Improving the inevitable big bailout

My biggest concern with the proposed $700 billion bailout of the financial system is that it might not solve the credit crunch because it provides less than sufficient means to ensure financial institutions are able to raise capital, nor does it contain enough incentives to convince financial institutions to become more willing to lend.

Five University of Chicago’s Graduate School of Business professors, Douglas Diamond, Steve Kaplan, Anil Kashyap, Raghuram Rajan and Richard Thaler, have considered the proposed $700 billion bailout of the financial system. They find it wanting and suggest some improvements that address my concerns in a much more articulate manner than I.

The professors say that any bailout ought to fulfill at least three objectives:

1) It has to have a real chance of preventing the deep and prolonged recession that is likely to ensue if the financial system is not recapitalized.

2) It should strive to achieve that first objective at the lowest possible costs to the U.S. taxpayer.

3) It should not bail out the existing investors to avoid sowing the seeds for the next crisis.

According to the professors, the proposed big bailout plan — to buy distressed securities in the marketplace — addresses only the first objective, and only indirectly. They agree that the problem is undercapitalization. The financial system is undercapitalized because of the losses it has sustained and because of the growing risk aversion of lenders:

Undercapitalized financial institutions are forced to try to reduce their assets, and, of course, this means they will make fewer loans, even to the healthy portions of the economy.

The proposed big bailout attempts to recapitalize financial institutions in three indirect ways:

1) By paying above the market value for illiquid assets (paying the hypothetical "held-to-maturity" value), the Treasury hopes to indirectly recapitalize institutions.

2) By creating a market for illiquid assets and allowing prices to be established, it hopes other private players will enter the market, "liquifying" the market.

3) Treasury also probably hopes that once the illiquid assets are off balance sheets, institutions will be able to raise capital, and will become more willing to lend.

The professors find that there are many ways in which the proposed big bailout could go wrong, including providing less relief to the financial institutions best able to expand lending:

The institutions with the most toxic assets are the ones that have made the worst decisions, and are likely to be the closest to default. While they may get the most relief from selling assets, they are unlikely to turn around and expand their lending quickly (nor should they, given their record). In contrast, relatively healthy financial institutions that probably have the greatest ability to expand lending may not be those getting much of the additional capital in the Treasury plan for they have few illiquid assets to sell.

Improvements suggested by the professors include:

1) Use some sort of a reverse Dutch auction without any intent to overpay. That would jumpstart the market by establishing trading prices.

2) Require all regulated financial institutions to raise 2% of their assets in additional capital over a short period.

The professors effectively articulate why financial institutions should be required to raise additional capital:

Thus far banks have been urged to voluntarily go out and raise capital, and some, including Goldman Sachs on Wednesday, have. But banks, especially some of the best managed ones, have been hesitant, in part because potential investors might view a bank’s approach to the market as reflecting the bank’s expectation that it will have to bear additional losses, which will cause them to lose confidence in the bank. The value of mandating this decision is that no individual bank sends an adverse signal to the market when it goes to raise capital.

I still don’t like the idea of our tax dollars being used to bailout the folks that caused this mess. Nevertheless, I recognize the need, both economic and political, to do something. Having conceded that point, I still hope that we will at least take enough time, have enough debate, to get this big bailout as right as we can. We can start by removing the mandate, lurking in the proposed big bailout, to fund community organizer groups that have historically supported, and in return have been supported by, the Democrats.