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A Beautiful Financial Rescue Package

by BruceMcF Wed Oct 1st, 2008 at 05:02:44 PM EST

So, Monday a bail-out package described by opponents as excrement on toast went down to defeat because after getting compromises to make it, in my view, worse, the Republican leadership could not then deliver enough Republican votes to get the thing passed "on a bipartisan basis".

Like they are unwilling to take unpopular votes to protect business interests? What was more than a decade of votes against the Minimum Wage about, then?

So, the first step is to see if the non-finance sector business lobby has been on the phone with the Rebel Replicants, cursing them a blue streak for screwing the pooch so badly before the Christmas shopping season. Perhaps they are, and so perhaps they will toe the line.

And if not, then the Democrats can turn to putting together a Beautiful Financial Rescue Package that the caucus can support. So, what would that look like?



The Problem to be Solve

I've done one or two diaries on bits and pieces of this:
A Midnight Thought on Whether a Bit of Keynes can Fix This Mess
Mea Culpa: The Fed May In Fact be in a Financial Mess.
Close the Barn Door after the Horse Broke His Leg. (Agent Orange)
Solvency Crisis: Fed VP Called it in May ... but didn't NAME it.
How a Little House Threatens Pension Funds and Insurance Companies (Agent Orange)
The Political Sweet Spot on Rescuing Main Street from this Mess (Agent Orange)

... but the upshot is fairly straightforward.

We are facing a solvency crisis, because financial firms, including commercial banks, held assets on their balance sheets at inflated credit ratings.

The inflated credit meant they had far more exposure to a drop in the value of their financial assets than they should have had, and so some of the institutions were sliding toward insolvency. So now everybody wants to sell this junk, not enough people have the ability, let alone the desire, to buy it, pushing the market value of the assets down, dragging more firms into insolvency.

Insolvency is when your obligations exceed your assets. But the Fed and the Treasury have been pretending for a year that its a problem of liquidity, and all of their "solutions" were providing more liquidity.

Its like someone coming into the emergency room with an infected wound, and they put in stitches and send them on their way ... it covers up the problem, but it does not fix it.


Is the Crisis Real?

From the gray lady (h/t Matthew Yglesias):

Cities, states and other local governments have been effectively shut out of the bond markets for the last two weeks, raising the cost of day-to-day operations, threatening longer-term projects and dampening a broad source of jobs and stability at a time when other parts of the economy are weakening.

Lots of people use "The Shock Doctrine" to argue that this is trumped up. But in a trumped up crisis, Lehman Brothers does not fold. Rather, what "The Shock Doctrine" should tell us is that one of the first reactions to the crisis will be for the Corporate Sector to use it as a distraction to grab for things they want.

So, yes, of course there are those trying to leverage this crisis, which is very real ... and indeed an entirely predictable and predicted outcome of taking financial deregulation to extreme lengths ... into yet more long term benefits for Megacorps.

But its a real crisis. And the advantage in facing down the Shock Doctrine during a real crisis is that there are a very large number of real businesses that are at risk of going bankrupt during the current recession, if the Finance Sector is not there to tide them over.


What Rescues firms from Solvency Crises?

You can only re-capitalize from borrowing if you can turn around and generate surplus income from those funds ... and finding enough good income in the middle of a recession to keep up with asset values in free fall, that just is not going to happen. So that route is out, at least short term.

So Santa Paulson's original plan was to buy shaky assets at inflated prices, re-capitalizing firms on the "Ho, ho, ho, Merry Christmas" principle.

The third way to re-capitalize a firm is to give an equity stake to the source of the funds. Then the existing shareholders lose out, but they lose out more if the firm goes belly up.

Dodd's plan was to have the firms hand over warrants, so when the Public Trustee loses money on those assets, it would be an interest-free loan for the real long term value of the asset, and an equity stake for the size of the overpayment.

But why should these firms get interest-free loans because they were too greedy and handed out as income what should have been kept as prudential reserves? Whether or not the ratings companies gave inflated ratings, managing risk is their business and they blew it.

