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Net worth certificates, from the FDIC
One alternative is a "net worth certificate" program along the lines of what Congress enacted in the 1980s for the savings and loan industry. It was a big success and could work in the current climate. The FDIC resolved a $100 billion insolvency in the savings banks for a total cost of less than $2 billion.
Here is more. Here is an FDIC summary of the program, under the heading "Other Resolution Alternatives." To the extent bank recapitalization is needed, this is the best way to do it. As Andrew Sullivan will tell you, experience really does matter. I would like to see more economists promote this idea as an alternative to Treasury warrants.
Posted by Tyler Cowen on October 2, 2008 at 08:13 AM in Economics | Permalink
Comments
I would not be so optimist about the FDIC, as it is currently sabotaging what the bailout plans are trying to achieve: get bank to lend again (link)
Posted by: Economic Logician at Oct 2, 2008 8:48:18 AM
What's the relevant distinction in this case between subordinated debt (which is what these "net worth certificates" are, according to the article) and preferred equity, which is what I've seen a lot of economists suggest?
Posted by: Brock at Oct 2, 2008 8:55:46 AM
Two points.
First, I agree that experience does matter. That's what I've been telling you for some time. You refer to AS, however. If he's the one that you have referred in past posts and since you have referred to him often, can you tell me what experience he has that is relevant to anything you write?
Second, you suggest "the best way to do it (bank recapitalization)." This means that you've have changed the problem to fit your best solution. Some posts ago, you correctly mention that the "problem" was to find out which banks were having problems. Your best solution assumes that you have a can opener.
Posted by: E. Barandiaran at Oct 2, 2008 8:56:11 AM
@Brook: Bravo! What is the difference between net worth certificates and direct capitalization? It is, at the balance sheet level, the same approach.
Posted by: Alex at Oct 2, 2008 9:11:59 AM
@Brook: Bravo! What is the difference between net worth certificates and direct capitalization? It is, at the balance sheet level, the same approach.
Posted by: Alex at Oct 2, 2008 9:12:25 AM
Interesting link Econ Logician.
In my view, we don't necessarily need lending so much, but we need banks to not go out of business, at least all at once. The left hand doesn't seem to know what the right hand is up to, or maybe they do. Maybe it's CYA like the late-in-the game credit rating reductions.
I'd rate an experienced politician or bureaucracy the same as an experienced prostitute. Just be prepared for what you are going to get.
Posted by: Andrew at Oct 2, 2008 9:15:50 AM
I'll defer to Andrew on the prostitute issue. ;)
There's been nitpicking around the edges of the Paulson proposal in the last two weeks, but no real discussion about alternatives (not here, but in Congress and the executive branch, where it matters).
This quote from Iacocca isn't about this crisis, but seems apropos:
"Am I the only guy in this country who's fed up with what's happening? Where the hell is our outrage? We should be screaming bloody murder. We've got a gang of clueless bozos steering our ship of state right over a cliff, we've got corporate gangsters stealing us blind, and we can't even clean up after a hurricane much less build a hybrid car. But instead of getting mad, everyone sits around and nods their heads when the politicians say, "Stay the course." Stay the course? You've got to be kidding. This is America, not the damned Titanic. I'll give you a sound bite: Throw the bums out!"
Posted by: ZBicyclist at Oct 2, 2008 9:34:13 AM
Andrew, I totally agree with you on what the goal of policy should be.
To allow the market to correct without breaking the system in away that causes even good lenders only to be able to get loans at very high rates.
To me the policy of the Fed and Treasury before the bailout talk was accomplishing that goal.
The bailout and the recapitalizatoin plans seem more focused on increasing lending back to past levels to avoid a recession or at least make the recession shallow.
But the problem is that almost everyone agrees that we were borrowing too much as a country and lending on too easy of terms. So it seems to me that we need a correction in which lending goes down. Also everyone seems to agree that our financial system was too big relative to the economy. So some institutions need to fail and there needs to be contraction.
Seems that the bailout is trying to stymie this correction in hopes of not having to give up the ephemeral GDP gains made over the last few years that were a result of too much lending.
Posted by: eccdogg at Oct 2, 2008 9:45:20 AM
I have no experience!
Posted by: Andrew at Oct 2, 2008 10:04:19 AM
The Problem with Inflation Right Now
I don't think cash will necessarily address the problem.
There seems to be two problems. The structure of cash flows don't match the expectations of banks when they bought these MBSec's, so many have a bad mix. Banks are afraid to lend to each other because they don't know who has a bad mix. The second problem is that aggregated, these MBSec’s have lost value for the same reason that banks ended up with a bad mix: Default Risk went up dramatically from expectations. Just like borrowers, banks are faced with lower asset values and lots of leverage (some banks should actually have higher asset value because they may own MBSec’s that are backed by cash flows that weren’t expected but are now coming in, like balloon interest rate payments).
