Another Bailout Proposal

Everyone else seems to have a simple, idealized, infeasible bailout proposal, so I decided I should have one too.

This proposal (a) removes toxic assets from balance sheets, (b) recapitalizes banks, (c) limits executive pay, and (d) gives taxpayers a share in any profits from the bailout.

Here's how it works. If a bank is in trouble, the government:

1. Takes temporary control of the bank. The government then replaces the management, purchases the assets at price P as determined below, and sells the assets back to the private sector later at price X. Thus, the government's profit is X-P (or loss if negative, also, I'm assuming everything has been discounted properly).
2. The new management will be paid a base salary, B, plus the share, s , of any profits the government makes on the assets, i.e. managers are paid B + s*(X-P).  There is also a maximum amount that managers can earn, M. Thus, managers' salaries are in the range B < B+s*(X-P) < M. [B is set below the value of managers' services in other endeavors so they will only bid if they expect to make a profit.]
3. Managers are selected through an auction to a large number of pre-selected professional asset managers. The management firm bidding the lowest value of s wins the bid. [If no bids are forthcoming, the firm is declared insolvent, and liquidated/merged/etc.]
4. After the managers are selected, the managers sell the assets to the government at price P, and managers are free to choose any value of P they believe is best. This would include consideration of recapitalization needs.
5. After a period of time, the government sells the assets back to the private sector at price X. If there is a loss, taxpayers absorb it. If there is a gain, taxpayers get (1-s)*(X-P), plus 100% of any profit over and above M, the maximum amount managers can receive.
6. There's an incentive for managers to sell the assets to the government at a very high price. Why? Selling at a high price gives the firm a strong chance of surviving and, although this means that X-P is likely to be negative, and hence that managers will only receive the base salary, if the managers are still around in later years after the firm returns to private control, they could reap large profits, enough to more than make up for only receiving the base salary in the first period. To remove this incentive, managers must be replaced within a short, predetermined time period after the government sells the last asset back to the private sector.

Why does this give managers the right incentive? When they choose the price P, if they make the government pay too much, their salaries will be lower since X-P will be lower. But if they sell the securities at too low a price, the firm will be in danger of failing and they won't get anything beyond their base salary. So they would want to sell the securities as cheap as they can (so their share is maximized) without endangering the firm's survival (including recapitalization needs). I'm assuming managers will have inside information about the quality of these assets, and this gives them an incentive to use that information to maximizes taxpayer benefit (because they will set P is low as possible based upon all information at their disposal).

One more note. The value of s would differ across banks since those banks that are in more trouble would be riskier for asset managers than those with safer balance sheets. However, the auction (properly structured) should compensate for this variation in risk and, by forcing asset mangers to bid just enough to make a profit for their services, still maximize taxpayer share.

Comments

[James Kroeger]

I think this is a noteworthy effort, given the limited goals you were trying to achieve with your proposal: (a) remove toxic assets from balance sheets, (b) recapitalize banks, (c) limit executive pay, and (d) give taxpayers a share in any profits from the bailout.

Unfortunately, your proposal also (1) gives little weight to the issue of economic justice, (2) makes little attempt to minimize the costs taken on by the taxpayers, and (3) does almost nothing about the moral hazard problem.

If---after all this fear and trembling and expense---the result is a financial sector that is comforted by the fact that the taxpayers can be counted on to bail out the bad decisions of bankers and Wall St. players, then very little will actually have been achieved, don't you think? Why would we want to spend that much money on a 'fix' that does nothing but restore the corrupted system that got us here? Moral hazard has got to matter or the entire model you are trying to save is worthless.

Now it would help with my points (1) and (2) if you were to add a stipulation that the $700b. will be paid for with a 10% transactions tax on all sales of equity on secondary markets and/or perhaps a return to the steeply progressive income tax rates that existed prior the the Reagan Revolution (sans loopholes) and/or the elimination of the distinction between income derived from wages and capital gains.

You would really impress me if you could come up with a way to keep the REAL ECONOMY on Main St. humming along while the taxpayers buy up the assets of private banks at fire sale prices. Taxpayers should get at least as good a deal as the Bank of America got when it purchased Merill Lynch. Forget about buying the toxic assets; the only cure that will really put the whole industry back on a sound footing is writing off trillions of dollars of worthless paper.