So I think its more beautiful to have the purchase of shaky assets tied to the up front acquisition of an equity stake.


What Should the Size of the Rescue Be

Paulson says he needs $50b per month. SO $100b up front, and $100b on approval of Congress in a late November lame duck session, would, in Paulson's estimation, tide us over. Stick the number on Paulson.


What Should the Content of the Rescue Be

I've describe before the non-voting Preferred Share. It has a face value interest rate like a bond ... but its a dividend, so that when the company is running a loss, it doesn't have to pay the dividend. Unlike a debt, on it cannot drive a firm into bankruptcy. But like a debt, voting shareholders cannot take a dividend for themselves unless they have paid the Preferred dividend in full.

And of course, the firms that are actually rescued should end up refunding the cost of their part of the rescue. So set the Preferred Share Dividend Rate at the Treasury Rate for the bonds to finance the purchase of the dividend, plus 3%.

So, the Public Trustee buys a dollar of Public Preferred Shares alongside every dollar of shaky assets. Plus, the company gives warrants for additional Preferred Shares, to make good any losses on the shaky assets.

The Bail-out, as part of the compromise, makes the weakest possible concession to the idea of limiting executive pay. The Preferred Shares have a condition attached that, whenever the firm is not paying the Preferred Dividend, the only executive compensation allowed that is more than 10 times median income are common stock options maturing in five years or more.

There two beautiful things in there at once. First, corporate American has a direct stake in median incomes. And second, the greed of management is dragged out of the "next quarter's results" mentality, and into the performance of the firm in the actual time of strategic plans made and beginning to bear fruit.

If Ms. Fiorina had been paid mostly with Hewlett Packard stock options maturing in five years time, she would have reached the point of having to quit just to save the value of her stock options ... no golden parachute buy-out on the risk of staying and destroying more shareholder value would have necessary.

I'll add another rider ... because a lot of time income is taken out as part of Mergers and Acquisitions activity rather than dividends ... the Public Trustee must approve any Merger and Acquisition activity unless the Preferred Shares have been fully paid for two fiscal years.

With Executive Pay and freedom to engage in Mergers and Acquisitions hinging on paying the Preferred Share Dividend, firms will pay that dividend if they possibly can.


Houses:Everything Else, Fifty:Fifty

Finally, the real kicker. Dean Baker has a beautiful program for coping with the foreclosure crisis that is called "Own to Rent".

Someone is facing foreclosure on a house in a depressed housing market. The mortgage broker granted that loan without even bothering to check if it could be repaid, because the assumption was that the house could always be sold for a gain if necessary to someone else.

Oops, when you ASSume you make an ... oh, well, you know the rest.

Open up a new foreclosure route. If the owner is willing to hand the title back, they can continue to stay in the house as a renter, paying a rent based on the current fair market value of the house. That right is attached to the title, until they surrender it.

An economic assessment is made of the value of the property with this rider attached, and the Public Trustee takes over the title from whomever owns the mortgage, including a "structured investment vehicle", replacing it with 10 year Treasury Bonds. The structured investment vehicle takes its loss on the value of the house, but on the other hand the risk of that part of its cash flow is substantially reduced.

The authorization includes explicit authorization for any investment vehicle allowed to hold mortgage assets to accept Treasury Securities in their place at an assessed current market value, including the loss from the Own to Rent rider.

The Public Trustee would be allowed to sell those properties, but mortgages against those properties could only be held by depository institutions in sound financial shape.

Given the extent of the foreclosure crisis, if Secretary Paulson thinks that his buddies on Wall Street need $100b in financial capital to keep going for the next two months, then let $50b be to re-capitalize financial firms that are over their heads, and $50b to rescue home-buyers who have gotten into mortgages over their heads.

Because 50:50 is a Beautiful Ratio.


Releasing it into the Wind

OK, there you go, the Beautiful Financial Rescue Plan.

Because, much as I love Xelander, at the rate he seems to be going, we are not going to be able to bank on his rescue plan ...


