Tuesday, September 23, 2008

A Simpler Solution

I just got an email that proposes a simpler solution to the financial crisis. Just use the $700 billion (or more) to buy preferred stock in shaky financial institutions. That solves both the capital problem and the liquidity problem (the latter by deferring indefinitely the need to sell the illiquid assets) and does so in a way that doesn’t obviously cheat taxpayers. And it avoids all the problems associated with having the Treasury buy and own complex illiquid assets. (And of course the Treasury could sell off some preferred stock in one institution and use the proceeds to buy stock in another institution, so just like under the current plan, money can be reused.)

There is still, though, the moral hazard problem for stockholders with limited liability, so banks have an incentive to overcharge for the preferred stock (i.e. the dividend rate will be too low). So actually taxpayers do get cheated a little bit. There should be some provision for declaring a financial institution shaky and then forcing it to issue preferred stock on terms that are not its own choice. I guess there’s still a place for my idea of making aggressive write-downs and then forcing institutions to sell stock at book value.


UPDATE: My next post refines this idea.

14 Comments:

Blogger Wrong Emergency said...

"America's economy does not face an emergency--only its financial system does. This is a distinction lost on the bankers in Washington, but it is one worth remembering. ...[The] numbers are not pretty, but they do not add up to an economic Pearl Harbor or even close."

See "The Wrong Emergency" by Roger Lowenstein, for an article that explains why your thinking on this issue is misguided.

http://tinyurl.com/wrongemergency

Tue Sep 23, 02:01:00 PM EDT  
Anonymous Anonymous said...

KNZN - You seem to be spending a lot of time thinking about this issues. Could you explain why they simply don't bail out homeowners instead, making them solvent? They would not have to unbundle a bunch of complicated securities.
My brother-in-law thinks it's because it's because of the transaction costs. What do you think?

Tue Sep 23, 02:50:00 PM EDT  
Blogger knzn said...

I think there are a couple of reasons that bailing out homeowners might be less preferred.

One is that the government is less likely to get its money back. If you say, "Now you're OK with the bank, but you owe the money to the government," it doesn't really solve the problem, although it might mitigate the problem. If you say, "Here's the money. Take it," then the government doesn't get to recover anything. There could be an intermediate solution, but that's just going to have the same problems, but smaller and combined. You could say, "Here's the money. Now give us 10% of your income for the rest of your life," which is probably theoretically the best way to do it, but it sounds really ugly, so I don't think it would go over well with Congress or the public. On the other hand, if you bail out banks, you really can say, "Give us 10% of your income for the rest of your life," and Congress and the public will be fine with it.

The other reason, which is sort of the same reason, is that you probably get more bang for the buck with banks. To make homeowners solvent, you have to make up the entire amount that they aren't able to pay, and since they aren't able to pay it to the bank, they can't pay it to the government either, so the government has used up that money.

With banks, you have assets that are already written down, and hopefully they are close to some notion of market value, so the government can resell them, and the only money used up is any loss the government took; the rest it can reuse to buy other assets. (Ideally, the government shouldn't have to take many losses, but I think the government will generally be overpaying and have to take some losses. Hopefully in the long run, it can make enough profits to make up for the losses.)

Tue Sep 23, 05:42:00 PM EDT  
Anonymous Anonymous said...

OK - thanks. I hope it works, but as a "low income" taxpayer, I'm not tat all impressed with executive pay, and they better do something about that. It also seems wasteful from a cost-benefit point-of-view to have a lot of people out of their homes and at the same time a huge real estate inventory of unoccupied homes. Your perspective appears to me to be the "guardian" perspective, where the government budget bottom line is the criterion, rather than Kaldor-Hicks CBA criterion for efficiency. In your view, will this bail out get people back into their homes?

Tue Sep 23, 07:05:00 PM EDT  
Blogger caveatBettor said...

Warren Buffett might be reading your blog!

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