Alternative Bailout Plan: Good and Bad Ideas

Now that both sides of the U.S. House of Representatives cannot agree on Hank Paulson's $700 billion TARP package, the need for an alternative idea is clear. One of the ideas I have heard sounds pretty interesting to me.

Essentially, rather than buying $700 billion worth of mortgage-backed securities, the plan would be to have the government issue insurance on them and guarantee the holders against realized losses. How is this any better than the current plan? From what I can tell, in at least two ways.

First, it would cost far less to insure mortgages than it would to buy them outright, so the taxpayer would save money versus the current plan. Many people believe the current prices these bonds are fetching (if trades occur at all) are not reasonably reflecting the ultimate losses from the mortgages underlying the securities. If that is true, the losses that the U.S. would insure against would be far less than the current marks on these mortgages are predicting.

Second, and perhaps more importantly, if we woke up tomorrow and these mortgages were insured by the U.S. government, there is a very good chance that demand for them would increase significantly. All of the sudden a market for these securities would not only exist (essentially one does not now), but prices would likely rise and the banks could reverse some of their mark-to-market losses and write-up the value of their assets. With more clarity on the value of these assets, even more capital raising would occur in the banking sector.

So, what do you think? Would such an idea convert some of the naysayers of the current plan?

I am also a little confused. How will removing the mark-to-market accounting rule, an idea that is rapidly gaining traction, help solve the problem? If balance sheets are not prepared with market prices, it will allow companies to arbitrarily assign a price to the illiquid assets it holds. What kind of price are they going to select? Obviously, a high one!

To me, this will just lend less credibility to bank balance sheets because investors will assume the banks are choosing artificially high prices for the assets they get to assign values to. Will sovereign wealth funds, private equity funds, and hedge funds all of the sudden start to offer new capital injections into firms that are doing this? I highly doubt it.

One reason why WaMu, Wachovia, and Lehman Brothers went under was because nobody trusted their balance sheets enough to invest in them. Marking up those toxic assets arbitrarily would hardly result in more confidence than there is today.

Disclosure: No position in any of the companies mentioned at the time of writing

Comments

[RichardfromHB:]

How can anyone figure out how to insure an asset when its current value is unknown? They even want to stop the "mark to market" rule. The core concept proposed by Bush is flawed. Call some hearings and ask some economists. Google Sweden 1992 banking crisis. They had good success promptly steering their financial institutions back to safety. Learn the lessons, write it for the Dems, and own it. The tweeking that was done to the Bush proposal resulted in a toothless and weak 100 page bill that tried to bury and hide its weakness from the voters. Rather than condescendingly claiming that the American people didn’t understand (Cf, McSame of Obama at first debate), or that the leadership didn’t explain it well enough, the reality is that if you vote in favor of bailing out the bad actors, you may lose votes from constituents in five weeks at the next election. That is your moral hazard. The bill that failed would not have prevented one of the 10K daily foreclosure, could have been filibustered until Bush spent all $700B, would only have made some parachutes "non-deductible", merely required a report “suggesting” how the taxpayer will be paid back, and allowed the same lobbyists to set prices for their trash that the taxpayers would pay. As a final insult, instead of providing more confidence through transparency, the failed bill would allow Paulson to suspend the mark-to-market rule. This is intellectual dishonesty that will further erode confidence in our banking system. Do a better job on all these issues and allow bankruptcy judges to implement the rewriting of loans, or face the wrath of the voters. I think many voters would accept the temporary governmental equity position in the banking sector as long as the bad guys aren’t seen as maintaining their ability to subvert the programs and continue to rip off the system. Don’t pull another FISA cave.

2008 Sep 30 07:13 PM

[hooligan:]

This is getting pretty tedious. A recovery in the stock market on news that politicians come up with a deal that targets no-one but the people who caused the mess in the first place. World leader (also politicians) screaming for american politicians to pass the bill, as if they have any business interfering in the sovereignty of another nation or have any idea what the bill is targeting. Make no mistake, a guarantee by the government or a mark to whatever I please accounting switch is tantamount to tax-payer lending money (via a deposit placed with a bank) and then saying "hey I guarantee that you will pay me back my own money" ..what a crock. Of course, politicians are way too smart to see through that one. That is what the markets are for. Markets kill off malpractise, systematic abuses and false prophets and create new ones that are better and fairer. Ignroing the market forces correctly stating vlaue is pure communism. Who on earth gave a bunch of soon to be has-been politicians the right to pledge tax-payers own money for what they have already earned?

