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Sunday, October 12, 2008

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.

    Posted by on Sunday, October 12, 2008 at 02:43 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (26)

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