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Bankruptcy: Credit Slips
Thoughts on the Bailout Plan
By Adam Levitin
[Revised 9.21.08 at 1:40 pm
9.20.08 at 4:15pm]
The Treasury's bailout plan is out. There's really not much to it: under the plan, the Treasury would be authorized to purchase up to $700 billion in mortgage-related assets from US headquartered financial institutions. To put it in even simpler terms, Paulson has asked for a $700BN mortgage slush fund, no strings attached. Given where we are, this might be about the only thing possible. But there are still lots of questions raised by the Treasury's very terse proposal. Not least of them are:
1. How much toxic MBS paper is out there? Does $700BN cover it all? Does anyone know? I'm not real confident about this. Presumably $700BN doesn't cover everything at face value, but the Treasury isn't going to pay anywhere close to 100 cents on the dollar. So what is the average discount on MBS that $700BN would cover?
2. Will $700BN cover enough to stabilize the markets? We've already seen two (or three) situations in which the Powell Doctrine of overwhelming force has failed when applied to financial markets: first with Paulson's Fannie and Freddie bazooka, second with Geithner's $85BN purchase of an insurance company with $10BN market cap, and third with the Fed and other central banks' opening the floodgates to support the market on Thursday and Friday. Of course one could well argue that but for these displays of shock and awe, things would be much worse. Still, we should be very sure that this is the full price to taxpayers for the bailout before authorizing one; if Treasury comes back in three months and requests another $700BN, it'll be hard to refuse, but an upfront deal of $1.4 trillion might be a harder sell. We don't want to find out this is a really a blank check.
3. Will the Treasury purchase everyone's bad debts or only specific institutions? The proposal makes it discretionary. Will only commercial banks and i-banks be bailed out? Mutual funds? Hedge funds too? If it isn't everybody (and question 4, on mechanics, relates to this), then who will it be? Certain classes of institutions? Or certain size institutions? The discretion that the proposed legislation would give to Treasury could create serious fairness issues.
4. How is the Treasury going to actually do the bailout? The effectiveness of a bailout depends on its mechanics, and it doesn't appear that Treasury has decided on this. I can think of three possibilities:
(a) Offer X cents on the dollar for particular enumerated classes of MBS/CDOs, etc. Hold the offer open for a limited window, and no bailout late for anyone who doesn't cash in now. Of course, I doubt that Treasury would stick to that deal if a major firm were threatened down the road. The good thing about operating this way is it would be simple and fast. The bad part would be adverse selection (only paper worth less than X cents/dollar would be sold). A limited time window for the offer and the threat of litigation against directors who didn't take the deal and then found their institutions going bust might help overcome it, but that depends on the credibility of the "no more bailouts" threat, which just isn't that credible.
(b) Negotiate individual deals with each financial institution. If the Treasury goes institution by institution, are larger and more important institutions going to get better deals than the ones Treasury isn't so concerned about? What sort of transparency will there be in this process?
(c) Negotiate deals with each institution for each asset type or each individual asset? That seems like it would have huge transaction costs and take too long to accomplish to help out liquidity pressed institutions. If the Treasury does go asset-by-asset, are they really capable of marking them to market? If the financial institutions themselves can't figure out the valuation, how can Treasury? What a messy process this will be and what a feeding frenzy for deal attorneys.
[Added 9.21.08 at 1:40pm. Some indication as to how this bailout will be done may be found in the provision that would authorize the Treasury to appoint financial institutions as its agents. That points to methods (b) or (c), not (a). It also raises some serious questions about the possibility of self-dealing, churning, and other conflicts of interest, especially as there is no judicial review possible for any of this. The bailout has a bit of a look of a no-bid contract. Who do you think will get a piece of the deal action? Goldman Sachs? (In fairness, it's not like there are that many big i-banks left standing.) I would feel a lot better about the bailout package if it were to be run out of an independent agency (RTC-style) and were subject to more careful oversight. It's quite easy for a few billion to be wasted here or there when playing with $700BN no accountability, not even a reelection campaign.]
5. Does getting the toxic assets off banks' balance sheets actually solve things? If the Treasury takes them for a lower price than the banks have been carrying them, the banks' assets fall, which could itself cause trouble. By buying the MBS, the Treasury is essentially creating a market for them now, allowing assets to be marked to market more accurately. Our current situation involves tremendous uncertainty about financial institutions' solvency and hence credit risk. But ending that uncertainty might actually show that some institutions are in worse shape than anyone suspected. That could create other crises (but hopefully more easily contained ones). Of course, since the Treasury is playing with taxpayer money (and this administration is lame duck anyhow), the Treasury might not drive as hard of a deal as someone playing with its own money might.
6. What about the consumers? There's nothing in the bailout to help consumers, just to help banks.
Even if the Treasury purchases a boatload of MBS, it isn't clear that will stop foreclosures. To modify the terms of an MBS, a supermajority of the interests in a particular trust are needed. The Treasury might be able to scoop up the B and C tranches, but if the A tranches are in the money still, there might not be a deal. Even if Treasury can get to the underlying mortgages by purchasing the MBS, it will take quite a while to sort through everything and put the brakes on the foreclosure machine.
7. Isn't there a price tag for the financial institutions? Bailouts shouldn't be free. Any bailout bill should be passed with an explicit price tag: bailout now for serious regulatory reform later (I would suggest that should start with a return to Glass-Steagall, a requirement that OTC products to be exchange traded, and a move from disclosure-based consumer protection to regulation that focuses on the substantive terms of consumer debts.)
I don't know how one writes in a provision that any financial institution that accepts the bailout won't oppose future regulation, but the idea of banks getting bailed out now and then using taxpayer dollars to lobby against regulatory reform is pretty galling.
Treasury is making the case that time is of the essence, but Congress should get answers to these questions (and a host of others) before authorizing $700BN (and maybe more down the road).
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