Display:
... the seed will grow a branch with a link when the Agent Orange version is turned on at around 7pm Eastern (1 am Paris time)

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Oct 1st, 2008 at 06:07:08 PM EST
A Beautiful Financial Rescue Package xpost

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Oct 1st, 2008 at 07:01:43 PM EST
[ Parent ]
So Monday the House shot down Paulson's S.O.S.  During WW II that is what G.I. called glop on toast at the mess hall: Shit on a Shingle!  So now the Senate opened up the sandwich, vomited on it and sent it back to the House.  I hope the blue dogs are good to their word and refuse to again vote for it with added, un-paid-for tax cuts as "appetizers" for the Republicans.  Let the Republicans take their bite of the original poisoned apple or let the fires burn.

The Congress and the Administration are playing Kabuki Theater on this.  The Paulson Plan does nothing to save the real economy.  Even with the new money most of these institutions still have losses to come and will just hold onto whatever new capital they get instead of making loans against it.  The plan is fundamentally dishonest, does nothing for the real economy and is almost entirely directed to those who got us into this mess.

If Congress and the Administration are truly concerned about lack of commercial, consumer and real estate credit they should address that directly.  A good start would consist of creating new, uncontaminated banks backed with whatever was going to back Paulson's $700 billion bail-out.  I have bored everyone over and over with that plan. But I will keep bringing it up until someone shows me something seriously wrong with it.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Oct 2nd, 2008 at 01:06:11 PM EST
... already broken ... the original Paulson would have done on the Santa Claus principle, at the expense of setting up for a more serious melt-down in a few years, like the Panic of 1890 paved the way for the Panic of 1893-1896.

It would do a bit to cushion some balance sheets of some financial firms, so it would prevent some of the damage that will be caused over the next six months with inaction.

But as far as recovery, its got nothing for that ... it at best will reduce the damage cause by an asset value melt-down combined with the onset of a recession.

If it gets passed, then a real financial rescue package will be needed to be worked out by January/February, and it if fails, then it becomes even more urgent to get a real financial rescue package in place before Christmas.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 2nd, 2008 at 01:24:43 PM EST
[ Parent ]
Can this be done without creating new, uncontaminated banks to supply credit that has been destroyed by incompetence?  What we are witnessing is what J.S.Mill described: "Panics do not destroy capital. Panics only reveal the extent to which capital has previously been destroyed by being betrayed into hopelessly unproductive uses." (tip to London Banker for the quote.)

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Oct 2nd, 2008 at 01:56:56 PM EST
[ Parent ]
... "bad apple" excuse for corporate behavior.

The banks behave the way that commercial banks have always acted when permitted to. If we set up new banks and permit them to behave the way we permitted the existing banks to behave, sooner or later they will recapitulate a banking panic ... if we remove the license from the current banks to behave the way they have been behaving, they will go back to the boring business of banking, again.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 2nd, 2008 at 08:20:51 PM EST
[ Parent ]
If we set up new banks and permit them to behave the way we permitted the existing banks to behave, sooner or later they will recapitulate a banking panic
Agreed, of course, and in most of my statements of the proposal I have emphasized the need for a return to something more like 70s regulations.  But you would only respond to some tertiary point if at all to those comments. :-)

... if we remove the license from the current banks to behave the way they have been behaving, they will go back to the boring business of banking, again.
Agreed, but they would still be saddled with the bad assets they acquired during the bubble, so new regulations alone are clearly insufficient, unless you advocate that the public, via the government, relieve them of those bad assets.  While they are insolvent they remain impaired in their ability to extend needed credit.

New banks, created as I propose, and operating under competent regulatory schemes, would be able to finance ongoing economic activity and pick up the slack left by impaired banks.  Why is this not an appropriate thing for Congress and the Administration to do in the public interest?  I can see that it would be disadvantageous to existing banks, especially those impaired by toxic assets. TFB!  I can also see that this would, in effect, free the Main Street or real economy from being held hostage to Wall Street, as I believe Paulson is doing.  I can see that it would be strongly opposed for those reasons alone.  Can you comment on the substance of the proposal.  I am particularly concerned about any specific that would render it unfeasible and about consequences I don't foresee.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Oct 2nd, 2008 at 11:22:37 PM EST
[ Parent ]
Agreed, but they would still be saddled with the bad assets they acquired during the bubble, so new regulations alone are clearly insufficient, unless you advocate that the public, via the government, relieve them of those bad assets.  While they are insolvent they remain impaired in their ability to extend needed credit.

