Sandro Brusco explains how the Geithner plan can be improved by having bank managers put part of their own compensation at risk when purchasing toxic assets, and by using future profits and any executive compensation above some minimum amount as collateral for the loans:
How to improve the Geithner plan, by Sandro Brusco: Two major criticisms have been moved against the Geithner plan
First, the plan fails to activate a true process of price discovery in the market for mortgage backed assets. Instead, the plan tries to fill the gap between the willingness to pay of the potential buyers and the price at which the banks are prepared to sell with a public subsidy. The presence of the subsidy, in the form of no-recourse loans at a presumably low interest rate, implies that the prices that will be determined in the auctions will probably be of little help for the future.
Second, the plan places a lot of risk on the FDIC and the Fed. Given the nature of these institutions, if they end up substaining heavy losses, the general public will pay directly or indirectly a high price.
I believe that both criticisms are very valid. I have discussed elsewhere a possible alternative approach, and other sensible plans have been submitted. But the Geithner plan is what we have now. Thus, although maybe not optimal, we should try to see whether the plan can be amended in such a way that the two above-mentioned problems can be at least partially fixed. I believe this is possible, and here is what I propose.
First, to fix the price discovery problem we should ask the bank managers to lend their own money, alongside the FDIC and the Fed, for the acquisition of the toxic assets. Right now, it is claimed, the market for mortgage backed assets is not working because the banks put a value on their assets which is higher than what the potential buyers are willing to pay. The only way in which this makes sense, from a theoretical point of view, is that there is asymmetric information. The banks, or more precisely the managers who run the banks, know things about their assets that the investors do not know. If we want to reactivate the market the asymmetric information has to disappear. How do we get there? Well, if the bankers really believe that their assets are worth more than what the investors are willing to pay they should credibly signal their information. One simple way to do that is to participate in the debt financing of the assets' acquisition. The managers should be asked to put their money on the line, lending their money to the private investors who buy the toxic assets at the same conditions as the FDIC and the Fed. In fact, given that the managers have greater control and better information on the assets which are put on sale, their debt should be junior to the one of the FDIC and the Fed. How much should they put? For the operation to be credible it should be a sizable part of their wealth, this is the only way in which the market is going to believe that the bankers ''really mean it'' when they claim that their toxic assets are quite valuable. I don't know enough to provide a firm number, but a simple idea would be to look at their total compensation over the last five years or so, and ask them to invest a significant fraction of it.
Let me emphasize that the main goal of this measure is not to provide more funds for the acquisition of toxic assets. Rather, it is meant to provide incentives for a more realistic assessment of those assets. How exactly prices will be determined is still not clear, and it is the crucial point of the process. Even if the assets are sold through a competitive auction process, the final outcome will depend on parameters such as the total amount of assets supplied and the reserve prices which are set. The bank managers will presumably participate in the process of determining those parameters. Right now, managers have no incentives to make sure that the assets are correctly priced; on the contrary, they have all the incentives to make sure that the assets are overpaid. Since there is a public subsidy, the buyers may well accept to overpay. It does not need to be that way. If the managers have their own wealth at stake they will be careful in setting the parameters of the auction and in selecting the assets for sale. This will lead to more realistic values for the assets. Getting realistic values for the assets is the only hope to get the market to start working again.
Second, to reduce the risk for the public, the banks should put their earnings as collateral for the loans. Also, compensations for employees in excess of a certain threshold should be put as collateral. Under the current version of the plan, once the banks have sold their assets they are not responsible any longer for their performance. This is not a good idea. When there is asymmetric information the payoff to the seller should be linked to the future performance of the good which is sold. This is what happens, for example, when a car dealer offers a warranty on a used car. One simple thing that can be done is to use banks' future earnings to guarantee the debt of the FDIC and the Fed. The financing plan should specify that the banks are not allowed to distribute dividends until the debt is completely paid. Earnings should be put in a special fund. If the toxic assets underperform and the debt is not fully served, the money put in the special fund will go towards the service of the debt. In addition, all compensation to bank employees in excess of a certain amount should go into the fund. If and when the debt is fully served the employees will get their money and the shareholders will get their dividends. But if things go bad and there is default on the debt then the shareholders and the employees will have to participate to the losses. Asking the highest paid employee of the bank to provide their compensation as collateral would also strengthen their incentives to avoid overpayment of the toxic assets, thus additionally reducing the risks for the government.
I think that the two proposals can be defended purely in terms of their economic content. They lead to more credible prices and a better repartition of risk. However, since it is obvious that important political factors are at play here, let me add a couple of ''political'' considerations.
First, it is clear that the administration is reluctant to ask Congress for additional funds. Bailing out the banking industry, whatever its economics merits, is clearly unpopular in the US right now. For practical purposes it is therefore prudent to consider the amount of public money that can be pumped in the operation as fixed. This implies that maximizing its effectiveness in removing the toxic assets from the balance sheets is even more urgent. Having the managers participate in debt financing would be a good move towards that goal. To start with, it is likely that it will moderate the overpayment of the assets. Lower prices mean that each dollar of investment will remove more toxic assets from the banks, creating more bang for the buck. Moreover, the prices will be more credible and private investors will be more willing to believe that they accurately reflect the knowledge that the bankers possess on the true value of the assets. They would therefore require a lower leverage for their acquisitions. This way the funds provided by the FDIC and the Fed would attract a larger amount of private funds.
Second, if the value of the toxic assets turns out to be less than hoped (''expected'' seems too strong a word here) and there is default on the debt these arrangements will provide political cover for the administration. Imagine a scenario in which the FDIC loans are not repaid in full but at the same time the banks distribute fat dividends to their shareholders and large bonuses to their managers. That would probably cause a political firestorm compared to which the whole discussion on the AIG bonuses would pale. And, differently from the AIG controversy, the blame would be entirely and squarely on the current administration. The issue may explode at any moment before the midterm elections of 2010 or the presidential election of 2012, with lethal electoral consequences. If the two remedies suggested above are implemented this will not happen. If the FDIC ends up losing money no fat dividends and no large bonuses will be observed. On the contrary, the administration will be able to take credit for its cautious approach and will be able to claim that the money lost by the public did not go straightly into the undeserving pockets of powerful and connected people.