2008 Sep 30 07:30 PM

[karl22:]

I am shocked that no one has thought of utilizing the age-old gov't "Guaranteed Student Loan" program whose inception was brought about by the gov't seeking to GUARANTEE student's loans-students with no credit, and students, many of which turned into "deadbeat grads..." the gov't guarantees the program, and if the borrower defaults, THEN the gov't takes over the bad loan--AFTER DEFAULT, and like the IRS, the gov't WILL get their money. As another writer mentioned, how do you insure a product you cannot value--you can't-that is why you GUARANTEE the loan- the toxic loans will immediately have value and trade accordingly. Initial cost to taxpayers: $0; set a 3 year window-from 2005 to present for distressed homeowners. The gov't already has the student loan program in place (or it outsources)- just create a GUARANTEED SUBPRIME AND ALT-A loan program- and abolish future similar programs in the future. Problem solved.

2008 Sep 30 07:34 PM

[random guy:]

The original bill did allow for insurance of assets. It was in Section 102, otherwise known as the second (substantive) section of the bill.

2008 Sep 30 07:40 PM

[karl22:]

the assets cannot be priced, and thus a proper premium cannot be established for them; insurance is not the answer-Guarantee the securities

2008 Sep 30 07:55 PM

[Blackeyebart:]

Any workable plan needs to be both managable and transparent. You don't get confidence without that. The government should not buy any of these instruments. Not one. They should recapitalise the banks. But only if they get 51% ownership. The management need to know who they are working for. Mark to market should be retained. Confidence is built on the reality of actual market sales, not estimates, analysis or guesswork. The recession must be allowed to happen, and a raft of simple & cheap programs implements to move it along without too much damage to individuals. Spend on infrastructure. Build through the bust. The war on terror must end. The entireUS cannot be held to ransom by a few kooks. Stand up to them . Refuse to be scared.

2008 Sep 30 07:56 PM

[Ametrin:]

There is no difference between insurance and buying the bonds themselves. It is only a balance sheet transformation. Scrap the idea!

Suspending the mark-to-market rule will not improve theconfidence in the banking system. It will rather erode it.

There are two things to do:
1. Increase depositor insurance -> Improved confidence among depositors
2. Buy equity in the troubled companies -> Improved balance sheets and counterparty confidence, which will enable banks to lend again.

The basic principle in solving the Swedish banking crisis, was quite similar to what the FED did with Freddie and Fannie. The shareholders take the first hit.

The Irish solution is not a bad idea. That will give the banks some time to sort out the liquidity problems. Bad banks will still fail, but not due to lack of liquidity. They might fail due to substantial losses on bad investments, which is fair.

2008 Sep 30 07:58 PM

[101010:]

I'm going to make this short and to the point.

Text of the bailout plan (from the NY Times):
graphics8.nytimes.com/...

Sec 109c line 14 "principal write downs" of mortgages
Sec 110-2 Modifications (to mortgages)
(a) Reduction in interest rates
(b) Reduction in loan principal

Now think about this example:
There are two neighboring houses.

In the first house, Peter was prudent, saved his money, lived within his means, worked hard, and could afford his mortgage.

In the second house, Paul took on too much debt, lived beyond his means (possibly even taking out a HELOC or two to "live the good life"), worked just enough, and frankly cannot afford the mortgage he got himself into.

The aforementioned sections essentially say that the tax money that Peter has paid will go to help his neighbor Paul. Truly robbing Peter to pay Paul's mortgage!!

On top of that, everyone else who knew they couldn't afford a house and thus are renting... their tax money goes to help Paul too!!

That is f***ing ridiculous.

Sec 113a1. "Minimizing negative impact" -- This section is pure fluff but does clearly say there *will* be a negative impact, which they will attempt to minimize (ya right). None of "the gov't might actually make a profit" absurd punditry.

Here is a graphic showing who in the House voted for or against this absurd, Socialist bill:
www.nytimes.com/ref/wa...

