What Should a Banking Crisis Bill Really Look Like?

I have taken my time to let the basics of the Paulson Plan seep in before I rushed to judgment. But, the time to judge has come and the plan comes up short on all counts. His plan is geared more toward Wall Street and protecting the financial services than toward Main Street and protecting taxpayers.

Paulson and President George Bush have said that Congress must pass this bill quickly or else we risk further turmoil and calamity. But, this proposal is the financial equivalent of the Patriot Act that was passed in the wake of 9/11. It uses a climate of fear and panic to give the executive branch a blank check with zero oversight. Congress must this time hold firm and refuse to roll over again.

On Monday, I listened to The Diane Rehm Show, where market commentators Greg Ip of the Economist, former Fed Vice Chairman Alan Blinder and law professor Michael Greenberger discussed the proposal. Blinder was shockingly direct in his denunciation of the proposal, going so far as to say that Hank Paulson should be fired for it. On the whole, I agree with Blinder and I recommend we each fight this proposal tooth and nail. My senator, Barbara Mikulski, has already denounced the proposal, so I am heartened by her stance.

However, before we give our heretofore feckless and spineless Congress a free pass, let's ask two questions. What is wrong with the Paulson proposal? And if it is so bad, what should a banking crisis bill look like? Here are my thoughts:

Naked attempt to preserve status quo

The Paulson bailout proposal is a naked attempt to bail out the financial system at taxpayer expense, leaving the status quo intact as much as possible. It is a stealth recapitalization of the financial services industry using taxpayer money, but without any concessions on the part of banks as a binding condition of the proposal.

Where the financial services industry is now imperiled by the toxic assets on their balance sheets, under Paulson's proposal, taxpayers would bear the future risks of these assets. Such a remedy maintains the status quo in the financial services sector to the degree possible, despite this state of affairs having led to disaster. It perpetuates moral hazard by allowing private companies to keep gains while socializing downside risk. And it maintains overcapacity in financial services, preventing the sector consolidation that should rightfully occur.

In short, the Paulson proposal is absurd. What America needs is wholesale change in how it conducts and regulates finance. However, before we get this change, we must first deal with the crisis at hand, which the Paulson proposal fails to do.

What we must address first

First and foremost, regulators' responsibility is to prevent unnecessary dead weight loss in the financial sector from damaging the real economy. A credit crisis seizes up the normal functioning of the financial sector, putting healthy companies and unhealthy companies alike at risk. Financial assets of good quality decline with those of poor quality. It is this indiscriminate nature of crisis that policy makers must address in the first instance, lest it lead to damaging long-term economic consequences. Any bill should be designed to address these issues.

In the U.S. financial system, this role falls primarily on the Federal Reserve because it is the lender of last resort. Walter Bagehot's theorem says the lender of last resort should lend freely at a steep cost in order to provide liquidity to the financial services sector. The Federal Reserve has certainly provided enough liquidity, but it has not been enough. The problems are too severe. Hence the need for a legislative solution.

The legislative solution's primary goal must be to help the marketplace discriminate between financial institutions that are suffering due to short-term liquidity constraints and those that are fundamentally insolvent. In a credit crisis, liquidity is so constrained that even sound institutions fail.

This must be prevented by separating the bad assets from the good assets as quickly as possible. There are a lot of mechanisms to do just that. I have suggested the US adopt the Swedish model which I outlined in a post in August. Irrespective of which plan Congress adopts, these will be the factors to consider:

