How to tackle systemic malaise

Marshall Auerback here. Ed has had a few posts on the Swedish bailout plan with which I agree. I think the main political argument (made by Bo Lundgren in yesterday’s NY Times) is that you have ZERO political legitimacy unless everybody is perceived to be making sacrifices and getting some long term benefit via equity.

Therefore, I have my own plan, which I recently put forward in a Letter to the Editor at the Financial Times.

How to tackle systemic malaise

Sir, Your editorial “Time for a bail-out of bust U.S. finance” (September 20) is right: the objective must be to deal with the systemic risks, but also to inject a degree of social equity to ensure that U.S. taxpayers are not completely fleeced.

It will be argued that no bank would be likely to sell assets voluntarily at below their value because such sales would leave an even bigger hole in their respective balance sheets. But why should the taxpayer pay over the odds for these “assets”? The notion that the markets in which they trade are “illiquid” and unreflective of true value is Wall Street spin.

Any Wall Street trader will tell you that everything has a price. These assets are only illiquid because the bankers holding them do not want to sell them at the price investors believe is the right price. Those that are overvaluing them certainly do not want to be forced to admit they have been misleading investors about the value of those assets, but why are the regulators protecting them?

If the Treasury buys them for pennies on the dollar, the taxpayer stands a better chance of recouping something in the deal. Yes, that does leave the issue of banks being undercapitalised, but you solve this problem by injecting equity into the “good bank” now shorn of its toxic assets.

Taking equity in the firms you bail out and selling later also minimises the long-term cost to the taxpayer. This sort of equity is preferable to warrants, so that firms cannot try to pressure the government not to exercise the warrants. It would also be wise to insist that firms that receive aid issue senior debt to the government that has rights over all other bonds. That is to make sure some money comes back right from the start.

And then with the bad assets that the Treasury now holds, the Home Owners Loan Corporation (HOLC) can be used. This Depression-era institution was created to buy mortgages from banks at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed-rate mortgage rates. This programme allowed millions of households to avoid losing their homes and there is no reason why its role could not be replicated.

A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced. But you then go to the homeowners themselves and refinance, offering significant debt relief. And later you have to reregulate. Specifically, you have to restrict leverage, probably put on reserve requirements, rules on use of depositors’ money, and so on. It is vital that derivatives trading is restricted to exchanges. If you give them the money first, reform will never happen.

All of this has to be part of the same programme so that systemic issues are resolved, future long-term costs to the taxpayer minimised and a recurrence of the problem made less likely in the future.

Marshall Auerback,
Denver, CO, US

How to tackle systemic malaise – Marshall Auerback, FT

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Stopping a Financial Crisis, the Swedish Way – Bo Lundgren, NY Times

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