Beyond Paulson
| Sat Oct. 4, 2008 11:15 AM PDT
BEYOND PAULSON....The Paulson bailout plan has several underlying theories. First, by buying up toxic securities at above market prices, it injects needed capital into troubled banks. Second, by creating a market for these securities, it will raise the value of the toxic waste held by all banks, thus raising their capital base. Third, by creating this backstop, it will encourage private sources to inject capital into banks, as Warren Buffett recently did with Goldman Sachs and GE. Since banks need capital to make loans, all of this additional capital will free up the credit markets and allow borrowers access to credit once again.
As critics have pointed out, though, this might not work. And even if it does, it isn't the most direct way of recapitalizing banks. The most direct way would be to simply inject government money into shaky banks in return for preferred shares. It's true that if all goes well, the indirect method of the Paulson plan might produce a bigger bang for the buck — but then again, it might not. So what's next?
There are several policy measures that the government probably ought to think about implementing quickly. The key to most of them is to apply them to all banks, not just banks that are in trouble. If the policies are voluntary, any bank that takes advantage of them is admitting that it's in weak shape, which in today's market is as good as signing its own death warrant. Make them mandatory and nobody is stigmatized since they're just following the rules. A few possibilities:
Doug Diamond and others suggest that banks be required raise more capital: "The authorities could require all regulated financial institutions, no matter how well capitalized, to present plans to raise 2% of their assets in additional capital over the next quarter to preserve the stability of the financial system. This increased capital will not represent an increase in the permanent level of required capital for bank holding companies, but instead give institutions the extra capital that will allow them to lend."
Sebastian Mallaby passes along a proposal to suspend dividends: "The government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed."
Arnold Kling suggests temporarily reducing capital requirements for new loans: "My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2008, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don't want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations."
Of course, there's also the suggestion that we suspend mark-to-market rules, thus magically increasing the accounting value of bad assets and thus the capital base of the banks holding the assets. However, this seems like such a patently bad idea that I'm hesitant to add it to the list above. The rest of the ideas seem at least worth looking at, though, and can be done in addition to (and in parallel with) the Paulson plan. There's no reason to put all our eggs in one basket, after all.
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Comments
I know that getting rid of mark to market is a pretty bad idea in the best of times, but the idea that it would change anything is pretty clearly an expression of not understanding the problem. Banks don't believe the numbers as they are; how exactly an explicit policy of making values unreliable will help is beyond me.
Don't forget eliminating the penny; y'know, while we're at it.
Oh, and where are the reevaluations of Greenspan's tenure at the Fed? It seems to me that there's no other single individual at whose feet more blame for this crisis can be laid.
Submitted by The Lounsbury (not verified) on Sat Oct. 4, 2008 11:51 AM PDT.
The suggestion to lower capital requirements on loans seems really poorly thought out, as this effectively means allowing banks to increase leverage, and it hardly seems like a stunning risk to take.
The first two ideas, by Diamond, and Mallaby make real sense, as they directly strengthen the capital reserves of banks. The third from King , as has already been commented on sounds reckless to me. The first of these ideas is the best, although it causes dilution to existing shareholders (but if the bank is insolvent, a realistic assessment of the current value is zero), it is a fair (and capitalist) solution. If the money is injected by the government, the share ownership should be public, kinda like a partial Sweedish plan. Relatedly, what is the effect if we request well heeled mortage holders to prepay their mortages, i.e. pay down the principal faster than otherwise planned? I'm not an economist, I don't know if this would help or hurt the solvency of the banks. But it seems like a potentially no-risk no-pain method to provide some the the funds for recapitalization.
I don't think the M2M suspension makes much sense, although it might be a useful way to buy time (allow Wiley Coyote to not notice he is suspended over the abyss a little longer). I would think M2M should be modified, to avoid the possibility that a short term panic could spike valuations downwards, and precipitate a run. But, other than some prudent time filtering of the pricing information in the furtherance of avoiding potential rapid instabilities, we shouldn't mess with M2M.
I am concerned about the possibility of banks which are not in danger of becoming insolvent dumping their worst assets on the government, at taxpayers expense. We need some protection from the possibility of games to transfer all the bad assets to a designated fall-guy bank, so as to maximize taxpayer funded bailout.
Lower capital requirements for new loans? What? Isn't over-leveraging what got us into this mess in the first place?
To me, that plan sounds akin to increasing a person's credit line who is maxed out and can't even make the minimum payments. Brilliant!
Submitted by Legacy on Sat Oct. 4, 2008 2:33 PM PDT.
Yeah, lowering capital requirements for new loans sounds dodgy to me too. I'm not even sure Kling favors it anymore. (But he seems to be convinced that the apocalypse is near regardless, so who knows?)
