A Better Plan than the Paulson Bailout

by Chris Sturr | September 27, 2008

In 1992, a Swedish real estate bubble burst, creating a banking panic and freeze. The Swedish loaned banks money, but in exchange, forced banks to promptly write down bad real estate investments and issue warrants to the government. Warrants–the right to purchase stock at a preset price–gave the government bank stocks cheap. At the end of the crisis, and government sold off its shares at a profit, so the entire rescue cost less than 2% of Swedish GDP. See “Stopping a Financial Crisis, the Swedish Way” NYT Sept 22.

Treasury Secretary Hank Paulson has proposed that the US Treasury spend up to $700 billion to buy out US banks’ CDO’s and other lousy debts. The proposal has set off a storm of protest, for good reason. If Treasury pays the distressed market price for the debts, the banks will be just as broke as before, and unable to lend. If Treasury pays much more, it will recapitalize the banks at taxpayer expense–rewarding the rich bankers who helped create the problem. There’s a practical problem too: Treasury would have to value tens of thousands of bonds, making them liable to delays, mistakes–and overpaying.

Wednesday night, two economists, Larry Kotlikoff and Perry Mehrling, proposed an alternative plan, in essence a clever way to implement a Swedish solution in the US. See “The Right Financial Fix” on the RGE Monitor and “Bagehot plus RFC: the right financial fix” on the Financial Times website. On Thursday, a Republican contingent picked up the plan–and to Democratic House Finance Chair Barney Frank’s frustration, put it forward combined with a capital gains tax break!

The KM plan works like this:

Despite what we hear that “no one knows” the value of toxic bonds, there is in fact a market for them, current barely functioning at distressed prices. Holders of such bonds understandably don’t want to write them down to those levels; the bonds might rise again, and a write-down might make the holders “insolvent” –that is, their debts would exceed their assets.

Enter the KM plan. The Treasury would offer default insurance for the roughly five different classes or “tranches” of bonds sold in the market, ranging from the safest AAA bonds, to the worst BBB bonds. Insurance premiums would be set based on the market value of the bonds just before the crisis hit, and would range from low for AAA, to very high for BBB bonds. Buyers of insurance would pay either cash to the Treasury, or preferred stock. (Preferred stock is non-voting, but has priority in payout over common stock.)

The plan would have these effects:

1. It would get the market for toxic bonds active again–quickly.

2. It would allow bond holders to insure the bonds against default, simultaneously reducing their risk and effectively writing the bonds down to market. Holders could in fact sell bonds paired with insurance policies as relatively safe investments.

3. In many cases, Treasury would lay out no cash up front. It might even take in cash payments for insurance from stronger banks. Treasury might have to make loans to weaker banks–in exchange for more preferred stock.

4. With toxic bonds either insured or sold, confidence would return, banks would resume lending. Eventually, Treasury could sell its preferred stock at a premium.

Even with the crisis past, of course, the economy will take many years to recover from the waste and distortions caused by the real estate bubble. But by preventing a prolonged credit freeze, the KM plan can greatly lessen the damage–and ensure that the long-term benefit goes first to the taxpayers.

But what about homeowners desperately trying to renegotiate rip-off mortgages? The KM plan, by imposing a quick write-down on mortgage-backed securities, will make it much easier for homeowners and lenders to renegotiate. Rather than a loss, reduced payments from borrowers will look to lenders like gravy.

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