Forget the Bailout: Here's a Better Way

“The whole aim of practical politics is to keep the populace alarmed, and hence clamorous to be led to safety, by menacing it with an endless series of hobgoblins, all of them imaginary.”--H.L. Mencken

The $700 bn bailout of the financial system, what Congress wants you to call a rescue, even though the bulging $850 bn piece legislation is now a well-lit Christmas tree of gimmes, has been given a giant thumbs-down on Main Street. The U.S. House of Representatives is getting set to vote on the Senate's version of this bill.

However, there is growing recognition that spending $700 bn in taxpayer money on purchasing (and insuring) toxic paper could be a highly flawed form of intervention.

And a growing chorus of economists and stock-market analysts agree.

Below is a roundup of alternatives from the best thinkers out there, including a Nobel Laureate and other respected economists, who say there is a better way. I've also tossed in an amusing idea from actor Russell Crowe.

If you need a reason why you should take a look at the alternatives, here’s a sampling of quotes from Congress, pulled together by The Wall Street Journal, defending mortgage finance giants Fannie Mae and Freddie Mac at hearings in late 2004, in the runup to the housing bubble, prior to the implosion of these two recklessly managed, publicly traded companies -- companies that doled out plenty of political donations to buy cover for uniform, profound incompetence.

A reader also emailed me this video so you can see Congressional legislators in action defending the health of Fannie Mae and Freddie Mac.

Rep. Maxine Waters (D-Calif.): “Through nearly a dozen hearings, where frankly we are trying to fix something that wasn’t broke, Mr. Chairman, we do not have a crisis at Freddie Mac and in particular at Fannie Mae under the outstanding leadership of Mr. Frank Raines.”

Rep. Maxine Waters (D., Calif.): “Mr. Chairman, we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. Everything in the 1992 act has worked just fine. In fact, the GSEs have exceeded their housing goals.”

Rep. Gregory Meeks (D-NY): In a hearing several years ago about a report on the safety and soundness of Fannie Mae and Freddie Mac from their regulator, Armando Falcon, Federal Housing Enterprise Oversight Director, Falcon came under fire. Meeks said; “The GSEs have done a tremendous job. There has been nothing that was indicated that’s wrong with Fannie Mae, Freddie Mac has come up on its own,” adding the regulator was trying to give the two a “heart surgeon [sic] when they really don’t need it."

Rep. Barney Frank (D., Mass.): “The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities [Fannie Mae and Freddie Mac] that are fundamentally sound financially and withstand some of the disaster scenarios.”

Rep. Barney Frank (D-Mass.): In the same hearing several years ago about a report on the safety and soundness of Fannie Mae and Freddie Mac from their regulator, Falcon, Frank attacked Falcon: “I don’t see anything in your report that raises safety and soundness problems.”

Sen. Christopher Dodd (D., Conn.): “I, just briefly will say, Mr. Chairman, obviously, like most of us here, this is one of the great success stories of all time.”

Sen. Charles Schumer (D., N.Y.): “And my worry is that we're using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie's mission.”

Franklin Raines, former head of Fannie Mae: “These assets are so riskless that their capital for holding them should be under 2%.

Richard Syron, former head of Freddie Mac: “If I had better foresight, maybe I could have improved things a little bit. But frankly, if I had perfect foresight, I would never have taken this job in the first place.”

Note: Raines was forced out of Fannie Mae in December 2004 after the Securities and Exchange Commission launched an investigation into alleged accounting problems at Fannie Mae involving an estimated $6 bn in accounting problems. The Office of Federal Housing Oversight sued Raines in 2006, accusing him of aiding accounting shenanigans at Fannie, which allegedly involved the delay of reporting losses so top executives could earn large bonuses.

The suit attempted to recover the $50 mn Raines in pay got based on billions of dollars in overstated earnings. In total, OFHEO demanded $110 mn in fines and a clawback of $115 mn in bonuses for three executives accused, including Raines.

Raines, Fannie’s former chief financial officer and its former controller settled the case in April 2008, agreeing to pay fines totaling about $3 mn, paid for by Fannie's insurance policies.

Raines also agreed to donate the proceeds from the sale of $1.8 mn of his Fannie stock and to give up stock options, though the options were worthless. Raines also gave up an estimated $5.3 mn of "other benefits" said to be related to his pension and forgone bonuses. In the end, Raines kept most of his largesse -- in 2003 alone, his compensation was estimated at over $20 mn.