1. Guarantee of most deposits. Unfortunately, when a legislative solution becomes necessary, jitters among bank customers have reached a point where bank runs are likely. The only way to prevent bank runs at this stage in the crisis is to make a blanket deposit guarantee. This will mean a significant bolstering of the undercapitalized FDIC or a transfer of certain bank deposit guarantees to the new RTC-like administrators. That way, people can go back to worrying about making money and stop worrying about their life savings.
2. Separation of good assets from bad assets. As Lehman (LEH) had proposed before it went under, making a 'bad bank' and sticking it with all the 'bad' assets will increase bank counterparty confidence in the resultant 'good' banks and, thus, restore liquidity.
3. Discrimination of bad banks from good banks. Illiquidity is due to counterparty distrust. Therefore, the bill must provide a mechanism to identify which banks are solvent and which are fundamentally insolvent. When financial institutions become reassured of the solvency of their counterparties, liquidity will return to the credit markets.
4. Liquidation of bad banks. Once the companies that are fundamentally insolvent are identified, they must be liquidated as quickly as possible. There is no reason to beat around the bush. The faster the liquidation process is complete, the sooner confidence will be restored.
5. Defense against politicization of the process. The last time I checked, the Treasury was a step away from the President and, therefore, easily manipulated for political purposes. Having the US Treasury control the crisis resolution process is setting the United States up for a politicization of the process. The 'Bad Asset' or 'Bad Bank' buyer must be an independent body free of all political influence. The RTC certainly was.
6. Reduction in moral hazard. Any bailout scheme must align risk and reward as closely with the same agents as possible. Whoever takes the risk, also gets the reward or loss. There should be no free riders. An example here would be bailing out a fundamentally insolvent company to the benefit of existing shareholders rather than taxpayers. These types of shenanigans have to be stopped.

Paulson's plan is a trap

Whether you like Paulson's plan or not, Paulson has been very crafty in making his proposal. He is obviously a good negotiator because he has anchored the discussion around a false set of goals. Congress, which had been unable to present its own proposal, will probably take the bait and use this proposal as a baseline from which to craft legislation, rather than start from scratch with their own initiative.

Moreover, it remains to be seen whether this proposal will ultimately cost a measly $700 billion. Experience with Iraq War funding proposals and the history of Japan's experiences after their property bubble burst tell us that this is the first of many handouts that will be requested. And once the first request is passed, it will be very difficult for legislators to admit that the handouts were not money well spent. So, additional handouts are likely to pass as well.

If Congress allows this plan or some other remedy like it to pass, it will have confirmed its uselessness to the American citizenry. Just as with 9/11, Congress will have allowed the executive branch to usurp powers that are constitutionally held in the legislative branch. Therefore, in the end, when this proposal ends up costing much more than $700 billion, I will hold Congress to blame more than the Bush Administration.

Disclosure: None

Comments

[bbzz24:]

You are absolutely right there is nothing for the taxpayer in this proposal. But the taxpayer is so maxed out, it can only contribute with future tax liability which in turn will lead to decreased consumption, or with other words: another negative feedback loop.

Here is my proposed solution:
According to a separate article, the cash that sits on the SP500 companies' balance sheets is around 650bn. That includes treasuries of course. force those companies to buy mortgages since they do not want to invest in capacity. Ban any dividends. In the process break apart all MBS, ABS, CDO so there are no lawyers who pinch 0.25-0.5% annual servicing fees. This is proven communist practice that works: use enterprise money to fund housing affordability.

Then impose and enforce strict leverage requirements. pump up the system with just as much cash is needed to prevent deflation, of course it will be inflationary, but present living standards are not sustainable and have to go down.

Bring all troops back home and along with the fired from the financial sector start rebuilding sustainable cities, no urban sprawls. people should be able to live closer together, no need for 1 vehicle per person, be able to socialize and develop into responsible and aware society, not voting sheeple. this could be funded with the Pentagon and DHS budgets: if you do no harm no one is going to do it to you either (reference Switzerland).

It should not take more than one mandate to become self sustainable again and then there will be political change again: the riches will be paying voters to kick out the Democrats from office.

2008 Sep 24 07:38 AM

[bbzz24:]

Don't promote this plan to National Rifle Association members, it will be waste of time.

2008 Sep 24 07:46 AM

[Shiv Kapoor:]

I dis-agree. I feel the plan is a good one, and it is necessary. The actions of the government have used a Keynesian response through tax policy. They have used a monetarist response through rate cuts and the window.They are now using a further Keynesian response through governmental investment in a time of crisis. Its apt, its appropriate and it will succeed. What still needs consideration is using tax policy to stimulate private investment. A simple tool to use would be to permit remittance of foreign profits back to US without a tax charge.

