Bebchuk: A Plan For Addressing the Financial Crisis

Via email, an alternative plan:

A Plan For Addressing the Financial Crisis, by Lucian A. Bebchuk: Executive Summary This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms’ troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation – restoring stability to the financial markets and protecting taxpayers.

I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:

1. No overpaying for troubled assets: The Treasury’s authority to purchase troubled assets should be limited to doing so at fair market value.
2. Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury’s authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.
3. Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.
4. Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.

Compared with the Treasury’s proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers’ funds to address the financial crisis. [link to plan]

Dani Rodrik and Ian Ayres at Freakonomics discuss this proposal, and both highlight the following:

Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.

There are good ideas in this proposal, but I think we need to get something done as soon as possible. So there's a tension between implementing the perfect proposal, and implementing something that is politically feasible, provides the needed stability, contains the appropriate safeguards, and can be agreed upon in a relatively short timeframe.

Update: Brad DeLong says, now that "John McCain and the House Republicans have blown up the Paulson-Dodd-Frank compromise," we have three options:

• Do nothing.
• Bailout (a la Paulson)
• Nationalization (a la Sweden 1992)

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

• grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship
• requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless
• the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress
• grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury
• requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

• grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

Paulson had his shot. It's time for the Democrats to pass a nationalization in the taxpayers' interest bill and dare Bush to veto it. If he does, then announce that the congress will pass it again the day after the election. And if he vetoes it again, announce that congress will pass it yet again on January 21, 2009.

Update: I'm assuming Greenspan won' have much credibility around here, but he's not alone in signing this letter:

Economists’ Statement on the Federal Role in Relieving the Financial Crisis, Alan Greenspan, Robert Hall, and George Schultz: The U.S. economy is in the grip of the most severe financial crisis since the Great Depression. Even highly credit-worthy businesses are paying unprecedented premiums for borrowing. A large fraction of businesses are shut out of the credit market altogether. Past experience with financial crises shows that overall economic activity contracts soon after the crisis unless swift corrective action alleviates the crisis. Unemployment rises, employment falls, the nation’s production of goods and services declines, and consumers’ purchasing power diminishes. At worst, as in the Depression, the economy collapses.

Economists often disagree about the causes of financial crises, including the present one... But there is near-universal agreement that the federal government must take aggressive steps to protect workers and businesses from the harmful effects of a financial crisis. The great majority of those deserving this protection had no role in causing the crisis.

Experience has shown that the essential first step in heading off a crisis is to maintain the functions of critical financial institutions—banks and others performing bank-like functions. ... As a practical matter, at the current stage of the crisis, the only way that financial institutions can continue to function is for the government to provide financial support. The traditional form of that support calls for the government to buy assets from the institutions, swapping questionable assets for obligations of the government that are universally regarded as sound.

We endorse all plans that would preserve the key functions of the threatened financial institutions. As a group, we do not advocate any particular program for restoring confidence in those institutions, but we are aware that the traditional approach has succeeded in heading off crises in the U.S. and other advanced countries. We do not take a stand on the choice of institutions eligible for emergency assistance. Rather, we urgently advocate immediate, extensive action that would maintain the functions of credit markets and prevent a serious economic contraction.

We are deeply concerned about instituting reforms for the longer run that will prevent similar crises in the future. We applaud the increases in capital requirements for the institutions that have elected to become subject to the Federal Reserve’s capital requirements. But we do not believe that action to deal with the immediate crisis can wait until a comprehensive program for financial stability in the long run is developed and put in place.

Update: For yet another view, that of Robert Shimer, see here.

Dear Greg:

...I opposed the Paulson plan. I thought I would ... explain my reasoning.

Before doing so, let me be clear that I agree with your comments about Ben Bernanke. I too know him well from the seven years I spent with him on the faculty at Princeton and I share your respect for his intelligence. I also recognize that he is far better informed about the current situation than I am. This does not, however, mean that he is perfectly informed. Indeed, looking back over the last 13 months, it should be clear that the Fed and Treasury have repeatedly underestimated the extent of the problem. In such an environment, the distributed knowledge of professional economists and other imperfectly-informed observers may be superior to the knowledge of the Fed staff. In other words, you write, "In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could." That may be correct, but I am not convinced that he understands the situation better than the collective wisdom of all professors.

Next, let me explain what I think is happening in credit markets. ...