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E-MailTreasury Secretary Henry Paulson is seeking authorization to spend $700 billion of taxpayers’ money on “troubled assets” owned by financial firms. We’re told his plan is the only way to stabilize the financial markets. But the plan, as proposed to Congress, can be improved to be both less costly and a better stabilizing force for the markets.
The redesign should have three elements. First, the Treasury should only buy troubled assets at fair market value. Second, the Treasury should be allowed to purchase, again at fair market value, new securities issued by financial institutions needing additional capital. Third, to ensure that asset purchases are made at fair market value, the Treasury should buy them through multibuyer competitive processes with appropriate incentives.
If troubled assets are purchased at fair market value, taxpayers might get an adequate return on their investment. And the Treasury’s official statements say that “The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.”
But the draft legislation grants the Treasury full authority to pay higher prices, potentially conferring massive gifts on private parties. The final bill should not permit this.
Adding this fair market constraint by itself may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today’s fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.
But the best way to infuse additional capital where needed is not by giving gifts to the firms’ shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.
Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won’t necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.
Finally, how do we ensure that the government does not pay excessive prices for troubled assets or new securities issued by financial firms? The proposed legislation allows the Treasury to conduct purchases through in-house operations, outside delegation, or any other method it chooses. It would be best, however, to direct the Treasury to operate through agents with strong market incentives.
Suppose the economy has illiquid mortgage assets with a face value of $1 trillion, and the Treasury believes that buyers with $100 billion would be enough to bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion, and place each fund under a manager who does not have conflicting interests.
Each manager could be promised a fee, say 5%, of the profit his fund generates — that is, the difference between the fund’s final value and the $5 billion initial investment. Competition among the fund managers, armed with the needed liquid funds and motivated by their 5% fee, would produce prices set at fair market values.
Revising the Treasury plan in the ways just described would do a far better job of protecting taxpayers’ interests, and restoring financial stability, than what the Treasury initially proposed.
2 Comments
Following is letter which I forwarded to editor of NYTimes on 9/25 which addresses the same issues. We are apparently in agreement.
The solution to the problem of the Wall Street “meltdown” is to utilize the same elemental human selfishness and greed which created the
disequilibrium to bring the system back to equilibrium. While the cost may vary there will always be individuals and entities seeking
investment at what they consider a suitable return. The exertion of market and merchandising forces will minimize the distortion caused by insufficient reserves of investors and financial institutions.
The selfishness and greed which generated the creation and sale of esoteric and inscrutable investments and investment vehicles, (presently
incapable of reasonable evaluation,) are better qualified, and better driven to liquidate the amorphous investments and reserves of AIG, its subsidiaries, Lehman, Fannie Mae and Freddie Mac. The instinctual drives of self-preservation, merchandising, market experience and expertise of
commercial banks and investment banks are better suited to result in equilibrium than outright and complete government intervention and control. This is especially so where the natural forces will be exerted at a more or less natural, as distinguished from accelerated, (and panicked,) rate.
Capital infused by the government should be secured at the highest level of security and ultimately be reimbursed. The interests of financial entities, their management personnel, and investors should be
subordinated to reimbursement of advances made by the government, (or other current investors) to provide current working capital.
Those who undertook the risk were aware of the risk and should bear the consequences of their actions.
A Plan for Addressing the Financial Crisis
I have read with great interest and appreciation Lucian Bebchuk’s discussion paper addressing the current financial crisis with recommendations for tackling the problems facing the nation and the world’s financial system. I can only hope that there is widespread interest and attention paid to the piece, and incorporation of its ideas into the action plan being considered by the President, Congress, and other national leaders.
I am going to be so bold as to address some of the issues on which the paper focuses, and to offer some enhancements or additions to the work. Also, as the author mentions, the focus of the paper is on the government’s immediate actions vis-à-vis the financial institutions and I would like to offer some thoughts regarding the other side of the equation; namely, the mortgagees that must perform their obligations in order for any financial solution to work. If the government’s actions do not lead ultimately to the repayment of many of these loans, then the entire effort will have been in vain, and the U.S. taxpayer will have, in fact, shouldered the entire burden.
I most definitely agree that the entire plan is in danger of failure if the purchases of troubled assets are not done at market value. I like Bebchuk’s thoughts on how to insure that the assets are purchased at market value, and the supplemental thoughts regarding purchases of equities if the purchase of the troubled assets is not enough to save any particular institution. I would like to suggest that in addition to public funds, private funds also be offered the opportunity to invest in these obligations. If the structure of the program is well defined, and the government is committed to moving ahead with the program, then there will be tremendous interest among private investors to take part in the purchase of these troubled assets. This opportunity could be made available to the public through a mutual fund that targets specifically this opportunity and educates the public on the profit opportunity available through investments in the mutual fund. If this fund is successful, as I think it might be, it would immediately reduce the amount of public debt required to implement the program. At the same time, this private investment fund would be a major factor insuring that the purchase of the troubled assets was at fair market price. It is not necessary that there be only one such mutual fund. It is conceivable that several or even many financial institution could find that their clients were interested in taking part in this opportunity. After all, Mr. Warren Buffett has shown already that he is willing to play in this market.
Next I would like to describe steps that could be taken to enhance the percentage of these troubled assets that might ultimately perform substantially according to the terms and conditions of the notes that were signed.
First, I would suggest that the interest rates be reset to such a percentage that makes the current yield to the new securities owners the same as to the original issuer. The equation for the reset would be:
New Interest Rate = New Invested Capital/Original Invested Capital X Interest Rate of the Mortgage. This will obviously impact the calculation of the fair market value of the security, but the yield on invested capital will be equal to the yield on the original investment, and the payment required by the borrower will be substantially reduced, raising the probability that the debtor can perform.
Second, in order to keep debtors from walking away from homes with principal balances greater than current market value; I would have the government guarantee that the debtor would not be left owing any balance on their loan if the house is sold below the amount remaining on the loan. This would encourage people to stay in their homes, making payments on the loans, and give them a longer term outlook on the investment value of their homes. It would also relieve them of the burden of damaged credit if they decide to sell their homes and were unable to find a buyer at a price above the principal owing on their loan. If the house sells for more than the amount paid for the security, there is no loss for the new security owner, but the profit potential would not have been realized. In those cases where the home sells for less than the amount paid for the security, the government would guarantee the loss to the purchaser of the security.
Third, I would recommend that the loan be made assumable by purchasers of the home. Even if the fair market value of the home at the time of a sale is below the remaining principal of the loan, the other features of the loan outlined above might induce a buyer to assume the loan. Especially as the value of the home approaches the principal owed. In this case, the security holder’s chances of ultimately realizing the profit potential of their investment are enhanced.
Finally, I hope that Lucian Bebchuk sees some value in these additional thoughts, and that these thoughts along with those in the original paper find their way into the hands of those making the decisions that are going to govern the finance industry in the years to come.
David L Daniel
2016 Milford Street
Houston, TX 77098-5310
[email protected]
HBS MBA 1975