Can you expand your analysis in a way that addresses these important variables, Mark? If so, then I will indeed be very, very impressed...

[anne]

Well done.

[ken melvin]

In order to remove the bad debts from the system the debtors must be cleared, too, i.e., the bad mortgages must burned. so the bad credit card debt.

[ilsm]

There should be justice, fraud prosecuted, failure to exact due diligence is gross mismanagement and actionable in courts.

Get the auditors on these.

And insurance fraud, you cannot cover all perils, especially the fraud and gross mismanagement.

Consider Gitmo for financial terrorist who are out to destroy the American Way in much more serious fashion than radical Islam!!

Amend the patriot act to include gross mismanagement, fraud and failing due diligence as capital crimes.

The British royals did this up to bringing the Dutchman William.

[Robinia]

This is well worth some time thinking about-- obviously, you have put in some very good time on this. Thank you for moving our thinking beyond Gordon Brown's satisfying (very liberally paraphrased) "off with their heads!" and Paul Volcker's general thought that after the collapse of the Potemkin Village of our current financial system there would come a time of restructuring and rebuilding.

I am fascinated by the process. Your intro sentence
Everyone else seems to have a simple, idealized, infeasible bailout proposal, so I decided I should have one too.
could only be written in the age of the blogosphere. Economic restructuring has never happened, in real time, so fast or with so much open-source brainstorming.

The concept of a reverse auction for managerial talent to bring the welfare of the US equity-position in a financial services company into the equation is pretty unique, creative. Hmm. That might just be the real thing-- financial innovation. Cleverer than a CDS any day of the week. Nice work.

[Term Limits]

Requiring managers to be replaced after a certain period of time can have unintended consequences beyond the auction price. Managers would have no incentive to promote the most effective long term business plan. Managers need to have the long term interest of the company as their first priority. The inherent conflict of interest between the long term interest of the company and the short term interest of the auction might be better resolved by having an independent third party value the securities.

[baileyman]

$650 billion tax rebate, $50,000 per taxpayer i.d., payable to "Trust for the benefit of Mr. or Ms. Jones mortgage with successor rights to the benefit of Mr. or Ms. Jones".

This writes down the burden of all mortgages, does it immediately, and liquefies the banks, liquefies the consumer, builds savings.

What else?

[Jalin]

Well the bailout is a bandaid where an ace bandage was needed, but something had to be done and fast. Most of you can see why, so I will save my fingers. Suffice it to say that many revisions will be following/

[Barkley Rosser]

Not bad.

[Jalin]

The real problem on this bailout is that in order to get the necessary votes in congress, the Dems insisted on much pork being added.

[James Kroeger]

Managers need to have the long term interest of the company as their first priority. The inherent conflict of interest between the long term interest of the company and the short term interest of the auction might be better resolved by having an independent third party value the securities.This is a very important point and one aspect of Mark's approach that is in most need of revision. There is an implicit assumption in Mark's proposal [that the auction be populated by a large number of pre-selected professional asset managers] that the best individuals to put in charge of these banks are individuals who have fully participated in the disastrous risk-taking that caused this problem. Why? I think I'd rather put some academics in charge.

I don't think we should be afraid to punish---in perhaps a sweeping manner---the very culture that produced this Mother Of All Financial Crises. Is it that serious a threat to our whole society, or isn't it? If it is, then utter rejection of the model 'they' presided over is appropriate. I would even suggest that it might be a good idea to absolutely forbid the securitization of mortgages and other similar debt obligations.

We might even want to forbid the use of options as hedges, since they have clearly encouraged the kind of gambling that took place. If 'investors' were feeling enticed to buy paper assets because they perceived them to be less risky than they actually were, then perhaps we should remove that 'illusion' from their gambling decisions. If we can't increase the perception of risk, then what good does all of this status quo tinkering accomplish?

Bankers need to understand that if they want to participate in risky manipulations in order to chase higher yields, then they will have to do so without ANY bailouts. Such banks could be the successors of the investment banks. Other banks, that are content to serve society's 'banking needs' for very modest profits might deserve our efforts to bail them out in the future. We do NOT need to accept any kind of leveraged gambling activities in any of those banks that society is dependent on to keep Main St. going.

[save_the_rustbelt]

I think you would need two classes of management:

1) those who control the overall operations of the bank on a daily basis

2) those asset managers who gather and liquidate the weak assets

Two very different skill sets here.