The Experts’ Alternatives

William Isaac, former chairman of the Federal Deposit Insurance Corp., 1981-1985: Isaac suggests that the government might be better off injecting money directly into ailing institutions and taking preferred stock or equity warrants to help pay for the investment. Isaac’s idea echoes the Swedish government’s response to its 1991 banking crisis. Called the 'Stockholm Solution,' Isaac's plan would be to set up a government-backed company called 'Securum,' which would recapitalize distressed financial institutions.

Nobel laureate Myron Scholes (and former partner in troubled hedge fund Long Term Capital): Similarly advocates that the government only invest in troubled bank debt senior to existing debt and in preferred stocks senior to existing shares in any banking entity under duress. If all goes well, the government eventually gets out with a profit.

Brian Wesbury, chief economist of First Trust, advocates against a public rescue and instead a private sector plan that lets private companies instead hold these distressed assets: 

Why not allow financial firms with structured (Tier 3) assets issued between December 2003 and August 2007 to suspend mark-to-market accounting for those assets, and receive government insurance as a backstop?

This would be a temporary solution, not requiring any ultimate change in Sarbanes Oxley or mark-to-market accounting rules, and the government could even make money by selling insurance with less risk to the taxpayer than buying them outright. In essence a firm could sequester, or firewall off these specific assets from the rest of its balance sheet, and either finance this itself, or bring in outside financing.

The firm would promise to hold the securities to maturity, or until government insurance was no longer needed when it liquidated the assets. All of these deals could be settled in the private sector, in multiple locations with the government looking over the shoulder of each deal.

Janet Tavakoli, founder and president of Tavakoli Structured Finance and one of the best market analysts on the dangers of credit derivatives: Rather than adopt any form of the Paulson Plan, which uses billions of taxpayer dollars and forces risk and potential losses on taxpayers–instead of those who enjoyed the gains–I advocate an alternative.

Instead of the Paulson Plan, we can force creditors to accept a restructuring plan (this was done during the Great Depression). Creditors (debt holders) including credit default swap counterparties would be compelled to accept a restructuring plan. That requires partial forgiveness of debt in many cases and/or a debt for equity swap (in which the government takes equity stakes in these companies).

If we are determined to violate personal property rights, I prefer it be done through a forced debt forgiveness and a forced capital restructuring (debt for equity swaps), rather than through a massive bailout (any of the various forms of the Paulson Plan).

The Paulson Plan destroys capitalism (those who stood to gain –- and already made off with large gains –-should bear the risk) and violates the spirit of democracy established by the Founding Fathers of the United States.

R. Glenn Hubbard, dean of Columbia Business School, former chairman of the Council of Economic Advisers under President George W. Bush, and Chris Mayer, professor of finance and economics and senior vice dean of Columbia Business School. The two advocate a rescue of Main Street, first printed on the editorial page of The Wall Street Journal:

Housing starts are at their lowest level since the early 1980s, while there are more vacant houses than at any time since the Census Bureau started keeping such data in 1960. Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating.

House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions.

We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify.

The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today with normally functioning mortgage markets.  

The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth. Lower interest rates will mean higher overall house prices. The government now controls nearly 90% of the mortgage market and can (and should) act on this realization. 

Homeowners would have to give up the right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home. For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would be less than their current rate.

Now, what about mortgages on homes that are worth less than the total amount of the loan? These mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the current value of a home.

The government might use two approaches to mitigate its losses. It could offer owners and servicers the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking. Or the government should take an equity position in return for the mortgage write-down so that the taxpayers profit when the housing market turns around.

Our calculations based on deeds and Census data suggest that the total amount of negative equity for all owner-occupied houses is $593 billion. However, capping an individual's write-down to $75,000 would reduce the government's total liability to $338 billion and cover 68% of individuals with negative equity. Even this loss will be reduced as the proposal spelled out here raises housing values and economic activity, and contemplates loss sharing with lenders, hopefully matching the experience of the old Homeowners Loan Corporation.

While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit "conservatorship" of Fannie Mae and Freddie Mac.

In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others.

Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans.

But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place.

Lucian Bebchuk, a professor of law, economics, and finance at Harvard Law School, author of “A Better Plan for Addressing the Financial Crisis,” idea first printed in the Financial Times: Recognition has grown that, notwithstanding these large costs, the proposed plan would fail to provide the financial sector with capital infusions that would be as immediate, large, and appropriately targeted as needed.

Because the bill would provide financial firms with extra capital largely through overpaying for troubled assets (or underpricing insurance for such assets), it would provide capital only following the consummation of complex and time-consuming processes and cannot be counted on to supply capital where and when it would be most useful.

Consider the government’s recent infusion of capital into AIG. Facing the risk of AIG’s collapse, the government provided $85 bn right away and received in return an agreed upon set of debt and equity instruments.