New banks, created as I propose, and operating under competent regulatory schemes, would be able to finance ongoing economic activity and pick up the slack left by impaired banks.

But this is shifting the ground ... it was framed as not putting it in the hands of the bank managers who had failed, rather than being a balance sheet problem.

I don't see how the balance sheet of the private banking system is fundamentally different ... how the new capitalization to allow newly established banks to lend somehow free of interaction with existing banks and their crappy balance sheets is any different from the re-capitalization of the existing banks.

The way the banking system works as a system is that purchasing power flows from one bank to the other and the temporarily liquid institution lends its liquidity to the temporarily illiquid institution, and what you seem to be describing is a system that only functions in terms of liquidity when liquidity has flown to insolvent institutions, who would of course be happy to lend it at very short terms to the newly founded solvent institutions. If the liquidity has flowed to the solvent banks, why will they lend to the insolvent banks?

Sharply curtail the ability of existing banks to play speculative games, force bank holding companies to be organized so that their commercial banking subsidiaries can be bailed out individually while allowing the bank holding company to fail, eliminating the "too big too fail" moral hazard, re-capitalize the system with a permanent public equity stake, which since it will act as a tax on finance sector firms during normal times that is automatically not collected during serious downturns acts as an automatic stabilizer, and throw substantial new real paying business the way of the Main Street oriented part of the finance sector with a massive crash program to construct a New Energy Economy.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Fri Oct 3rd, 2008 at 12:00:00 AM EST
[ Parent ]
But this is shifting the ground ... it was framed as not putting it in the hands of the bank managers who had failed, rather than being a balance sheet problem.
It is shifting the ground back to the question I asked, which is not in your frame.

I don't see ... how the new capitalization to allow newly established banks to lend somehow free of interaction with existing banks and their crappy balance sheets is any different from the re-capitalization of the existing banks.
The difference is the taxpayers get the benefit of new credit to the economy without first having to pony up the capital to "recapitalize" the existing banks.  It would have the advantage of offering a clear view of what is the necessary cost of winding up an insolvent institution and insuring that the public does not bail out stock or bond holders. It would have the added advantage of creating new, healthy institutions that could buy up viable assets of banks that could be allowed to go out of business due to insolvency.

If, other than those trivial practical differences, there are no other significant differences, I will be very pleased.  I see no reason why this scheme could not enjoy all of the advantages enumerated in your last paragraph while administering a healthy dose of "market discipline" just where it will do the most good.  

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Oct 3rd, 2008 at 12:33:39 AM EST
[ Parent ]
... yours here:
Can this be done without creating new, uncontaminated banks to supply credit that has been destroyed by incompetence?

I don't presume incompetence to be at issue. Banking systems operating without little or no regulation always end up have serious banking panics, destroying a large amount of credit.

Whenever there is a systemic problem, those who have been less well managed have a greater likelihood of being on the chopping block, but if all banks had been run more competently, we still would have seen roughly the same result, though perhaps with some reshuffling of the list of which institutions went under when.

On this:

The difference is the taxpayers get the benefit of new credit to the economy without first having to pony up the capital to "recapitalize" the existing banks.

... as it seems likely it would be more capital overall required to capitalize these banks sufficiently that they are not dragged down as the existing banking system collapses around them, it seems that this difference is that providing more capital for an equity stake in newly established banks feels better than providing less capital for an equity stake in existing banks.

The difference is the taxpayers get the benefit of new credit to the economy without first having to pony up the capital to "recapitalize" the existing banks.  It would have the advantage of offering a clear view of what is the necessary cost of winding up an insolvent institution and insuring that the public does not bail out stock or bond holders.