Or am I just confused with the proposal?

[bakho]

Depending on details your proposal is reasonable. The part about short term managers being replaced would be difficult to enforce in the future.

What about the root of the problem. The system could benefit from a process that would re-negotiate mortgages to minimize foreclosure. This process is broken because the loan originators no longer own the mortgages. There needs to be a process with rules for local agents to renegotiate loans. I don't see any movement by this administration to do this. The holders of the loans and their derivatives seem unable to do this. Partly this is because of battles between owners of the loans and the insurers of the loans. Renegotiating the mortgages at the local level would finalize the losses (which will be substantial). This would allow Big Finance to correct its balance sheets rather than fighting over them.

Setting up a process to manage foreclosed properties as rentals needs to happen and quickly. This process is also broken because the companies that foreclose on the houses often lack local agents that can manage their investment and don't understand the business of managing rentals. It is not clear why this will not be a booming private sector business. There are too many houses with not enough buyers. Owners who cannot sell property can recover some money by renting.

This financial tangle needs to be attacked from all the loose ends. The processing of bad mortgages at the individual level could have started months ago.

[Jennifer]

Ah if only we could return to the good old days, so innocent in retrospect, when a simple "off with their heads" got the job done!!

[yamada]

Well, what actually has been occurring is that everyone is expecting (X-P) to be negative in despair, under spiral asset depreciation. The majority of economic entities is about to be insolvent.
I would also like to remind, if (X-P) is always negative, there is no value on s(=securities, or equity, if it stands for in this meaning), because the entity may be insolvent.
But if everyone begins to think that the price of asset is so depreciated as to be enough when the historical level is considered, then someone begin to think (X-P) to be positive, which time when your proposal begin to work.
Before that level, the model as follows works:

Why not make use of FRB’s profit when they print dollars? In this model, it won’t cause inflation, because it come back to FRB at last. In this model, the printed dollars won’t be withdrawn, because each economic unit(including bank) legally forced to write-off next economic unit that they hold credit.

Bubble is caused by peoples’ expectation that the price of asset(real estate) will soar in future, with pouring high-powered money to the asset side of economic units’ balance-sheet. So, to solve this problem, such asset bubble on economic units’ balance-sheet must get ridden of, by the new system as below. Though it may be seen contradictory, high-powered money enables to work this new system. Please remember, no one has ever invented the solution in history.

1. Every economic unit’s(including banks) assets that caused the bubble(real estate or CDO et al) on balance sheet should be evaluated on mark to market basis by the authorization of a third party(maybe auditor), which brings about some insolvent(i.e. debt section surpasses asset section on balance sheet) economic units.
2. FRB decide to write off a certain amount of the loans to the banks, which amount distributed to each bank according to the amount of each banks’ insolvency, calculated on 1.
3. Every bank that gets profit from written off should next enforced to, by using the profit from written off as original fund, write off its loans to its each debtor, according to the amount of insolvency of each debtor. If the bank is unable to use all the written off profit it earned, the remainder is taxed all.
4. Other economic unit that gets profit from the written off by the bank should next enforced to, by using the profit from the written off as original fund, write off it’s loan(or trade claim) to its each debtor, according to the amount of insolvency of each debtor. If the economic unit is unable to use all profit it earned, the remainder is taxed all. These processes are to be repeated operationally.
5. In consequence, the bubble portion of the targeted asset is extracted from the economy, and is transformed to tax.
6. The tax claims is finally assigned to FRB. It’s up to FRB how they dispose of their above claims, considering the situation of economy, of each bank and of each economic unit. Talking about the latter two, as a option the FRB should examine the possibility of the bank’s and economic units’ turnaround, together with the other creditors, remaining desirable debt to the bank’s and economic unit(empirically it's ten to fifteen times annual earnings before interest, taxes, depreciation and amortization, known as EBITDA, of the economic unit), writing off the rest debt, with taking into account the value of disposable collateral(that do not accrue earnings), of guarantor and of consolidated basis.
7. Every write off must be supervised and tracable by centralized function of the system. So every write off must be executed through this function. Every write off may be done through this function, which exist on internet for access.
8. For cross-border. For each non-residential economic unit, the amount of write off should also be calculated in the same way as 4. , on the only cause from specific asset depreciation in the resident country. Economic unit that will be written off should next write off in the same booked currency. In case profit of the written off exists on the non-residential economic units, it's taxed and absorbed by the foreign(=non-residential) government and handed over to the sovereign(=residential) government of the currency, based on treaty.
9. In case inflation expectation exists, the system enables FRB to on one hand raise benchmark rate to cope with inflation expectation, on the other hand restructuring the balance sheets of economic units.
10. FRB should carefully watch the rate of the number of insolvent economic units to the number of all economic units in the US, when deciding the amount of the loans(trade claim) written off on 2.
11. FRB print greenbacks(bring about profit) correspond to the write-offs, which return to FRB as tax claim, so these greenbacks could be stored to the safe in FRB forever.