Had the bill passed on Monday and AIG subsequently needed assistance, the funds authorized by the bill might not be usable for such capital infusion by the government.

Purchasing the large and highly heterogeneous portfolio of troubled assets owned by AIG through valuation processes would not provide an effective and timely form of intervention.

The Treasury’s direct capital investments should be guided by the objectives of restoring stability to the financial markets and protecting taxpayers.

When a firm is solvent and undercapitalised, the Treasury should insist on getting a set of new capital securities that would provide the government with adequate return on its investment.

In cases in which a firm is insolvent and not merely undercapitalised, the Treasury should still be permitted to make a capital investment if it views the firm’s continued operations as necessary to avoid disruption to the financial markets.

Taxpayer losses from the legislation would be limited to such cases, and these losses would be kept to a minimum by the government’s investing in such cases only on terms effectively enabling it to take over the firm’s equity.

Congress should move quickly to adopt legislation authorizing the use of $700 bn for infusing capital into financial firms.

John Ryding, Chief Economist, RDQ Economics LLC, excerpted from a recent report: We suggest that a better program than the TARP [the Troubled Asset Relief Program] would be a troubled asset term lending (TATL) facility.

The Treasury could create a facility that would make conservative loans to private sector money managers to purchase mortgage assets (say at a 50% haircut to the assessed collateral value of the security). Such a facility would afford considerably more protection to taxpayers than the TARP and could not be viewed as a bailout.

The facility would very likely be profitable for the government, in our judgment.

...these troubled assets have been forced onto bank balance sheets and financed by FDIC insured deposits (with the taxpayer effectively on the hook if the bank should fail).

The lack of term funding means that private money managers have to buy mortgage assets on an unlevered basis, which, given a hurdle rate of return in the mid-teens, means that these assets will be bid for at only very depressed prices. In our conversations with various trading desks, the idea of a term-lending facility has been met with enthusiasm relative to the TARP.

So how would a TATL facility work? The financing arrangements would be for the maturity of the troubled asset. Leverage would be conservative, set at 50% of the assessed collateral value of the security.

Financing rates could be either fixed or floating (depending on the asset being purchased) and the financing rate would take into account the quality of the asset, the term of the loan, alternative financing options available, the financial strength of the borrower, and other market based indicators.

The structure of the loans would be similar to repurchase agreements and the traditional bond market form would be used to document the transaction. As with most repurchase agreement transactions, the lending would be done on a full-recourse basis.

However, given the large haircut and to ensure maximum participation, we would propose that the assets are not marked-to-market for the purposes of making a margin call on a TATL loan. The funding for TATL would be the same as the TARP, namely the issuance of Treasury debt.

The attractions of a TATL facility over the TARP are significant. First, it directly addresses a market failure—namely the lack of a term-funding market to finance risky long-maturity private debt. Second, the U.S. taxpayer would not be exposed to first loss equity risk. The taxpayer would be, in effect, the senior lender against assets that are already at low dollar prices and would be afforded the additional protection of a 50% haircut from these prices.

The financing rate for the TATL facility would be well above current Treasury rates (perhaps in the range of 6% to 8% depending on the quality of asset being purchased and the strength of the buying firm), which would make the TATL facility immediately cash-flow positive for the U.S. taxpayer. (If, for example, the Treasury were to set the size of the TATL facility at $700 bn, it could return roughly $25 bn per year to taxpayers).

Private sector asset managers would own the assets rather than manage them on behalf of the government (as would be the case under TARP) and this would properly incentivize the managers to work out of positions and maximize returns. Assets would end up in the hands of those best equipped to manage the risk.

Russell Crowe, actor, first printed in the New Zealand Herald: The New Zealand-born actor announced, during a US TV talkshow appearance, a mathematically-flawed plan to cure America's financial crisis.

"I have been intently watching the political process," Crowe told talk-show host Jay Leno.

Crowe believes the U.S. government should give each American $1.5 mn.

His reasoning is the U.S. has a population of about 300 mn, so the $300 bn outlay is a fraction of the $700 bn financial bailout package rejected by politicians in Washington DC yesterday.

"I was thinking," Crowe said."If they want to stimulate the economy and get people spending so they can look after their mortgage ... give everyone US$1 mn."

His plan would actually cost $300 tn.

The actor is preparing for another film based on Robin Hood, and has grown his hair past shoulder length.

"I'm going to play Maid Marion," Crowe, twirling his long hair, told Leno.

Crowe will play the Sheriff of Nottingham and Sienna Miller has been cast as Maid Marion.