Monday, September 22, 2008

I’ve Solved the Banking Crisis

Now if I can only get Congress to listen :)

Here is the KNZN-II plan
  1. Give the Treasury authority (or does it already have the authority?), on an ad hoc basis, to make commitments to insure the liabilities of individual financial institutions, so as to prevent “runs” by creditors. (Obviously it will seldom be necessary to invoke this authority for commercial banks, since most of their liabilities are already insured.)

  2. Mandate regulators to be aggressive (in a sense that I will make somewhat more precise later) in forcing write-downs of illiquid or troubled assets.

  3. Mandate financial institutions to accept any bid above book value for an illiquid or troubled asset.

  4. Prohibit the Treasury from bidding more for an asset that it has to in order to be certain of having the bid accepted. (In other words, given 3 above, it can only bid slightly above book value for illiquid and troubled assets – unless it is bidding against a competitor, in which case why would it be bidding in the first place?)

  5. Subject to the above, give the Treasury unlimited authority and discretion (but with certain guidelines) to use TARP funds to buy assets held by financial institutions, including the right to arbitrarily choose institutions from which to buy any given category of asset.

  6. Give the Treasury authority to take over lines of credit and purchase all types of loans from financial institutions that are inadequately capitalized or at significant risk of falling below capital requirements.

  7. For financial institutions that are undercapitalized but solvent and cannot present a credibly reliable plan to achieve adequate capitalization, give the Treasury unlimited authority to use TARP money to take equity positions on its own terms and without the consent of stockholders.

  8. For financial institutions whose capital is adequate from a regulatory point of view but judged to be at significant risk of falling below the requirement given the institution’s current balance sheet (after using any cash obtained from the Treasury’s purchases to retire liabilities to the extent that adequate liquidity can still be maintained), or that are not subject to a regulatory capital requirement but are judged to have too little capital, give the Treasury the authority to use TARP money to take equity positions, subject to the requirement that current equity cannot be valued below book value, but otherwise on the Treasury’s terms and without the consent of stockholders.

  9. For insolvent financial institutions, give the Treasury limited authority to take them over and supply necessary capital so as to avoid bankruptcy, if it is judged to be in the overall interest of taxpayers (where “taxpayers” is understood to mean “concrete people who happen to pay taxes” rather than “abstract people who own an interest in the Treasury”).

Details and Explanation

  1. The point of the ad hoc insurance is primarily to calm creditors who are worried that mandated aggressive write-downs will render an institution legally insolvent.

  2. First of all, from what I remember from when I studied accounting, asset valuations are supposed to be conservative, which is equivalent to saying write-downs are supposed to be aggressive, so it seems to me this point is just saying that regulators have to respect GAAP and do their job correctly. But maybe they need to be reminded. In particular they may need to be reminded that it is someone else’s job to prevent the banking system from collapsing due to banks’ having inadequate book capital.

    I would include the specific mandate that regulators should apply appropriate risk premia in valuing risky assets. And set up an oversight board to make sure that they do so. And, in cases where there is a question, require them to produce explicit economic/financial analyses to justify the premia they have applied.

    My impression is that inadequate write-downs tend, in most banking crises, to be much more frequent than excessive write-downs. The mandate to be aggressive, while it may be implicit in GAAP anyhow, is meant primarily to correct for this apparent bias.

  3. This mandate essentially says that financial institutions have a fiduciary duty to their creditors. If they refuse a bid above book value, they are essentially gambling with creditors’ money, hoping for an increase in value but risking that the asset will become worthless and bring them closer to bankruptcy.

    That’s the theoretical justification. Probably a more important practical reason for the mandate is to prevent the institutions from overcharging the Treasury when it buys assets.

  4. The Treasury cannot overpay. In other words, if it is going to give away money, it must do so explicitly.

  5. The primary guideline for Treasury purchases of assets is to “triage” financial institutions. In other words, give priority to the ones that are illiquid but either adequately capitalized or capable of reducing their balance sheets (once the Treasury’s asset purchases are made) so as to meet capital requirements with a reasonable safety margin, or that are currently thinly capitalized but capable of reducing their balance sheets sufficiently to meet capital requirements comfortably once the Treasury's purchases are made.

    If an institution is liquid and meets capital requirements, then buying its assets is not necessary (although it could be helpful, since more liquidity is better). If an institution cannot achieve adequate capitalization, then buying its assets may not do any good (although, if it is solvent, there is a chance that it could be saved). If an institution is insolvent, of course, there is no point in buying its assets, because it will still be insolvent. (You can’t triage a patient who is already dead.)

