Arnold Kling  

A Simpler Solution

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On many occasions, including my Cato paper, I have suggested that we can solve the problem by reducing capital requirements for banks on an interim basis. Nobody seems to be listening to this idea, or even discussing it. It has flaws. But those flaws seem much more manageable than the Paulson plan.

The Paulson plan is based on the clogged plumbing theory. The mortgage assets are stopping up the plumbing of the financial system, so the government has to buy up those assets to unclog the system.

Why worry about the clog in the first place? Because banks have some of these securities, they are marking these securities to market value, which means marking them way down. As a result, their balance sheets show a shortage of capital. To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending. As they curb lending, the economy suffers.

That is why some people say that the solution is to get rid of mark-to-market accounting. Let the banks estimate the "intrinsic" values of their mortgage securities. These values are higher than market values, so that using this alternative accounting the banks' balance sheets won't looks so bad. That way, they can keep lending. My problem with that is that phony accounting has a history of keeping failed institutions in business, raising the cost of the subsequent cleanup.

My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2008, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don't want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.

As with changing accounting rules, lowering capital requirements ultimately exposes the government funds that insure banks to more risk. That is the flaw in the idea. However, there has to be some risk exposure to tax payers for any policy that encourages bank lending.

The risk exposures in the Paulson plan are many and complex. I worry about adverse selection--the institutions selling the securities to the government know more about what they are worth than the government does. The government is almost sure to get ripped off relative to what it thinks it is buying.

I worry that it will cost the government more to deal with bad mortgage securities than it would cost the private sector. Government is going to have all sorts of political constraints in dealing with this, including pressures to be generous to home borrowers (people who put so little money down that they effectively borrowed their homes).

I worry about the sheer glee that the Left is experiencing as they chorus, "The market failed! The market failed! We need government to take over everything. Dictate executive compensation! Take equity stakes in private firms! Increase regulation by orders of magnitude!"

When your plan is to put up $700 billion to buy assets from private firms, how can this not send a message to the American people that we need socialism? The Democrats who oppose the plan want more socialism, and they probably will get their wish when the legislation is enacted. And Paulson, by emphasizing the drastic need for the bailout, has thrown away any negotiating leverage. They can't veto a bill that is supposed to save the world.

I don't think we need socialism. And I don't think we need the Paulson plan. We need some creative policies with regard to bank capital requirements.


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Gary Rogers writes:

Some real common sense like this would go a long way in restoring my confidence in the system. I have not heard a politician yet that has any clue as to what to do. Most are blaming the other party, which is probably the worst thing to do right now. Hank Paulson just says we need to do the recovery package or everything is going to fall apart, but I think it is going to do that anyway. The whole bail out does not pass the smell test. Keep offering ideas!

Gary Rogers writes:

Eliminating mark-to-market accounting does not necessarily mean adopting phony accounting. Since there is no market for the securitized debt, mark-to-markiet may be as phony or worse than other methods. There should be some mark-to-model value that will account for some of the risk but not reduce the value to near zero. Valuation also needs to be done by the manager of the loans where the information is available rather than by the holders of the securitized debt who have no way to assess the value. Add a temporary reduction in capital requirements, and we have a possible solution.

Maybe the Swedes got the incentives right:

Sweden didn't just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting pounds of flesh from bank shareholders before the state started writing checks.

That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. Even the chairman of Sweden's largest bank got a stern answer to the question of whether the state would really nationalize his bank: yes, we will.

[...]Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden's largest bank. Wallenberg, the scion of the country's most famous family and steward of large chunks of its economy, heard from the finance minister that there would be no sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a bailout at all. SEB turned a profit the following year, 1993.

"For every krona we put into the bank, we wanted the same influence," Lundgren said. "That ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized vast swathes of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

chris janak writes:

I believe two apparently inconsistent beliefs on this:

1) MBS are worth much less than holders originally thought, but they should still have quite a bit of real value.

2) There is very little liquidity in the MBS market; lot's of sellers but very few buyers. It’s very difficult if even possible for banks to liquidate their MBS positions right now.