The proposal in the diary does not bail out stock holders ... it dilutes their equity by from 100% to 200% of the amount of shaky assets taken out of the system, and creates a permanent tax on gross corporate profits.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Fri Oct 3rd, 2008 at 11:41:04 AM EST
[ Parent ]
Thank you for your response, Bruce.
...it seems likely it would be more capital overall required to capitalize these banks sufficiently that they are not dragged down as the existing banking system collapses around them...
I fail to see how it is less expensive to provide capital to new, uncontaminated banks than it would be to first cover all of the losses and bad bets of existing banks and then provide the capital to re-capitalize them. And how would anyone know if all the bad assets had been identified when they were re-capitalized.  Please explain.

I don't understand why new banks would not be more resistant to being dragged down by existing banks than are existing banks.  All of their business would be conducted under more conservative banking regulations and there should be a lot of very experienced, sadder but wiser bank officers available to staff such institutions.  In the current climate most such officers would be very glad to have good paying employment, acutely aware of the consequences of playing fast and loose with the rules and constrained with the possibility of legal consequences for future bad behavior.  They might no longer have the prospect of doubling their personal wealth in three years from their work, but they would have good salaries and benefits.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Oct 3rd, 2008 at 12:03:09 PM EST
[ Parent ]
I fail to see how it is less expensive to provide capital to new, uncontaminated banks than it would be to first cover all of the losses and bad bets of existing banks and then provide the capital to re-capitalize them.

Its not necessary to cover all of the losses and bad bets of existing banks. Much of the losses and bad bets are in the range of bank equity, and its not necessary to cover bank equity for the bank to remain solvent.

But push the institution over the edge, its bonds suffer a hit, and now there are more financial firms that were previously solvent who are pushed toward insolvency ... and at the same time as liquidity in the system takes a hit, so even firms who could work their way back to solvency face difficulty staying in business long enough to do so.

Indeed, on the part of the ABC "AM" news radio coverage, from Austalia, on "the impact of the US banking crisis "over here", the interviewer was prodding a politician (either the PM or Treasurer, I forget which) on whether Australia really was in better shape than the US and UK, the "scare figure" was that a certain banks balance sheet showed derivatives and structured vehicles amounting to 70% of shareholder equity, which means they could all go bust, and the bank would still be solvent.

And saying "covering losses and bad bets of existing banks and then providing the capital to re-capitalize them" is double counting ... the covering of the losses and bad bets necessary to remain solvent is the capital that is re-capitalizing them.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Fri Oct 3rd, 2008 at 12:16:23 PM EST
[ Parent ]
Lots of people use "The Shock Doctrine" to argue that this is trumped up.

Bruce, do you refer to Naomi Klein's book specifically? It would help if those "lots of people" were concretized.

Actually, Naomi Klein disclaims wide conspiracy theories, noting towards the end of her book that (any or other) shocks happen now so regurlarly that whole economies can be build upon them.

It is an open question how much power the Wall Street community has. If the US state owns $10 trillion to them, who really controls what? Ain't it convenient to that small community that the economy health is measured by a few Dow Jones statistics?

We can tell something about the character of Wall Street eagles after all these years. They employd at least IMF & the World Bank not only to protect their interests (and interest rates) around the developing world. They got bounties of "Chinese character" opportunities through every Friemanian "straight-jacket" shock-therapies and free trade muscles. The selling-out/buying-in of the 1997 Asian crisis alone was worth more than Tchengis Khan could ever loot. I would love to see how a small shock therapy (of not paying up the "bailout" ransom) would help the Wall Street legend.

by das monde on Thu Oct 2nd, 2008 at 01:56:35 PM EST
I am referring to the bloggers abusing the Shock Doctrine to claim that this is a trumped up crisis.

The idea that we can let banks behave this way without eventually having a Banking Panic is silly ... every time before that we allowed commercial banks to behave this way in a primarily industrial economy, we have had Banking Panics.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Oct 2nd, 2008 at 08:23:13 PM EST
[ Parent ]


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