    Another guideline is to give priority to institutions whose failure or illiquidity would have adverse systemic effects.

  6. Technically, the authority to purchase loans is implicit in 5, but I have made this a separate point because it has a different purpose. Rather than providing banks with liquidity, the purpose is to avoid the credit crunch that might result from undercapitalized banks’ having to call in loans and reduce lines of credit.

  7. If you can’t save the bank, take it over. If there is still some shareholders’ equity, no resources should be wasted on haggling about how much this equity is worth. Shareholders are at the mercy of the Treasury. In deciding the terms of the takeover, the Treasury needs to balance the obligation to be fair to shareholders against the obligation to protect the interest of taxpayers.

  8. This will perhaps be the most controversial point, and it may be subject to constitutional challenges. (Even if nobody is allowed to sue the Treasury, presumably they can sue the Congress for making the law in the first place if the law is alleged to be unconstitutional. There might, for example, be 5th Amendment issues, although I would certainly argue that book value is “just compensation.”)

    But look, if we’re going to restore confidence in the system, we can’t have a bunch of sick financial institutions refusing medical treatment and risking becoming mortally ill and passing on lethal infections.

  9. It should seldom be necessary for the Treasury to take over insolvent commercial banks, since there is already the FDIC, but in some cases it might be judged appropriate, to better serve the health of the financial system, or to make more effective use of resources, or to ease the financial burden on the FDIC so that it would not require explicit additional funding.

    In the case of investment banks and other kinds of financial institutions, a Treasury takeover might often be be judged worth the cost to the Treasury in order to spare the financial system the costs associated with bankruptcy, including potential broader loss of confidence.

UPDATE: Point 10. Authorize the Treasury to buy preferred stock in financial institutions for the purpose of making additional capital available to facilitate lending. Not sure about the details yet, but reading over the plan, I realize it doesn't do enough to facilitate lending. "Adequate capital" isn't enough if it means that banks have to struggle to maintain adequate capital and can't afford to make many loans. The overall purpose of the plan should be not just to restore the health of the system but also to enable and encourage (prudent) lending, since that's the main purpose of having a financial system in the first place.


Blogger Jason Snyder said...


These posts have been really helpful in aiding my understanding of the financial crisis. Thanks a lot!

Tue Sep 23, 11:00:00 AM EDT  
Anonymous Anonymous said...

In terms of equity ownership, what about foreign corporations?

Is the 'capital' of all the world banks larger than the potential credit losses? I'd say no.

Why is the U.S. government even thinking about recapitalizing anything but something that is willing to be called a U.S. commercial bank?

Are we headed towards a one world bank owned by the U.S.?

Winslow R.

Tue Sep 23, 11:55:00 AM EDT  
Anonymous Anonymous said...

Even if mbs are exchanged for tsy secs 1 for 1, the cash flow being redirected to the treasury by this plan could reduce aggregate demand.

Currently the private sector has $700 billion in MBS which ‘pay’ some 8% which will be replaced by $700 billion of tsy secs which pay 4%. (I’m guessing here)

The reduction in private sector cash flow would be some $28 billion/yr redirected to the treasury.

Of course this deflationary effect would be magnified if government ‘under’ pays for the assets.

Winslow R.

Tue Sep 23, 11:59:00 AM EDT  
Anonymous Anonymous said...

An additional deflationary blow would be created by the government ‘allowing’ homeowners that can barely afford their mortgage to stay in their homes with adjusted terms.

Instead of going through bankruptcy and moving into a rental unit at half the cost, government sponsored homeowners with renegotiated mortgages, will be paying as much as economically possible into the treasury.

Also as we’ve discussed before, banks are currently allowing many homeowners to live rent free! This ‘financial sector directed stimulus’ is currently creating growth in the future federal deficit that Paulson will eventually take on at the treasury. Once Paulson’s plan is implemented, the ‘financial sector directed stimulus’ will likely be reduced as the government forecloses or renegotiates with delinquent homeowners.

It looks to me that unless the government overpays, we will need more deficit spending. Preferably that deficit spending would come from ‘government directed stimulus’. What’s sad is both Obama and McCain think this ‘financial sector directed stimulus’ won’t allow them to spend, perhaps they are right.

Winslow R.

Tue Sep 23, 12:00:00 PM EDT  
Anonymous Anonymous said...

Way too much discretion there. And too much reliance on "book value".

