September 24, 2008 11:09 PM UTC

Bailout: the Dan Plan

• 9 Comments
• by: Danny the Red (hair)

(Danny for Secretary of the Treasury – promoted by DavidThi808)

Fortunately, congress has opposed Paulson being given unsupervised authority.  Non Starter.  Any bailout has to serve 2 purposes: 1. protect the system from freezing 2. stabilize the housing market so that pricing can normalize.

Contrary to logic, I want to start with the 2nd purpose..

During the great depression,  one of the first acts by FDR was to form the Home Owners’ Loan Corporation.  Its purpose was to refinance home loans to prevent foreclosure.  HOLC was pilloried at the time of its foundation as costly socialism, but the program actually made money for the taxpayer.  From a 1948 Time magazine article.

Most government excursions into the field of private enterprise have cost taxpayers money. So when the Home Owners Loan Corp. was created, Congressional sibyls prophesied that the Government would lose at least $1 billion. Last week HOLC’s spry old board chairman, John Henry Fahey, produced figures to show how wrong they had been. When HOLC is finally liquidated in 1948, he said it will show a net profit of some $11,000,000.

Starting in 1933, when mortgages were being foreclosed at the rate of 1,000 a day, HOLC made more than 1,000,000 loans, totaling some $3,500,000,000. In the next three years (its lending period) it refinanced one-fifth of the nonfarm, owner-occupied, mortgaged homes in the nation. Thanks to the war boom, more than three fourths of the loans have now been paid off. By the end of 1945, only 483,000 borrowers were still on the books, while another 348,000 borrowers had paid their loans in full without waiting for them to mature. HOLC had foreclosed on less than 200,000 loans, most of them from 1937 to 1940. It has already sold all but 120 of the houses. Fahey says its net loss of $50,000,000 to the end of 1945 will be more than covered by HOLC’s income from other loans.

http://www.time.com/time/magaz…

Right now mortgages are held by Special Purpose Vehicles, non recourse standalone entities that issue mortgage backed securities.  SPVs as single purpose entities must foreclose on slow loans, it is written in to their operating agreements.  Unlike bank held loans, there is no room for forbearance.  MBS are a useful tool to help banks rid themselves of Non Performing Loans NPLs, but remove from the system any party that is able to work out NPLs.  MBS have flowed through global markets like a river and bad NPLs have come back onto the Bank balance sheets through a multitude of ways in addition to touching people miles away from the original spill.  To put it simply, the banking system gets all the risk and none of the control.

Someone needs to step in and take control over the asset workout that banks used to handle themselves and falls to the SPVs which are structurally required not to work them out.  That someone must be the government, no one else has the authority.

On to the second purpose of any properly structured bailout and the only one that Paulson plan is addressing.

Let me just start by saying the Paulson plan should work, but as currently structured it is a $10K tax on every household to pay for the bonuses of Wall Street traders and investment banker.  Unacceptable.

The purpose of the bailout should be to protect the system not individual banks.  Banks are lining up to get on board with the bailout.  Meaning management sees a benefit to being bailed out.  Unacceptable.

Adding executive compensation caps, government warrants and criminal investigations to the bailout are all an attempt to place some punitive measures in the bailout to encourage banks to work out their problems on their own.

I have often advocated the “Swedish Plan.”  First a little history, from an academic article in 1999 explaining the Swedish banking crisis in the early 1990s.

Newly deregulated credit markets after 1985 stimulated a competitive process between financial institutions where expansion was given priority. Combined with an expansive macro policy, this contributed to an asset price boom. The subsequent crisis resulted from a highly leveraged private sector being simultaneously hit by three major exogenous events: a shift in monetary policy with an increase in pre-tax interest rates, a tax reform that increased after tax interest rates, and the ERM crisis. Combined with some overinvestment in commercial property, high real interest rates contributed to breaking the boom in real estate prices and triggering a downward price spiral resulting in bankruptcies and massive credit losses. The government rescued the banking system by issuing a general guarantee of bank obligations. The total direct cost to the taxpayer of the salvage has been estimated at around 2 per cent of GDP.

http://ideas.repec.org/a/oup/o…

Sound familiar.

Sweden did not bail out its financial institutions by having the government take over the bad debts. Bank shareholders took the hit first:  Banks had to write down losses and issue warrants to the government–government didn’t take debt, they took equity.  Senior managers were forced out and new managers brought in.

The government held banks responsible and turned the taxpayers into an owners just like any private white knight that brought capital into a struggling company. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

This cut the bailout cost at least in half and instituted punitive measures against the managers that got the banks into trouble in the first place.  The punitive measures encouraged manager and shareholders to do everything in their power to avoid turning to the government for the “bailout.”  Whether that meant a capital call or a merger, managers and shareholders knew they had to protect their own interests on their own.

How was the system protected given the limitations on “bailout?”  The government protected the depositor and creditor part of the banks balance sheet.  This prevented runs on the bank.  In addition regulators forced banks to take losses.  This required them to find new capital or go into government ownership.

The Swedish plan was hard on managers and stockholders, but the system survived because creditors and depositors knew they were “safe”.