I will vote for, and contribute to, the incumbent campaigns of those who voted against this bill.
I will vote against, and contribute to, the challenger campaigns of those who voted for this bill.

As a taxpayer, one who lives well below his means, and an American, I am utterly furious that House Speaker Nancy Pelosi, D-Calif., Senate Majority Leader Harry Reid, D-Nev., Paulson and House Republican Whip Ray Blunt, R-Mo could come up with this absolute garbage.

Moreover, the fact that Henry J Paulson originally asked for $700,000,000,000 without any oversight at all, just a "trust me, I'll spend it right" attitude, is completely un-American and goes against our democratic system of checks-and-balances. He is a snake, a complete failure at his duties, and should resign immediately.

I implore all of you:
PLEASE send emails, write letters and tell your Senator and Representatives that you-- as a financially responsible homeowner-- REFUSE to help pay the mortgages of your financially irresponsible neighbors. They don't need to be very long-- just a paragraph or two to get to the point.

Tell them you will send money to support the challengers to kick out the incumbents to voted for this bill.

And tell those Representatives who voted against this bill that you wholeheartedly support their vote, and will be contributing to their campaigns.

They need to know: Vote for this bill and they will be out of office.

2008 Sep 30 09:22 PM

[Steven Hansen:]

we are in the no win scenario. doing nothing will hurt everyone. doing something benefits people unequally, but still everyone will take a hit. it seems to me the lower you are down on the food chain - the less benefit you will have by doing something. but i fear that the average american may be better off by doing nothing.

2008 Oct 01 01:57 AM

[Signe:]

The guaranty idea is superior to Paulson's Purchases for a myriad of reasons. I agree that it would a) cost much less -since the actual losses on such mbs will be much less than predicted. In fact, I have yet to read about realized losses i.e. foreclosure or short sale proceeds are not enough to pay off the original loan) associated with any investment grade bond.
b) it would be much easier to administer -GinnieMae, a division of HUD which currently guarantees certain mbs has the infrastructure to monitor and pay US government guarantees in the event of actual realized losses on mbs.
c) as guarantor, the US government would be in a position to offer individual borrowers relief, such as lowering interest rates, forgiving principal,etc. This would not be possible with Paulson's Purchase, as it is highly doubtful that all owners of a single mbs issue would agree to sell their bonds to the U.S. Treasury.
Note, I am not advocating that the U.S. Treasury offer borrowers relief, but a government guarantee as opposed to a government purchase gives us this option and therefore should appease those who think that victim borrowers are owed.

2008 Oct 01 08:37 AM

[Signe:]

Correction: Wachovia did not go under.
Also, the reason why Lehman and Wamu failed is because their lenders demanded more collateral for loans made to these two institutions for mbs or cds. These loans were called because the "value" of the collateral currently posted by Lehman and Wamu had declined -even though the payments on the mbs posted as collateral were current.

2008 Oct 01 08:39 AM

[Britishsteel:]

people vote against this bailout or you will be reduced to poverty not seen since the great depression, this was on kudlow tonite: 9/30/08

"Paulson and Bush threatened to veto the legislation if there was an explicit prohibition of transfers from foreign banks to an American subsidiary."

THE ASSETS DO NOT EVEN HAVE TO BE AMERICAN MORTGAGE ASSETS - THEY CAN BE AN OFFICE TOWER IN SHANGHAI!

YOU ARE GOING TO GET FLEECED FOR HUNDREDS OF BILLIONS OF DOLLARS IF THIS BILL PASSES - THAT MONEY IS GOING TO GO IMMEDIATELY OUT OF THE COUNTRY!




SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES AND CENTRAL BANKS.

The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.


votenobailout.org/

2008 Oct 01 08:45 AM

[RSAAKS:]

Insuring the mortgage securities by the US govt, you state will be cheaper, and save tax-payer money. Doesn't that mean if there are defaults on any of these securities, the Govt becomes liable for losses, but if their values recover or go higher, the banks make money. Once again, socialize the losses but privatize the profits. Isn't that what we have been doing so far??

2008 Oct 01 08:51 AM

[msoori:]

Job creation is the ultimate solution to this problem. People file foreclosure when they cannot make the mortgage due to loss of income. So, why don't we address that real problem first?