I would rather use open market auctions, wherin the treasury agrees to match the auction price and quantity.

I would do this two ways. One, add capital to distressed firms by buying preferred stock. The treasury could act as underwriter here, but would agree to buy one half of the new preferred stock issued, with the other half sold on the open market. The price determined by the market is the price the treasury agrees to pay.

I would do something similar for aquiring distressed assets. Auction them in an open market transaction, with the treasury aggreeing to buy half the assets at the market prices. What I'm not clear on, with assets, is how you really can match these assets exactly as far as terms and risk.

Finally, Winslow is correct that it is more important to have fiscal stimulus in the form of government spending. I would tie any financial system bailout to this directly. Thus, we should include, say, $300 billion in grants to states to support infrastructure spending of their choosing.

On top of that, we should recognize that the health care crisis is a far bigger threat to our economic well being than this financial crisis, and should be addressed with equal seriousness in a similarly bipartisan fashion. Since both major presidential candidates have plans that would cost over $1 trillion over the next decade, and disagree mostly on how that would be utilized, why not just include a bugdet resolution appropriating $700 billion over the next 10 years for the purpose of expanding health insurance coverage, with the details of how this is utilized (subsiudies, tax credits, whatever) left to the next congress and president?

Tue Sep 23, 01:44:00 PM EDT  
Blogger knzn said...

Regarding deflation: I don't think you're going to get much income effect from just financial income. Do people really spend much less when their bond yields go down? People who own financial assets aren't liquidity constrained, so they don't have to modify their lifestyle when their income goes down. If there is an income effect, it will be very gradual, as people gradually adapt to lower income, and meanwhile hopefully you will have a recovery that counteracts this effect. Also, much of the income on illiquid assets is itself illiquid: many of them (the ones the government is most likely to buy) are already in default, so they aren't producing any current income. For the ones that are producing current income, that income is largely being hoarded by undercapitalized banks.

I don't see how the effect on homeowners is deflationary. I'm not sure how the bankruptcy laws work these days, but bankrupts will either have to keep paying something after the bankruptcy or they won't. If they don't, then they won't want to lower their standard of living, so they'll move into rental units that are comparable in cash flow cost to what they would have paid to the government. If they do have to keep paying something to settle their old debts, that is going to reduce their liquid income just like the mortgage payment would.

I do think a fiscal stimulus is a good idea in any case, because the bailout won't be enough of a stimulus, and the effect will be slow. I'm all for grants to state and local governments. At this point even unrestricted grants would help a lot, because they prevent governments from having to cut services as tax revenues fall due to the weak economy.

It is a shame if the next president feels his hands are tied. That's one reason to prefer having the treasury pay fair value rather than some inflated value based on either a reverse auction or a book value that involves insufficient write-down. If the Treasury can do this in such a way that it can credibly say it expects a profit, then the president will realize that this is not really an additional expense and needn't tie his hands.

I suppose open market auctions would be OK. But there is a problem with any solution in which bank participation is voluntary. The expected auction prices are likely to be too low to induce many banks to participate, except those that are desperate for liquidity, and those banks aren't likely to want to use up that liquidity by making a lot of new loans, so I'm not sure that solution really accomplishes much.

I think for any solution to be both effective and fair to the taxpayer, there has to be some carrot and stick, or maybe just a stick, to get banks to participate. (Otherwise, they won't be willing to accept any fair value for the assets; they'd rather take the risk of failure, which falls largely on their creditors.) In my plan, the stick was just an absolute mandate, but I guess it could be some other carrot and/or stick. (I'm thinking about what that could be.)

Tue Sep 23, 06:30:00 PM EDT  
Anonymous Anonymous said...

"In my plan, the stick was just an absolute mandate, but I guess it could be some other carrot and/or stick. (I'm thinking about what that could be.)"

The stick could be an asset tax. The higher the bank values an asset the more they pay in taxes. All assets could be assessed.

Winslow R.

Tue Sep 23, 09:27:00 PM EDT  
Anonymous Anonymous said...

"I'm not sure how the bankruptcy laws work these days, but bankrupts will either have to keep paying something after the bankruptcy or they won't. "

I should have said foreclosure rather than bankruptcy as most foreclosures don't result in bankruptcy. In most states the bank can only collect the house.

Currently many homeowners are living a year for free. Living in a home for free adds to aggregate demand while reducing bank capital. Think how much more you'd have to spend if you didn't have to pay rent or a mortgage.

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