Dispatches from the Creation Wars

A Better Bailout Plan

Lucian Bebchuk, a professor of law, economics and finance at Harvard Law School, presents what seems to me to be a much better bailout plan than the one being offered by the Bush administration (though again, I admit that this is not at all my area of expertise). Here’s the summary:

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.

And here are the details. On the first plank:

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.

Even worse, potentially conferring massive gifts on private parties that have contributed enormous amounts of money to both the president and the members of Congress of both parties who are negotiating this bailout. There needs to be an explicit procedure for determining fair market value for the assets being purchased and that process needs oversight, not merely a blank check.

The potential for conflicts of interest on the part of Paulson, who is proposing that he be given exclusive and unilateral authority to spend that $700 billion. Paulson is the former CEO of Goldman Sachs, for crying out loud. And Bebchuk argues that he is intentionally trying to get the authority to pay above market value prices for these assets:

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.

The way to avoid that, Bebchuk says, is to allow those companies with bad mortgage assets to issue new securities that can be placed on the market, securities that the government can then buy:

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.

This strikes me as a brilliant idea. Forget reverse auctions, let’s have real auctions and let the market determine the real value of those assets as they are bundled into a new type of security issue.

Lastly, he argues that the funds that is set up to purchase those assets should be managed privately with a profit motive to ensure that those assets are purchased at a fair market value that will make it far more likely that taxpayers will at least break even on the purchase of those securities:

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.

Again, this strikes me as a great idea. Far more rational and well thought out, and with none of the need to simply trust a man with enormous conflicts of interest to be a good steward of an enormous amount of money from taxpayers.