For further details, please see the blog as below:

http://reversewealtheffect.blogspot.com/

[Term Limits]

"We might even want to forbid the use of options as hedges..."

At a minimum, forbid writing options that an institution doesn't have the means to pay off on.

"...perceived them to be less risky than they actually were, then perhaps we should remove that 'illusion' from their gambling decisions..."

Certainly transparency must be established. People do need to know for sure what they are being asked to buy.

"...absolutely forbid the securitization of mortgages..."

This situation came about because domestic banks/shadow banks lacked sufficient deposits to meet domestic demand, by a wide margin. They came up with the creative answer to securitize the debt (with no oversight), and sell it overseas to meet domestic credit demand. Obviously, it was the wrong answer, as it created insurmountable agency conflict of interest problems. Sommething must change.

[Robinia]

I like how this proposal recalibrates the incentives of the managers of assets. But, it is a legitimate question whether or not people would trust any asset managers from the "old regime." One way around this (without building institutional framework from scratch) is to look for professional asset managers in scalable situations, using proven models. Those models and structures are, actually, already there in terms of nonprofits and foundations, full of professional asset managers with an interest in public well-being, and the bankerly structures of credit unions, community development finance institutions, mutual insurance associations, and others, too, I am sure.

Very interesting to me is the idea of applying tools from scientific disciplines with analogous functions to the task of rapidly assessing the value of the underlying assets. The value of the houses underlying the derivatives is not economically feasible to determine based on the model of ownership devised by the Wall St. securitization crew, which relied excessively on various abstract models that may have resulted in very little empirical observation being included in the valuation. This lack of observable empirical information results in a very speculative value assigned: houses then become worth whatever you can get for them, and, in a volatile market, that might be volatile, in a frozen one, that might be nothing. And yet, those houses have observable value-- as well as a geographic anchor for the open source on-line accumulation of observations in a georeferenced database. A good deal of information is likely already publicly available through Googlemaps images and satellite photos, plus in some places public records of the local or state property assessment office. Additional observations could be accumulated and attached in a system similar to the one used at http://ebird.org/content/ebird/about/why-ebird This is a voluntary effort to log observations of birds that is very popular among birders worldwide (in US, this overlaps the population with assets to keep in trust very neatly, too... and there is established systemic trust there). In aggregate, it creates scientiically trustworthy information to be used in analysis. If house by house valuation were accomplished via the centralization of distributed effort at local observation recording, it could indeed provide some guidance in the reconstruction of thoughtful underwriting.

Of course, those tracking and mapping the influences of predatory lending have already done some of this work, including this interesting map from the NY Times:
http://www.nytimes.com/interactive/2007/11/03/weekinreview/20071103_SUBPRIME_GRAPHIC.html?scp=1&sq=subprime%20mortgage%20map%20NYS&st=cse
Doubtless it is feasible to produce such information at lower levels of geographic scale, as well. The problem inherent in a proposal like McCain's to buy out these mortgages at face value is that they lock in place the valuation schemes that this flawed system of asset valuation has assigned to cities and regions throughout the US. There are Las Vegas situations, and the market collapse in that kind of place is incorporating valid and important information in those houses prices even at this moment. To put the government in the way of that market correction (between geographies) would be a huge mistake.

[Gegner]

What use are solvent banks in a world of tapped out consumers?

We can recapitalize the banks, but if there's no one to lend too (actually too few creditworthy customers to support the necessary level of economic activity) What will you have achieved?

In a world already suffering from 'overproduction', more credit is hardly the answer.

