Which Way Out?

While many agree that dramatic governmental action is needed to restore confidence in financial markets, there is less consensus on the precise form that action should take. Secretary Paulson has sketched out one approach and Democratic leadership in Congress has responded with useful refinements. But there are better ways to structure the intervention and defray its costs.

On the structural side, consider how the government should spend its $700 billion. The basic strategy of both the Paulson and congressional plans is to buy back large quantities of toxic mortgage backed securities in some sort of auction process. These purchases would remove troubled assets from the balance sheets of selling institutions, and (hopefully) clarify the prices of similar securities held by other investors. But, exactly how this clarification of prices is to come about is unclear. Will the government’s purchases be considered accurate measures of market value or merely fire sales by frantic firms facing bankruptcy? The ownership of underlying mortgage pools will still be highly fragmented. The mere shifting of ownership of large quantities of securities may do little for price discovery, and could serve simply to transfer government resources to selling institutions.

A more effective strategy would be for the government to purchase all of the loans in mortgage pools underlying specific securitization transactions, starting first with the lowest quality subprime and Alt-A mortgage pools, which is where the underlying problems lie. With congressional authorization, the Treasury could force the purchase of these assets through eminent domain and make an immediate payment of an estimate of the loans’ current fair value, which would then be reviewed for adequacy by an appropriately constituted judicial forum at some point in the future. If the initial payment did not provide just compensation, additional compensation plus interest could be paid. Attacking the problem from the loan end of the securitization process, as opposed to the investor end, has numerous advantages.

To begin with, purchasing whole pools of loans would force liquidation of the mortgage backed securities used to finance those loans. Investors would get an immediate distribution of the government’s cash plus some sort of residual interest for whatever additional proceeds might come out of the after-the-fact judicial valuation proceedings. Critically, whole issuances of the most complex mortgage backed securities would disappear, and the market would receive strong pricing signals for comparable instruments.

A key advantage of this approach is that it moves whole loans (and not fractional securities) under government control. Once it holds these loans, the government can itself take charge of workouts and refinancings. This is the approach that the Home Owners Loan Corporation took in the Great Depression, and the FDIC is already operating such work-out programs for loans held by failed banks under its control. If the Treasury Department would start buying up whole pools of subprime loans and Alt-A transactions, it could dramatically expand the FDIC’s program, offering relief for borrowers who were mislead or abused and then dealing more harshly with those who knowingly entered into speculative transactions. In other words, a strategy of whole pool loan purchases provides the government with a vehicle for giving relief to home owners and not just financial institutions.

A further benefit of authorizing the government to purchase whole pools of loans is that it could change the incentives now facing loan-pool trustees. One of the reasons it has been so difficult for the market to adjust to falling housing prices and increasing foreclosures is that mortgage backed securities trustees have been reluctant to renegotiate individual loans, out of fear of litigation and uncertainty as to appropriate terms. Facing the threat of forced sales to the U.S. government and with clear guidance on how much the government is likely to pay for their loans, mortgage backed securities trustees will be highly motivated to renegotiate loan terms on their own, further clarifying market values and enhancing price discovery.

We also need to think harder about financing the cost of government intervention. Under the Paulson proposal, the American taxpayer would pick up the bill for whatever the government loses on its $700 billion of asset purchases. Exactly how big that bill will be is unclear, but the taxpayer is going to be on the hook for the full amount.

Congressional Democrats attempt to soften the blow by requiring the government to receive an equity interest from selling firms. While laudable, this approach does complicate the transactions – as the structure of equity interests will need to be negotiated on a case-by-case basis and the price signals to the market from these hybrid purchases will be less clear than it would be with purely cash transactions. More importantly, the extraction of equity stakes from selling firms does not spread the costs of the program to the many other financial institutions who benefit from the program by having the value of their portfolios clarified or increased through government purchases.

A cleaner approach would follow the model that Congress set up in 1991 for the FDIC when it spends extra funds to shore up systemically important commercial banks: impose an after-the-fact assessment on the entire industry to defray the costs. Congress could do exactly the same thing with the Paulson proposal. Once the government’s losses are clear, the Treasury should assess some share of the costs (let’s say one half) on all of the financial institutions eligible to participate in the program, based on some objective formula such as the value of assets held at the time the program was proposed. Assessments could be spread over a number of years, so as not to infringe upon current cash flow. But this would be a more equitable approach to cost sharing than what is currently being proposed on either side of the aisle. Also it would give the financial-services industry a strong incentive to help the government keep costs down and avoid similar interventions in the future.

The challenges facing the Treasury and Congress are formidable. And time is clearly of the essence. But even in the face of such pressures, it’s important to take the time to consider alternative approaches that may offer a more efficient and more equitable way out of the nation’s difficulties. A parallel program to purchase whole loan pools could easily be grafted onto the Paulson plan as could a mechanism for after-the-fact industry assessments.