Why did default risk go up? After 2005 oil prices went up ~100%, gas prices ~50%, other commodities went up… costs of consumables went up in price relative to everything else. Incomes for the majority were flat and negative. Expenses/Income increased significantly for the broader population. Viola, default risk jumps.
Here’s the problems with the solutions we’ve been given: Because costs have gone up so much relative to income, it can be expected that any inflation we will see will fall disproportionately on consumables. Combine that with the assumption that consumption and taxes are probably larger than income minus principal and interest payments for most people, it means default risk will rise with more inflation [until (Income – Tax – Interest – Principal Payment) is > Non-Interest Expenses].
Posted by: aaron at Oct 2, 2008 10:34:54 AM
Wait a minute. All this does is give the bank relief from regulatory capital requirements, on a declining schedule. (In the 1980's case, the schedule declined to zero in 7 years.) It's up to the bank then to recapitalize itself out of earnings or in the private market. That may be a good idea, but why give it a fancy name?
Posted by: Ostrich at Oct 2, 2008 11:30:57 AM
DeFazio (D-OR) has introduced this to the House as an alternative to 349 pages of pork riding 107 pages of bailout gunk. It'll never see light again.
Posted by: buermann at Oct 2, 2008 4:32:09 PM
Right now - there doesn't seem to be any consolidated competition for the Paulson plan. Lot's of organized criticism and independent ideas - but no organized full plan with a consensus group behind it. It seems like some type of a wiki or voting system could facilitate wide participation from respected Economists. The project would then have authority and weight and get media attention. Even if the collaboration process is flawed and difficult (which is likely) - the outcome might still be better than what they're working with on the Hill today. Anyone know of an initiative like this or want to try to start one?
Posted by: MK at Oct 2, 2008 6:25:06 PM
Why does it help to close down zombie banks? This was offered as what solved the Japanese crisis.
Is it that a certain amount of money has to be lost by people, and closing a bank chooses (at random, let's say) enough people to add up to the necessary amount of loss?
Because it seems to me that credit drying up is just unwillingness to volunteer one's personal assets for the necessary loss pool.
I don't exactly see why there'd be a necessary sum that has to be lost, however; first of all because money isn't wealth.
Posted by: rhhardin at Oct 3, 2008 7:06:07 AM
My wife's bro-in-law worked for the FDIC for over 31 years. He examined mutual (know what that means?) savings banks in NYC that had them NWC's. He said, the main thing to learn from that experience was that it was a better system than the one the nuts at FHLBB let the S&L's do which increased the taxpayers' losses by 100 times. Plus, there were not a material number or aggregate assets in mutual (no shareholders, there are a few left) savings banks - concentrated in NY and MA - compared to overall FDIC insured banks and the FSLIC's S&L industry.
Here is his down and dirty. NWC's only worked with mutual savings with adequate surplus to survive until market interest rates came back down to earth. Those that did not failed. Back then, the problem was negative net interest margin; interest rate risk.
He says another urban myth was the mortgage did those guys in. Actually, it was that plus the Mut S/B's had 40% to 50% of assets in long bonds that were also deeply depreciated due to high rates. Mortgages throw off cash flow each month, P & I plus escrow for taxes and insurance. Say a Telephone bond throws off cash flow only once each six month and no principle(sp?) or taxes. Were any of you alive when the prime rate was 20%?
NWC's were accounting fictions. Each quarter, the mutual savings bank would take its net loss and debit an "asset" NWC, and credit a capital surrogate (for want fo a better term) NWC. When net profits returned the entries reversed or they just wrote them against each other. The banks with surpluses sufficient to withstand the two or three years that it took for rates to come back down to earth survived. FDIC resolved mut s/b's that had NWC's greater than their surplus accounts. Most survivors became stock companies and have merged.
This type of accounting fiction/capital forebearance is already kind of de facto in place, or there'd have been 2,000 bank, pension fund, and broker/dealer failures. It may be a solution for the mark-to-market problem, except where the mark will never recover because the underlying assets are real losses (foreclosed houses held in markets with multipe years' supplies of houses for sale), not just illiquid market losses/accounting fictions. It worked because the 1980's market came back (interest rates declined) and the problem was in only a small portion of the FDIC universe of insured assessment paying institutions. Not systemic as we have now.
Some above comments remind me of Orwell's quote about believing stuff so crazy only an intellectual could believe it. None of you: don't ever leave that college campus until you take 12 credits of accounting and 12 of corporate financial management!
Dollars to donuts their Obama fanatics.
Posted by: T. Shaw at Oct 3, 2008 4:28:42 PM