2008 Oct 01 09:23 AM

[oldsuretyguy:]

I'm not supportive of a plan that measurably benefits banks and the industries that got us into this mess. Maybe we should be looking to some new avenues for lending or credit creation. The country needs to see the Wallstreet "junk" dealers and "junk" financial products eliminated from the world financial scene. Much of this is unregulated and/or subject to regulatory avoidance. And where does public financing of Wallstreet stop? I hear that the finacial disasters looming on the horizon will be coming in waves like a sunami...... How much of this junk Treasury paper will the foreign markets buy? I think the world credit markets, if they're smart, may be getting close to saying "enough" and no longer willing to buy this nearly worthless Treasury paper. And then what?
Maybe then we will have to fall back on a redevelopment of our own manufacturing base. Oh My God, what a novel idea! Instead of just wheat, maybe we could export some new renewable energy products that would create US jobs, capital and profits instead of creating junk finacial products people were stupid enough to buy! Nah.....! That's way too logical and totally lacks the "fast-buck" appeal.......

2008 Oct 01 11:40 AM

[unimpressed...:]

It is evident from several of the comments from respondents that they do not understand mark to market and its destructive effects on a company's inventory values. Mark to market leads to chaos as every sale revalues the inventory creating turmoil of ever changing asset values. No company's balance sheet is worth a damn that changes asset values multiple times each day. This entire concept is ridiculous and antagonistic to good business practice.

The older accounting practices of LIFO and FIFO lent stability and provable value to a company's assets. Investors had a good feel for their investment under such conditions. Mark to market is an example of clueless Democrat/Socialist do-gooder tinkering in an area they did not understand or comprehend the disaster they were building. Suspending it would give the market and business an immediate boost and restore confidence in the value of a company's assets.

Of course, if you are a Democrat who backs the Marxist philosophy of Obama, you neither understand the concept nor favor the end of the current crisis. If you are successful in electing the empty suit from Illinois, you will discover what real chaos and catastrophe are.

As to the bailout, a.k.a., Democrat CMA for supporting the collapse of Fannie and Freddie and accepting bribes in the process, it will be a disaster for the taxpayers as insurmountable debt is piled upon exponentially expanding liabilities. However, the miscreants of Wall Street will retain their homes in the Hamptons and their mid-Manhattan penthouses, increase their personal worth through egregious golden parachutes, and reap billions of dollars in profits as Paulson buys their 20-cent paper for 80 cents. Is that what We the People want? Absolutely, NO!

Give a cheer and show appreciation to those Republicans and Democrats in the House who stood up for the taxpayers and defied the leadership and self-interested Paulson. They deserve to remain in office in November while the rest of them must be heaped on the worthless debris of history.

God bless the patriots who protect this nation from its destructive, incompetent, and self-interested representatives in government.

2008 Oct 01 01:39 PM

[bernie bicoy:]

If the immediate problem is that money for loans is not available due to mortgage portfolio losses...mostly by investment banks...why not go straight to the heart of the problme for 'Main Street'.

Do not depend on 'trickle down' economics opening up credit lines. Instead go to the solvent commercial banks and make the 'bail out / rescue' money available to those banks at the fed discount window at an attractive rate. Say 1%.

The solvent banks then could make a 4-5% profit on the money, while simultaneousl.y bailing out Main Street.

Anyone who owns mortgage backed securities can repackage them into good and bad packages, resell the good, and write off the bad. In short practice the same kind of clawback economics all of the rest of us have to when we make a horrendous mistake.

Bernie Bicoy

2008 Oct 01 02:40 PM

[JOHN123:]

How To Fix Our Banking System
The “Genesis” Plan
by Karl Denninger
[e-mail]

It is clear that we must act to stabilize our financial markets. What is also clear is that if we act imprudently we will destroy our financial markets and system instead of saving it, and are likely to usher in a Depression.

What Henry Paulson and Ben Bernanke have proposed will do the latter, not the former.
The root cause of the current lack of trust in our financial markets is threefold:

1. Nobody can trust a balance sheet. This is due to off-balance-sheet vehicles (which were supposed to be banned after ENRON) and “Level 3” assets, which nobody can analyze the true valuation of, as identification of the claimed assets and their valuation models are undisclosed.