Worse, since this overproduction isn't evenly distributed, keeping our banks capitalized becomes an exercise in futility.

If printing money were the answer, Zimbabwe would be the most prosperous nation on the planet.

This isn't about money, it's about repairing the usefulness of money.

[Lafayette]

Two distinct banking models, both necessary

The challenge is to maintain the risk management character of investment banking. For the moment, the existing IBs have been folded into other banks or run for cover (having changed to Commercial Banks).

Excuse the repeating of a simple notion, but there are two business banking models; one is Risk Averse (Commercial Banking)) and the other is Risk Prone (Investment Banking). Never the twain should meet. (I can't imagine what the people of Goldman Sachs thought they were doing by changing their stripes. They are not Commercial Bankers by nature and therefore neither by competence.)

Meaning this: The Swedish model was perhaps the best thought out. Bring in the Civil Servants to clean out the mess then hand operations back to banking professionals. If done properly the state makes a profit. If not, too bad -- the state pays the price for its lack of "due diligence" (in exercising its regulatory powers).

Regulatory powers are at the heart of any future effort to assure that the subprime mess never happens again in any other form. Meaning, further, this: Before the nerds on Wall St. think of a financial engineering manipulation, regulators should be doing exactly the same kind of thinking. And stop them cold.

The best police in the world think like crooks, which is why they catch crooks. You have got to think like one in order to know what they are likely to be fomenting.

[melvin polatnick]

No finagling at the top alone will restore the American economy. 75 percent of the economy is driven by the spending of ordinary consumers and they are frightened. Call it PTS and it will not be cured easily. The distribution of free booze and Prozac will jerk start spending again. That is the only quick fix that is possible.

[flubber]

"Thus, managers' salaries are in the range [...] so they will only bid if they expect to make a profit."

Maybe I'm unclear on the concept, but when managers would presumably be bidding, or researching balance sheets to see if profits were possible, wouldn't there be a lack of information about asset values without price discovery in the market. So, like today, there might be a perceived "first mover" disadvantage, and stasis.

Also, the managers are tasked with selling off the assets for as cheap as possible, to increase their own rewards. How is this reconciled with the pain this inflicts on the companies' balance sheets?

[ken melvin]

Somewhere in this pile of a mess there is the straw the broke the camel's back. This straw must be found and punished afore our heads again rest easy.

[save_the_rustbelt]

Let's assume for a moment the potential new managers would be coming from banks that are not in trouble (unless we want to recycle the bankers who created the mess).

Why would the managers want to leave a well run and solvent organization to clean up a mess like this? Or,

Could the compensation formula provide enough of a premium to make bankers derail their careers for a risky proposition?

And there must also be someone to manage the day to day operations of the bank.

[Lafayette]

KM: Somewhere in this pile of a mess there is the straw the broke the camel's back. This straw must be found and punished afore our heads again rest easy.

I maintain that it was supreme foolishness to allow the Finance Industry to self-regulate its mortgaging, credit agencies and investment banking that perpetrated this fraud.

I can assure you, for what it is worth, that the European media as well as several outspoken European governments, are taking Uncle Sam to task for this lack of proper audits/controls in the Finance Industry that permitted The Great Credit Seizure of 2008.

It was colossally stupid.

[Lafayette]

Sic transit gloria mundi

Then, again, there is Greenspan.

Excerpted from the NYT explanation of the word "derivatives": In recent years, a bewildering variety of derivatives have been developed. Two types that have played a central role in the recent turmoil are mortgage-backed securities, whose value depends on the value of the mortgages, which depends on how many of them are being paid off, and credit default swaps, which are in essence a form of insurance policy, and whose value swings with the fiscal health of the transaction or asset it is written to cover.

The derivatives market today is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

The contracts allowed financial services firms and corporations to take more complex risks that they might have otherwise avoided — for example, issuing questionable mortgages or excessive corporate debt. The fact that they can be traded in one sense limited risk but also increased the number of parties exposed when problems emerged.

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. But the financial industry lobbied heavily against such measures, and won backing from important figures, including Alan Greenspan, chairman of the Federal Reserve from 1987 to early 2006.

He's the fall guy. Sic transit gloria mundi.

[ken melvin]

"The derivatives market today is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago.

And worth every penny, I dare say. Be a very good time to rid ourselves of this rot along with tax havens the array of loopholes.