A friend told me the economist Charles Kindelberger had two rules for a credit economy. Rule one was everybody should know that if they get over-extended they will not be bailed-out. Rule two was if everybody gets over-extended they must be bailed out. The U.S. economy has over-extended itself, triggering rule two. But that still leaves open how a bailout should be designed since designs are not all equal.
Currently, two models are on the table. One is the Paulson model (also supported by Bernanke) that proposes government buy the bad assets of financial institutions. The other is a Buffet-style recapitalization model that would have government invest in and recapitalize banks, just as Warren Buffet has done for Goldman Sachs.
The underlying problem is the financial system is short of capital owing to massive asset depreciation. This shortage is impeding provision of credit, which threatens to tank the economy by interrupting normal commerce.
Banks are caught in a pincer preventing them raising capital. On one hand, if they sell assets to cleanse their balance sheets and make themselves more attractive to investors, this could cause such large losses as to trigger bankruptcy. On the other hand, uncertainty about bank worth means the market is demanding such onerous terms for fresh capital that banks are unable to meet them.
Reading between the lines, the Paulson plan appears to propose government buy securities through a “reverse” auction whereby banks (and other firms) offer to sell assets to Treasury at a price of their naming, and Treasury accepts those offers meeting its acceptable price. Implicit in Treasury’s thinking is the assumption that the market will recapitalize banks on reasonable terms once they have been cleansed.
The essence of the Paulson plan is that financial markets have been hit by massive fear-based price disruption, requiring government to create a new market to break the logjam. If correct, by purchasing assets now at distressed prices and holding them to maturity, taxpayers could eventually make a profit, making the bailout costless.
The recapitalization model completely sidesteps cleansing banks and instead has government directly re-capitalize them. It can do this by buying compound cumulative preferred stock from banks, and also taking warrants that give an option to buy common stock in future at today’s low price. That way, if all works out, taxpayers are rewarded for the risks they take today.
Since preferred shares rank above common shares, existing shareholders would be hit before taxpayers should there be future unexpected losses. Meanwhile, taxpayers would get the benefit of the preferred stock dividend. Furthermore, if banks suspend dividend payments, the suspended dividend will cumulate and compound so that taxpayers ultimately recoup delayed payments.
Recapitalizations can also be accompanied by other useful provisions, including restriction of dividend payments on common stock. Additionally, banks could sign a memorandum of understanding with the Fed suspending capital standards and mark-to-market asset price accounting. Both of these practices have squeezed banks by causing further losses as asset prices fall. Since markets are not working well by the Treasury’s own admission, it makes no sense to keep using market price accounting.
The Paulson plan is subject to three fundamental criticisms. First, the Treasury may over-pay for assets, saddling taxpayers with large losses. If the Treasury sets its acceptable price too low, there is a risk it will buy insufficient assets and banks will not be cleansed. If it sets prices too high, the risk is Treasury overpays. Second, Treasury is taking a big risk as prices could fall further, yet it is not being properly rewarded for this risk-taking. That is tantamount to subsidizing banks which have created the mess. Third, markets may not provide finance even after Treasury’s purchases, in which case banks will remain undercapitalized.
The Paulson model defense is taxpayers are protected by the reverse auction design. Banks need money and will therefore offer assets for sale at true worth, knowing they may be undersold by other needy banks if they ask for too high a price.
Criticisms of the recapitalization model are twofold. First, what price should Treasury pay for preferred stock? Second, which banks should get funding? The danger is that zombie banks apply for funding, seeking to save themselves by gambling for redemption with taxpayer money.
The recapitalization model defense is accounting information exists, due diligence can be conducted, and judgment can be exercised when it comes to setting warrant prices and interest rate terms on preferred shares. Indeed, due diligence and judgment are also needed under the Paulson plan to establish the maximum price government will pay for different types of securities.
The reality is there are two fundamentally different models for addressing the financial crisis. Both have strengths and both have weaknesses. Time is needed to deliberate on them, and Congress should not be stampeded into a decision. Nor should Congress hand over a seven hundred billion dollar blank check, particularly to the Bush administration in its waning days.
Finally, both the Paulson and recapitalization models deal only with the supply of finance. Neither deals with the problems of re-regulating finance, jumpstarting the economy, and ensuring the economy delivers shared prosperity that escapes the trap of relying on debt and asset price inflation to drive growth.
It is no good fixing the supply of finance if there is no demand for finance or if the demand for finance is based on rotten foundations. That is why helping Main Street is as essential as bailing out the banks.
Originally published on September 25, 2008 at Thomas Palley and reproduced here with the author’s permission.