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A BAILOUT PLAN THAT PUTS TAXPAYERS FIRST Jim Stodder. Hartford Courant. Hartford, Conn.: Oct. 8, 2008, pg. A.25 |
(Copyright The Hartford Courant 2008)
Taxpayer resistance to Treasury Secretary Henry N. Paulson's $700 billion bailout forced Congress to consider revisions. But tinkering with Paulson's plan does not remedy its weaknesses.
There are three big problems with the Paulson plan: First, the original investors get maximal protection, while taxpayers get only risk and no upside.
Second, we don't have any idea how much these junk securities are worth, and thus are likely to overpay. Third, if we buy up all their bad debt, what influence do we get over these banks? How do we stop more golden parachutes for their CEOs, or more foreclosures for families in our towns?
There is a better way. First, the government can simply force investment bank bondholders to swap some of their bonds for stocks. Second, as the Senate's banking committee chairman, Sen. Christopher Dodd, has proposed, the government can get an option to buy up distressed banks' stock. Let us consider these ideas in turn.
The first idea would force current bondholders to swap out some of their currently unsalable bond claims for stocks of equal face value. The bondholders won't like this, because stocks are riskier. And current stockholders won't like it much either, because their remaining shares will be diluted. This is a remedy commonly enforced by bankruptcy courts. It would be the least-bad option for a bank too busted to raise private capital on its own.
Such a bonds-for-stocks (or "debt-for-equity") swap generally raises the price of any remaining bonds, because they are now more likely to be repaid. Stockholders will also usually benefit in terms of their share price as confidence in the corporation increases.
So if it's such a good deal, why don't they do it voluntarily? Because of coordination problems: A single creditor swapping a few bonds would take on all the risk of holding stock, with little to show in terms of increased corporate viability. The government has to force a sufficient scale of cooperation.
By itself, a large forced debt-for-equity swap would cost taxpayers next to nothing. However, it also does nothing to change corporate governance - all those golden parachutes and foreclosures. This is where we need a government purchase of an equity stake.
The government's stake should be in "preferred" stock that is first in line for any profits that may one day be available. Government purchases should be conditional on the bank raising private capital to "match" its public stake. (A bank that can get enough private money without this match doesn't need our help.) We should also insist on new standards for executive pay and the renegotiation of mortgages.
The three big problems with the Paulson plan get fixed - the government doesn't need to guess how much the toxic debt is worth, taxpayers get the benefit of a preferred equity stake, and we are now stakeholders who can both profit and push for better corporate standards.
Jim Stodder teaches economics in the business school at Rensselaer Polytechnic Institute in Hartford.
By Thomas Hoenig, FINANCIAL TIMES, May 4 2009
When the financial crisis began to unfold in 2007, US policymakers reacted quickly out of fear that rapidly evolving events would lead to a global economic collapse. In my view, the policy response to this point has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions to stabilise markets and institutions, uncertainty continues and markets remain stressed.
I believe there is an alternative method for addressing this crisis that deals more effectively with the issues we currently face while also considering the long-run consequences of those actions: the implementation of a systematic plan to resolve large, problem financial institutions.
In recent weeks, I have outlined such a resolution framework for dealing with these large, systemically important institutions. Boiled down to its simplest elements, the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. These firms would be operated by outside individuals with no conflicts involving either the firm or its competitors.
Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible. This plan is similar to what was done in Sweden in the 1990s and in the US with the failure of Continental Illinois in the 1980s.
This plan has many advantages, including that management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. These are important reasons to implement this kind of resolution process.
In contrast to this suggested approach, the current policy raises a host of issues:
● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. Capitalism is a process of failure and renewal, and a “too big to fail” policy undermines this renewal and makes the financial system and our economy less efficient.
● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.
● The US government has poured billions of dollars into these firms without a defined resolution process, adding to our national debt. While there will be some repayment, there also will be losses. The longer resolution is postponed, the greater the losses and the larger the debt burden.
● As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This is reflected in the fact that its balance sheet continues to swell, which may compromise the independence of the Federal Reserve and make it more difficult to contain inflation in the years to come.
● Failing effectively to resolve these non-viable firms has long-term consequences. We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.
Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run.
A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefore manageable; and there will be fewer adverse consequences compared to the path we are on now.
Because we still have far to go in this crisis, there remains time to define a clear process for resolving large institutional failure. Without one, the consequences will involve a series of short-term events and far more uncertainty for the global economy in the long run.
While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.
The writer is president of the Federal Reserve Bank of Kansas City (Copyright Financial Times Limited 2009)