These two don't really fit. If MBS clearly retain a lot of value, then somebody... healthy banks, hedge funds etc. should be eagerly buying them up. Alternatively, if it really isn’t clear how much value these things have (because we don’t know how much worse the housing market will be, etc.) then maybe number 1) is wrong.

But maybe there is another possibility. Perhaps there are plenty of buyers, but MBS holders are simply unwilling to lock in the loss at current market clearing prices. Rather then stop the bleeding as disciplined risk managers would, maybe these guys are crossing their fingers, praying for a) a miraculous turn around in home prices, or b) some sort of government bailout in which they get cheap financing courtesy of the feds or maybe the feds end up buying MBS at higher prices than the market is willing to buy at. The longer they leave these positions open, the more value is lost if housing prices keep dropping and liquidity keeps drying up. But if the feds pass a huge bail out, they’ll look like geniuses for leaving the positions open.

So what I'm saying is that I'd assumed banks weren't selling MBS because they simply couldn't. But maybe the truth is that they choose not to. I suppose that is one form of moral hazard, a case of executive incentives not aligning with shareholder interests, or possibly both.

JoeChip writes:

"I worry about the sheer glee that the Left is experiencing as they chorus, "The market failed! The market failed! We need government to take over everything. Dictate executive compensation! Take equity stakes in private firms! Increase regulation by orders of magnitude!"

Not to be contrary regarding the glee the Left is theoretically experiencing (or will be soon), but isn't a right wing, supposedly neo-conservative government banging the drum loudest here for your socialist wet dream?

And isn't this same government responsible for the largest increase in government spending in 30 years?

Despite ideological archetypes, the Republican party is the current champion of socialist enthusiasm.

Lord writes:

This isn't socialism. Fascism perhaps, kleptocracy most likely.

Bill Woolsey writes:

There is a bit of a paradox with capital requirements, just like reserve requirements. The requirements mean that the reserves or capital cannot serve their purpose.

A bank builds up reseves so that it can face adverse clearings or currency withdrawals without selling off assets or borrowing money. But if the reserves are held to meet a regulatory requirement, then must do just that.

Similarly, a bank builds up capital (net worth) in good times to avoid default when there is a run of losses. Then, profits from good assets allow capital to be built back up. But capital requirements mean that the cushion cannot be used. While it is possible that the bank can find new investors, the usual practice is to shrink the balance sheet to meet the requirement.

I would note, however, that free bankers, (like me) have emphasized past practices of reporting capital in order to reasure depositors. That sort of informal capital requirement could have much the same result.

And, of course, forebearance in the Saving and Loan crises involved are reduction in capital requirements. (Though I suppose Kling is suggesting going from, say, 10% to 6%, rather than 4% to something negative.)

RobbL writes:

Arnold,
I can't seem to get to this paper but the synopsis seems to claim that your ideas doesn't work;

http://sol.sapo.pt/blogs/fcc/archive/2008/09/22/-Economist--_2D00_-Beyond-crisis-management.aspx

Terry writes:

Something we should all note: a lot of this is zero sum, so, in some sense, a lot of the "costs" people are talking about aren't really costs we should be worrying about.

For instance, people who overpaid for a house are mirrored by people who were overpaid for their houses. So current occupants of big houses transferred money to the people who sold their houses to them, most notably retirees who moved to rentals or much smaller houses.

For people who built houses, there may have been no loss since money was spent and a house built. That is not obviously a bad thing. There might have been some inefficiency because the costs of building was driven up by the demand and too many houses were built, but that is a much smaller cost than the cost of the houses built.

In mortgage lending, there was no net cost since group A gave money to group B who are not going to give it back (because they gave the money to the people who sold them their houses). There are externalities which are costly, such as the possible breakdown of the financial system and the very real psychic costs of worrying about your mortgage, but this is (hopefully) not equal to the loss numbers being thrown around.

