assets. Because of the way the laws and regulations were written and interpreted, this did not count as insurance, so no reserves were required.
Obviously the buyers of such insurance should have caught this, the sellers should have been more responsible and not written it, and the credit rating agencies should have caught it. This all being said, it is clear we need a legal change here, whereby these types of derivatives are classified as insurance and standards are set for collateral and capital ratios.
5) Ensure stronger financial institutions.
Citibank’s acquisition of Wachovia’s banking operations in a deal brokered by the goverment was really a result of Citibank moving quickly to bolster its capital position when this crisis first broke, whereas Wachovia dithered as it tried to avoid the dilution to existing shareholders such capital raising involves. In the end, Wachovia’s shareholders lost almost everything.
We wrote a piece here in which we called for companies to be restricted from buying their own stock, as this practice was being used to distort the market.
Now it is clear that both dividends and stock buybacks by financial and insurance institutions need to be deeply restricted. If a company is not profitable, it should be restricted from paying dividends or doing stock buybacks until it reestablishes a long-term record of consistent profitability — say ten years of profitable operations.
Tougher capital requirements, tougher reserve requirements and, most important, an assurance that all financial instruments are backed in this way — not a netherworld of derivative schemes that are neither insurance, nor securities — must be instituted to rebuild confidence in our financial institutions.
6) Segregate proprietary trading.
The root of a lot of these problems is that there has been a lot of confusion between a business and investing. Getting a commission on trading stocks is a business; giving financial advice on mergers and acquisitions is a business; managing money for investors and getting a fee to do so is a business; using a firm’s capital to buy billions in mortgage debt in the hope one can sell it at a higher price is just not a business — it is an investment, a speculation.
There is nothing wrong with speculating — but it shouldn’t be done by businesses as it creates conflicts of interest, and the inevitable losses will provide unnecessary shocks to the financial system.
Let proprietary trading be done by separate investment trusts.
Basically, the current crisis requires better capitalized financial institutions. Yet the proposal of the Paulsen plan to make them better capitalized by buying their troubled paper is very problematic, because the process of determining a value for that paper is fraught with difficulty and the potential for abuse.
Bill Kristol, who edits The Weekly Standard, pointed out that professor Lucian A. Bebchuk of Harvard law has come up with a very interesting proposal that involves the use of rights offerings to enhance capital ratios:
…financial firms that are undercapitalized but clearly solvent, as many financial firms seem to be, should be able to raise significant additional capital from private sources. It should be emphasized that the government has thus far not exhausted its options in terms of inducing financial firms to raise additional capital from private sources.
Following the Bear Stearns collapse in March, the government urged and encouraged some financial firms to raise additional capital. However, the government has not thus far required financial firms to go out and raise additional capital, and it should do so.
As pointed out by Raghuram Rajan, for financial firms that have substantial but sub-optimal capitalization, the government could and should require raising capital through right offerings to existing shareholders. While such right offerings would not be effective for firms in relatively fragile situations, they could bring significant additional capital to firms that are clearly solvent; this would substantially increase the aggregate capital available to the financial sector and, in turn, expand the pool of credit available to Main Street.
There can be little doubt that if, say, Bank of America were required to make a right offering at a price significantly below its current market price, the offering would be fully subscribed, would bring in significant additional capital, and hence would expand the capacity of this bank to provide financing to the real economy.
Because the proposed legislation is partly motivated by a concern that the financial sector’s undercapitalization might undermine its ability to finance Main Street, mandating such right offerings would contribute substantially to addressing this concern. Furthermore, it would do so at no cost to taxpayers. Thus, mandating right offerings for an appropriate subset of the country’s financial firms should be a useful supplement to (and partial substitute for) the use of public funds for these purposes.
We would say that some combination of four things needs to happen:
- People and companies must be reassured that their money is safe so there is no run on the bank.
- Housing policies should be reformed to be rationally related to the long term public interest.
- Short-term incentives need to be instated to boost the housing market.
- Financial institutions need to be recapitalized.
The Paulson plan does none of these things. Let us hope that its rejection will lead to a new, stronger policy, focused on the four points we have defined.