Still, it seemed worth including as an idea. There might be limited applications for it in an emergency.
Canceling dividends? That's canceling a portion of people's income, isn't it?
My mother never held any bank stock, but she did invest my dad's life insurance money in some stocks specifically for the dividends and those amounted to a portion of the income she relied on to pay her bills in her old age.
Not everybody who gets dividends is a fat cat.
So, let's see. We pump over a trillion dollars of tax payer money (whatever was doled out so far + the new bailout plan) but we don't want to hurt banks' feelings. To help the criminals hide their bad stuff some bright guys are proposing that ALL banks be mandated to raise new capital and to suspend dividends.
What's wrong with this picture? It is disastrous on several fronts. What's the incentive to be a responsible banker if no one effing cares if you ran your company responsibly or not? We have become such a bunch of ninnies that we don't want to hurt the feelings of banks that brought us to the brink of collapse?
And someone is proposing banks suspend all their dividends? Dividends, dear friends, are a sign of a company's health. If a bank pays dividends even if it doesn't have the income to do so, it is eating its seed corn. That is irresponsible behavior but it is between them and their shareholders. A strong bank can issue dividends without dipping into its seed corn. This is a good time to let banks differentiate between themselves. We should know who brought us to the brink and who was responsible.
There is another problem with suspending dividends. Dividends are a way for shareholders to reap the benefits of ownership. In some cases shareholders convince themselves that the underlying company can put income to better use to achieve a higher revenue/profit rate at which point they can generate an even stronger dividend stream. If govt mandates that dividends be cut off, that is denying shareholders the rewards of ownership. The bad banks and their shareholders are already screwed. Why screw the shareholders of banks that were responsible and capable of paying out a dividend? What investor in his right mind will hang on to a stock and accept the risk of ownership without having an income stream to share in the profits generated by the company?
And there is another problem with having all banks cut off dividends. When they do so, income piles up and gives rise to all sorts of funny ideas. Like offering a $32 share price for a mediocre company whose shares closed at $19 and in decline.
The way our stock markets are set up right now, dividend is about the only mechanism keeping the companies honest. Everything else is smoke and mirrors. Without dividends, the only concrete way most shareholders can realize the benefits of their ownership is by selling it to a greater fool.
With each passing day we are degenerating into a centralized economy. Why did we bother spending trillions of dollars and wasting hundreds of thousands of our soldier's lives in wars meant to stop Communism, if we are going to follow down that path anyway? Slap yourself and wake up.
Submitted by Robert Waldmann (not verified) on Sun Oct. 5, 2008 3:38 AM PDT.
I'd place Kling's idea in the trash can along with suspending mark to market.
I recall what happened the last time capital requirements were relaxed (2004) they were relaxed for "investment banks" a strange 20th and early 21st century type of firm which doesn't exist anymore.
I think the idea of more flexible rules for "new loans" is silly. Old loans can be made new by paying them back and relending. I don't think it would be practical to keep the lower requirements at the margin.
The issue clearly isn't excessive capital requirements. If it were, the equity of seized banks would be very valuable. In fact, they seem to be worth less than their debt, that is, they broke the 0% equity line not just the 12% (or whatever) equity capital requirement.
Kevin's first paragraph provides an interesting description, worth parsing carefully. First, if the government is buying these "above market," we know two things: a) there IS a market and b) the government is paying more than that market says these securities are worth. Actually, the first point is synonymous with the 3rd: private sources are ALREADY injecting capital. Buffett's purchases at Goldman and GE and Wells Fargo's at Wachovia all happened BEFORE the buyout passed, and therefore all at REAL market prices.
We also know from point b) that Buffett, Barron's and others, who tell us that this is a great deal for taxpayers, can't be right. You make money by buying in at an undervalued market price, and then waiting for the market to re-adjust, NOT by overpaying and hoping for the best. Buffett knows this: he's just done it.
In any case, all of this puts into question Kevin's second underlying principle about "creating a market." Manifestly, the market already exists. It's just that the banks don't want to recognize their losses.
What you really have here is insolvent banks begin allowed (now encouraged) to hide their insolvency and eliminating confidence in the remaining banks, since nobody knows who's who. It's not much more than a sophisticated game of three card monte with the government stepping in as a new (and exceedingly wealthy) mark.
This might just be the biggest confidence game in American history. The Bridge to Nowhere was just a practice run.
Here's my take on suspending mark-to-market. Doing so will increase doubts about bank balance sheets, as it should. If banks are allowed to use some sort of model-based valuation, why should I, as someone thinking about lending to, or buying new equity from, banks, believe what their balance sheets tell me? Mark-to-market has, at least, a transparently clear meaning. Changing that now cannot be a way to increase investor confidence, can it? (I suppose it can if investors are among the class of poeple you can fool all of the time...)
