Glaring gaps in the financial system
By Thomas I Palley
A friend told me the economist Charles Kindelberger had two rules for a credit
economy. Rule one was everybody should know that if they get over-extended they
will not be bailed out. Rule two was if everybody gets over-extended they must
be bailed out. The US economy has over-extended itself, triggering rule two.
But that still leaves open how a bailout should be designed since designs are
not all equal.
Currently, three models are on the table. One is that favored by US Treasury
Secretary Henry Paulson (also supported by Federal Reserve chairman Ben
Bernanke), which proposes government buy the bad assets of financial
institutions. A second is a Warren Buffet-style recapitalization model that
would have government invest in and recapitalize banks, just as Buffet has done
for Goldman Sachs. A third, proposed by Republican lawmakers,
would have Wall Street firms purchase insurance on mortgage-backed securities
and advocates tax cuts and relaxed regulations.
The underlying problem is the financial system is short of capital owing to
massive asset depreciation. This shortage is impeding provision of credit,
which threatens to tank the economy by interrupting normal commerce.
Banks are caught in a pincer preventing them raising capital. On one hand, if
they sell assets to cleanse their balance sheets and make themselves more
attractive to investors, this could cause such large losses as to trigger
bankruptcy. On the other hand, uncertainty about bank worth means the market is
demanding such onerous terms for fresh capital that banks are unable to meet
them.
Reading between the lines, the Paulson plan appears to propose government buy
securities through a "reverse" auction whereby banks (and other firms) offer to
sell assets to the Treasury at a price of their naming, and the Treasury
accepts those offers meeting its acceptable price. Implicit in the Treasury's
thinking is the assumption that the market will recapitalize banks on
reasonable terms once they have been cleansed.
The essence of the Paulson plan is that financial markets have been hit by
massive fear-based price disruption, requiring government to create a new
market to break the logjam. If correct, by purchasing assets now at distressed
prices and holding them to maturity, taxpayers could eventually make a profit,
making the bailout costless.
The recapitalization model completely sidesteps cleansing banks and instead has
government directly re-capitalize them. It can do this by buying compound
cumulative preferred stock from banks, and also taking warrants that give an
option to buy common stock in future at today's low price. That way, if all
works out, taxpayers are rewarded for the risks they take today.
Since preferred shares rank above common shares, existing shareholders would be
hit before taxpayers should there be future unexpected losses. Meanwhile,
taxpayers would get the benefit of the preferred stock dividend. Furthermore,
if banks suspend dividend payments, the suspended dividend will cumulate and
compound so that taxpayers ultimately recoup delayed payments.
Recapitalizations can also be accompanied by other useful provisions, including
restriction of dividend payments on common stock. Additionally, banks could
sign a memorandum of understanding with the Fed suspending capital standards
and mark-to-market asset price accounting. Both of these practices have
squeezed banks by causing further losses as asset prices fall. Since markets
are not working well by the Treasury's own admission, it makes no sense to keep
using market price accounting.
The Paulson plan is subject to three fundamental criticisms. First, the
Treasury may over-pay for assets, saddling taxpayers with large losses. If the
Treasury sets its acceptable price too low, there is a risk it will buy
insufficient assets and banks will not be cleansed. If it sets prices too high,
the risk is that the Treasury overpays.
Second, the Treasury is taking a big risk as prices could fall further, yet it
is not being properly rewarded for this risk-taking. That is tantamount to
subsidizing banks that have created the mess. Third, markets may not provide
finance even after the Treasury's purchases, in which case banks will remain
undercapitalized.
The Paulson model defense is that taxpayers are protected by the reverse
auction design. Banks need money and will therefore offer assets for sale at
true worth, knowing they may be undersold by other needy banks if they ask for
too high a price.
Criticisms of the recapitalization model are twofold. First, what price should
the Treasury pay for preferred stock? Second, which banks should get funding?
The danger is that zombie banks apply for funding, seeking to save themselves
by gambling for redemption with taxpayer money.
The recapitalization model defense is that accounting information exists, due
diligence can be conducted, and judgment can be exercised when it comes to
setting warrant prices and interest rate terms on preferred shares. Indeed, due
diligence and judgment are also needed under the Paulson plan to establish the
maximum price government will pay for different types of securities.
The reality is there are fundamentally different models for addressing the
financial crisis. Each has strengths and both have weaknesses. Time is needed
to deliberate on them, and congress should not be stampeded into a decision.
Nor should congress hand over a $700 billion check, particularly to the George
W Bush administration in its waning days.
Finally, both the Paulson and recapitalization models deal only with the supply
of finance. Neither deals with the problems of re-regulating finance,
jump-starting the economy, and ensuring the economy delivers shared prosperity
that escapes the trap of relying on debt and asset price inflation to drive
growth.
It is no good fixing the supply of finance if there is no demand for finance or
if the demand for finance is based on rotten foundations. That is why helping
Main Street is as essential as bailing out the banks.
Thomas I Palley is the founder of the Economics for Democratic and Open
Societies Project.
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