2. Credit Default Swaps (CDS) are “over the counter” (OTC) transactions with no margin or capital supervision. As a consequence nobody knows if their “counterparty” can pay. In fact huge percentages of these people can’t pay – but nobody knows who they are.

3. Leverage. The SEC removed broker/dealer 12:1 leverage limits in 2004. Every firm that has failed – all five (Fannie, Freddie, Bear Stearns, Lehman and AIG) had leverage far in excess of 12:1. The draft bill is even more dangerous as it accelerates a provision intended to go into effect in 2011 that allows Ben Bernanke to increase financial firm leverage by dropping reserve requirements on banks to zero should he so choose. It is excessive leverage that got us here in the first place, and this bill actually makes it worse.

The solution to the trust issues in our financial system is elegant and it will work.

1. Force all off-balance sheet "assets" back onto the balance sheet, and force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Enact this requirement beginning with the 3Q 2008 reporting period which begins next month. Total taxpayer cost: $0.00

2. Force all OTC derivatives onto a regulated exchange similar to that used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days to get this done; any that are not listed in 90 days are declared void; let the participants sue each other if they can't prove capital adequacy. Total taxpayer cost: $0.00

3. Force leverage by all institutions to no more than 12:1. The SEC intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly. Total taxpayer cost: $0.00

Once 1-3 are put in place then send in the OTS and OCC examiners and look at every financial institution in the United States. All who are insolvent and unable to raise private capital immediately are forced through receivership where the debt is converted to equity and existing equity is wiped out.

With the CDS monster caged the systemic risk is removed, the bondholders provide the cushion for recapitalization (as it should be) and the restructured firm emerges with no debt while the former bondholders are now the owners (of the equity) in the resulting firm. With a clean balance sheet the restructured firms remain in business and open the next morning able to raise and attract capital. For the few firms that have an insufficient debt-holder capital cushion to successfully complete this process, we are left with two options – a capital infusion or liquidation. There will be few of these and in fact each of those firms is a regulatory failure, as we should have never permitted a firm to become so far "underwater" that the bondholder's capital is insufficient to capitalize a restructuring.

For those firms, give the FDIC (or if an insurance company, the appropriate state and federal regulatory authorities) primary control. As the CDS monster has been caged, the primary threat is now loss to state and federal guarantee programs. If these regulators deem that this firm’s liquidation would result in an unacceptable loss to the system’s guarantee programs then recapitalize the firm as follows:

· The government shall be issued senior preferred debt ahead of all other debt and equity in the capital structure, paying a floating coupon of 3 month LIBOR + 8% adjusted quarterly, in an amount sufficient to bring regulatory capital above minimum limits.

· All dividends are suspended for as long as the preferred remains outstanding, and during that period no employee of the firm may receive any form of compensation exceeding that of the President of the United States for a corporate officer, and no more than that of a United States House member for any person who is not a corporate officer. At the issue of the preferred stock all outstanding deferred compensation, including options, are deemed cancelled.

· The firm may retire the preferred at its option by repurchasing it at the issue price.

· The appropriate regulator shall have primary authority to “call” the above debt issue at any time and force bankruptcy (along with recovery of invested amounts) should the firm fail to execute an effective turnaround
plan.

Finally, drop the silly shorting restrictions. Liquidity in the market stinks and this is a big part of why. Start prosecuting aggressively the rumors and other manipulation that leads to stocks both rising and falling.

This plan will instantaneously stabilize the credit markets as balance sheets will be transparent, the CDS monster will be permanently de-fanged, leverage will be returned to reasonable levels and the forcibly restructured firms will have no debt on their balance sheets and be able to access the capital markets. Firms that would fail once they have disclosed their true liabilities and result in unacceptable insurance program costs will be recapitalized with a reasonable expectation of the taxpayer not being stuck with the bill. Systemic risk will be removed.

Best of all, it will require zero taxpayer dollars with few exceptions, and for those instances where taxpayer dollars are required the amount of taxpayer risk would be small and well-protected.

This plan is very similar to what Janet Tavakoli proposed on September 25th in an open letter released on the web.

Ms. Tavakoli is an internationally recognized expert in these matters, is an adjunct professor of derivatives, and is widely published.

This and other alternatives must be examined before our nation embarks on what may be a disastrous path. www.tavakolistructured...

2008 Oct 12 02:49 PM