2008 Sep 24 07:56 AM

[User 143167:]

The Keynesianism is a wrong method to be used at a wrong time. The root cause of this crisis is not housing, but energy shortage. It is a supply crisis rather than demand, you can not use Keynesian's way to cope with that. Cause before the house prices stablize, oil price will hit $200 a barrel and economy will suffer more.

2008 Sep 24 09:21 AM

[sieraromero:]

Any bailout of wall street and the banking sector should include provisions that specify that any firms utilizing funds from the government include that the firms in question elimanate any golden parachutes to the previous executives. Also, that the firms dividends be curtailed until the government is paid back in full and that the government be issued warrents in the said firms for assuming the risk and possibly rewarding the american taxpayer instead of the priviledged few who will benifit from the proposed existing bailout plan.

2008 Sep 24 10:40 AM

[freddie:]

I tuned in to see if the 911 type fear tactics were working on the SA contributors. Yesterday I caught Cramer claiming that the bailout automatically guaranteed the end of foreclosures. His explanation: heck the govt can just sit on the mortgages and charge ZERO!

And here I get Ed's considered analysis. Thanks Ed, you restored my faith that it is worthwhile to read SA.

2008 Sep 24 11:11 AM

[Crookedwood:]

A well thought out position. What is missing is the need to have much tighter regulations and oversight of banking and finance. Housing is not the problem, but greed and munipulation are. Here is were governmental attention needs focus. If we bail out greed we learn nothing. Would I feel differently if the government were bail me out, but since that will not happen and I have taken my losses, lesson learned.

2008 Sep 24 11:31 AM

[monday1929:]

Great article, thank you.

2008 Sep 24 11:42 AM

[swaps:]

Here's the plan I posted at the NY Times and Denver Post
Swaps
Congress should not gallop ahead at full speed to fix in 48 hours a problem that has been building for years.
Paulson and the government until now have favored funneling the money into the top, instead of starting at the bottom.
Amounts from $300 to $1,200 were given away as a tax refund. The government giveth.
But I calculate the $700 billion bailout Paulsen requests for Wall Street comes out to $9,333 - before interest - for each of the roughly 75 million tax paying households in the U. S. Of course, the cost for the previous takeovers and bailouts swell the per household tax bill even higher.
Why not have Congress give the $9,333 instead to each house hold, with the restriction it could be used to only pay down debt or save in a financial institution or one of the identified financial services stocks. People in debt would repay lenders, which would help both. And people not in debt would invest savings or stock in the financial system, helping to build liquidity. The savings or investments would be restricted from cashing in for at least five years, to keep liquidity in the system. Financial systems that can't be helped by this plan because they are too far gone would be allowed to go bankrupt under the cleansing mechanism of Darwinian free market forces.
Congress has to realize the current $700 billion mess is just the latest in a series of crises still to come. That is how it has been playing out all year.

2008 Sep 24 04:35 PM

[elwind45:]

Again great article! I find it a little ironic how Treasury can scream about a liquidity crisis, yet 3 month bills went negative yield this morning. There is no way this bailout will work. This is a lifeboat promise to all the Titantic passengers. The 10 year yield has been trading in a small range 3.80%! What gives? The White House has a small business/unemployment problem and has decided to manufactor a crisis?

2008 Sep 24 07:00 PM

[HEARTSFORLOVE:]

THIS IS A BRILLIANT ESSAY WITH EXCELLANT SOLUTIONS TO A MUDDY MESS.

I HOPE SOMEONE FROM CONGRESS GOES THROUGH THESE POINTS IN THIER SIMPLICITY .

MAYBE TEN TRILLION WILL PUT OFF THIS CRISIS FOR A WHILE.
BUT NOT EVEN 20 TRILLION WILL DO THE JOB UNLESS
THESE POINTS OF ACCOUNTABILITY AND TRANSPARENCY ARE
ENACTED. WELL

2008 Sep 25 03:05 PM