Also, your desire to give mortgage holders a break could easily be done in a free-market way. Mortgage holders should be treated like any other parties to a financial contract. The bank made a non-recourse loan to them on collateral which cannot support the loan anymore. Rational re-negotiation would write down the loan to the new equity and reduce the interest payments accordingly. Government could help grease the skids to this outcome. You don't have to sell this as social do-gooding, it is something companies do all the time. The home-owner has every right to walk away from the loan the banks willingly made. This is a potent threat and so the banks should write down the loan. Walking away is a big pain for the homeowner and the bank, so the efficient outcome is renegotiation.

Thinking in this way suggests that the real objective here is not to minimize the "costs" which aren't really costs; the objective is to work through who should bear these losses with a minimum of damage to the financial system.

Here, it baffles me as to why people seem to assume that bondholders should be protected from losses on their investments. Bonds go kablooie all the time, and bondholders know that. I don't see why we have to give any of these bondholders or institutions money. And a lot of the bondholders are foreign. Why should American taxpayers give money to foreign bondholders?

It seems like we should just allow institutions to start up a fresh bank with fresh capital and leave the old assets in the old bank to be run off as best they can. The old bondholders get as much money as the old assets will generate, and take their lumps from any shortfall. The equityholders, of course are out of luck. So, it seems like the government should be smoothing the path to let this happen, perhaps by providing liquidity for the new, solvent banks. Managment of failing banks should, of course, be fired and sued en masse somehow. Not sure how, but the old equityholders have good grounds to sue and have the authority to fire.

Inagua writes:

Arnold: "To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending."

Me: No luck needed to sell new shares. It would be very simple. Issue rights at a deep discount. It would be massively dilutive, but it would get the job done.

No bank would do this voluntarily, just as virtually no bank ever voluntarily cuts its dividend; but the government could and should mandate both for all Fed member banks.

bc writes:

The argument for rescinding "mark to market" rules is that it is the rules themselves that drive down the underlying asset values in a destructive feedback loop. This part of the plan is the "no-brainer" part, but this does nothing to solve our remaining problems, foremost of which is our weak dollar. For whatever reasons, bankers astonishingly got it into their heads that building housing stock in Modesto, Ca. was a better use of funds than building manufacturing plants, or exploring for oil, or supporting new product development. These competing activities produce tradeable goods which would help float the dollar. The immediate reaction to the current liquidity crisis is solvable in many ways, but if the overarching outcome doesn't disabuse bankers of their mindless love affair with home building, our troubles are going to get much worse. Even a reallocation of resources starting now will take years to bear fruit as tradeable goods.

Dan K writes:

Even if the Gov't buys all of these toxic mortgages to allow banks to have room on their balance sheets to start lending again, who would there be to lend to? With a slowing economy, joblessness increasing and tighter credit standards, lending will be very slow. Since the banks will be losing so much by selling these mortgages to the Gov't for pennies on the dollar, why not sell it to the homeowner for a few more pennies. The under valued mortgage on an over value home would create instant equity on a tangible asset, not just more fiat money.

If we are EVER to get out of this mess AND prevent it from happening again we must address the real cause of the problem which IS the Fed and its power to create money out of thin air. We must get out of creating money through debt and go back to a value or asset based currency. When markets are this bad, investors always turn to gold. Why? It's stable always has been and no reason to think it wont ever be. Can we go back to the gold standard? I don't know if it would meet today's demands nor can it stop such things a cornering gold markets. Silver? It's more plentiful, harder to corner. Are their other assets money could be used?

The Constitution says only gold and silver and issued by congress, not a private bank cartel like the fed. Congress needs to take back its power to manage the people's money.

Value based money will regulate growth and have us live within our means. (That is why we went off the gold standard; to remove its inherent growth limitations.) I'd like hear some research done on that issue here.

Thanks for taking the time to read and listen.

Peace all.

Dan

crazy writes:

If these MBS and derivatives are so worthless under the mark-to-market rules why isn't that reflected in their investiment ratings (or is it?)? How did the rating agencies get these rated so incorrectly for so long? How can the market ever accurately price them if their ratings don't accurately reflect their value?

Larry writes:

This IMF paper disses the reduced capital requirements strategy. I like the equity injection model more than anything else I've seen...

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