Kip Hagopian

ALLEVIATING FINANCIAL CRISIS: “PLAN B” — A MARKET BASED SOLUTION

Kip Hagopian and Professor Ed Leamer

Congress has rejected the $700 billion “Troubled Asset Relief Program” (TARP) bill, presumably because neither the Treasury nor elected officials were able to make a clear case to American taxpayers why this plan would be effective, and at what cost, and because voters were up in arms over the prospect of bailing out the very people who got us all into this mess.

We propose an alternative to the TARP bill that might help attract more taxpayers and Congressional support because the risks to taxpayers would be clear and limited and because the intent and likely effects of the bill would be transparent and appropriate.

The essential idea is a public/private partnership to purchase mortgage-backed securities and to provide a capital infusion into needy and worthwhile financial institutions.

This plan can be used as a substitute for TARP or could be grafted onto it, in which case, the Treasury and its oversight board would have additional tools available with which to address the problem.

We believe, as many others have averred, that the problem has three components: 1) A severe lack of trust in the financial markets, not just from the public, but from investors and institutions; 2) A lack of liquidity in the assets held by financial institutions, specifically mortgages and mortgage backed securities; and 3) The danger of a collapse of many banks whose solvency has and will continue to be threatened by write downs in their mortgage assets, some of which could be saved with a capital infusion. The Treasury’s TARP plan directly addresses the lack of liquidity in the market for mortgages and mortgage-backed securities, but its effects on trust seem ambiguous. Most importantly, it does not address directly the other, perhaps most important, problem which is an insufficient amount of equity capital in the nation’s financial institutions.

The TARP plan might increase the capitalization of banks if the Treasury paid high enough prices for the securities, but the plan leaves ambiguous whether the Treasury would offer “fire-sale” prices, “fair market value” or some higher price. Of course, higher prices are better for the financial institutions but make the plan more costly for the taxpayers. Another problem with the plan is the enormous amount of government capital that would be required.

Lastly, administering a program under TARP will require the establishment of an oversight body and a sizable new bureaucracy that will take considerable time to create and will be very difficult to run efficiently.

Is there a better way? It’s hard to say with any degree of confidence; after all, we are breaking new ground. Nonetheless, we are proposing herein an alternative that could eliminate or mitigate some or all of the above-described weaknesses in the Treasury’s plan.

The Goals of the Proposal

These are the basic goals we believe any alternative plan should have:

• First, to provide, not just a market for illiquid assets, but also a market that offers prices as close to fair market prices as possible.

• Second, to create the means by which troubled financial institutions can more easily acquire equity capital at market prices.

• Third, to minimize the taxpayers’ financial exposure.

• Fourth, to manage the program with the highest level of efficiency and at the lowest possible cost.

• Fifth, to jumpstart the program so the benefits can be felt as soon as possible.

We believe all of these goals can be achieved by implementing this proposal.

Proposal

The fundamental principle underlying this proposed alternative is that the private sector is infinitely better equipped to save the financial system than the government. However, due to the current crisis in confidence, the markets are frozen, in part because sellers value their assets more than buyers and in part because, in many cases, selling assets will necessitate write downs in the sellers’ portfolios that will render some of them insolvent. Potential sellers suspect with great justification that the current offers to buy are undervaluing these so-called “toxic” assets. To get this market clear, we need to help the price discovery process by providing private investors with some government incentives. With this as a premise, our hypothesis is that all of the above stated goals might be achieved by creating a co-investment partnership with the private sector. Here is how it might work:

• Purchase of Mortgage Assets: We propose setting aside $350 billion as a pool of matching funds to be invested side by side with private investors (private equity funds, hedge funds, healthy banks, wealthy individuals, pensions funds, and other investing institutions.). The government’s funds would be co-invested with any creditable private investor on a dollar-for-dollar matching basis. Thus, $700 billion of capital would be available to purchase assets, but only $350 billion would come from the taxpayers.

Under this approach, private investors would conduct the analysis and due diligence of prospective purchases, would control the bidding, and would manage the investments when consummated. In the ideal, there would be several bidders for each asset or asset trench being offered, thereby creating a real market for the assets. The government’s investment would be Pari passu with the private investors, thus it would be sharing the risk proportionately. But to attract maximum participation from the private sector, the government would provide an enhancement to investor returns by allowing investors to share disproportionately in the gains. As a ‘straw man’, the government might accept interest only for a 10-year time period at the 10-year Treasury bond rate leaving the private investor to reap all the gains in excess of the interest paid. The government’s interest return would be enhanced by the taxes it collects on investor profits.

• Infusion of Equity Capital. The above approach should reestablish market prices for whole mortgages and mortgage-backed securities, but there is no assurance that fair-market-value prices will be high enough to keep the balance sheets of financial institutions sound. In fact, the establishment of market prices for certain assets may result in the holders having to mark down other assets in their portfolio to reflect the newly determined fair market value. This is required by accounting rules. Marking assets down could render these institutions insolvent and it is likely that many financial institutions will need to seek new equity capital for this and other reasons. Like the public/private partnership for the purchase of mortgages and mortgage-backed-securities, we propose that the government be prepared to offer the same terms for risk and profit sharing. Accordingly, the government would receive the 10-year bond rate of interest (plus taxes on investor gains) and private investors would receive the balance of any gains reaped from these equity investments.

The government fund available for equity infusions might be $50-100 billion which, when matched with the private sector, would provide $100-200 billion to recapitalize the banks and other financial institutions.

Advantages of the Proposal

We believe this proposal has several advantages related to TARP. They are as follows:

• The plan includes a provision for infusing equity capital into the financial system, which will almost certainly be needed to shore up some of the banks and other financial institutions.

• In comparison with a newly assembled team of Treasury officials and consultants, we believe private investors will be better able to price illiquid mortgages, mortgage-backed securities and equity investments and better able to determine which firms should be saved and which should be allowed to go under.

• In addition to superior investment knowledge and better incentives in the private sector, the personnel infrastructure for making these decisions is already in place and there is no need for the government to invest in an expensive new Treasury bureaucracy.

• Because the infrastructure is in place, efforts to produce needed confidence, liquidity and solvency will be accelerated.

• By involving the private sector, the amount of taxpayer exposure will be limited to $400-500 billion, but the amount of capital available to accomplish the Treasury’s objectives will total $800 billion to $1 trillion. This should make this approach much more palatable to members of Congress.

This concept is likely to result in prices paid for troubled assets that are much closer to fair market value than the Treasury plan, largely because it will produce more bidders with the expertise necessary to properly value the assets. It is possible, however, that prices would slightly exceed fair market value because of the disproportionate profit-sharing arrangement (which is the equivalent of a government subsidy). But considering the state of the financial markets, buying assets at slightly higher prices will be better than buying them under market.

Conclusion

The defeat of TARP can be turned into a victory if an alternative plan (or an add-on to TARP) can be developed that will attract more support. We believe “Plan B” is such a plan.