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Financial crises originate when speculators identify a country where the total debt level, whether it lies with the government, financial institutions, businesses or citizens, is excessive. Speculative attacks on governments and financial institutions follow in short order, and the consequences are readily available as historical information. This article proposes a solution.

Financial Crisis Capital Trusts

Unregulated capitalism has an inherent weakness - excessive concentrations of wealth and power are abused, leading to speculation and manipulation of financial markets as the dominant economic activity. Briefly, the consequences of economic instability fall hardest on those at the bottom of the economic totem pole. In contrast, for those at the top, instability simply creates more opportunity to buy underpriced assets at fire sale prices.

Financial Crisis Capital Trusts (hereinafter FCCT's) would resolve this issue, by giving those who control concentrations of wealth and power a stake in promoting economic stability. They would consist of special purpose vehicles sold to the wealthy, hedge funds, and large financial institutions on a mandatory basis, with yields slightly above the sovereign's normal rate, maybe 50 basis points.

These FCCT's would feature a put option, in favor of the government, whereby the trusts would be required to buy convertible preferred shares in systemically important institutions, should the government be required to buy any.

The point of this structure is, that persons and institutions that currently stand to profit from speculative attacks on the financial institutions of troubled sovereigns would have a stake in avoiding a financial crisis.

The Geithner maneuver, as performed on ailing US banks, recapitalized them with government owned convertible preferred, a form of bridge capital that enabled them to make economically rational decisions about the sale of questionable assets, and ultimately gave them access to capital and credit markets when they recovered. It had the positive feature of diluting shareholders, who should be the first to bear losses of this type. The proposed FCCT's pre-fund the resources needed to perform the Geithner maneuver.

The funds raised would be sequestered in separate accounts, the previously mentioned trusts, and invested in an extremely diverse basket of fixed income securities. A constitutional amendment could keep the government from making any other use of the funds.

Soft Capital

Arrangements of this type have been used by bond insurers and mortgage insurers in the past, and are customarily referred to as soft capital. When the crisis hit, they exercised their put options, and sold preferred shares to the investors involved. It worked exactly as planned, for the insurers, although the investors were no doubt extremely disappointed at the resulting ownership of preferred share in distressed financial institutions.

That's the point. If George Soros, as an example, were required to invest some of his wealth in FCCT's, he and others of his ilk would have a stake in promoting stability, rather than fomenting crisis.

A Hazardous Loose End

How would this work out for the Eurozone today? What happens to the sovereign debt of Italy or Spain? Don't their bonds need to be propped up by the ECB or some other buyer committing economic suicide? No. Most sovereign debt is held by banks or other large financial institutions. When recapitalized, these banks can hold the sovereign debt, or sell it, depending on their assessment of its true value. There will be no fire sales.

As for the sovereigns, their citizens and voters have a decision to make. They can either pay the prevailing interest rates for the conduct of the governments involved, or they can make changes. Changes like getting rid of corruption and crony capitalism, tracking down tax cheats, and making sure that social benefits are fairly split among recipients, and that the amounts involved represent the desires of the majority of taxpayers.

The markets will eventually resolve the issues, more effectively and efficiently if they are not destabilized by speculative attacks on sovereigns and the related financial institutions.

Not Taxing the Rich

It should be noted that this arrangement does not tax the rich. It merely requires them to have a substantial stake in economic stability. If the economy remains stable, they will receive the income from the FCCT's, in the form of interest.

So their precious money has not been taken from them, it is merely being held hostage. It's a one time levy, and in point of fact if they don't like the investments they could be permitted to sell them, perhaps after a mandatory holding period, somewhere between 90 days and one year. If they do so at a loss, that's their business. If they don't want to have a stake in financial stability, they can pay for that privilege. The markets will tell us all what that privilege is truly worth.

Once funds have been identified and sequestered for the purpose of financial stabilization, there would be no reason to continue the purchase requirement. Indeed, there would be no reason why there shouldn't be a secondary market for FCCT's. They would trade at a discount to NAV, and offer tempting yields.

The market for these instruments would be a kind of a fear gauge: they would decline in price during periods of financial stress, and increase in price when halcyon conditions prevailed.

Pre-Funded TARP

For those who remember the sickening feeling that came with watching our elected leaders prolong and exacerbate the financial crisis by failing to pass TARP when it was needed, this mechanism takes away the dread of a recurrence somewhere down the road.

The initial funding, for the US, would be $1 trillion, kicking TARP's $700 billion bazooka up to an appropriate size while there is less stress in the system. It might be desirable to build this up over a 5 year period, to avoid forcing the excessive sale of assets to fund the required purchase of FCCT's.

The No Bailout Illusion

While Dodd-Frank has spelled out that systemically important financial institutions will be taken down in an orderly manner by pre-planned methods, living wills, that is unlikely to work well in practice. There will be substantial pressure to do bailouts, as the least disruptive option in times of financial fragility.

With the exception of Lehman, governments have historically always propped up their systemically important financial institutions, to the limit of their own fiscal strength. Lehman, the exception to this rule, did not work out well.

With that in mind, it would be better to plan on re-capitalizing banks as needed, diluting shareholders who should be bearing the losses. The funds should be available at all times. Hence the suggestion: Financial Crisis Capital Trusts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Soft Capital As A Source Of Stability During Financial Crises