Bailout: the Dan Plan

(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.…

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.…

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”.

9 Community Comments, Facebook Comments

  1. redstateblues says:

    that Dan is smarter than the people who are running the show? Doesn’t seem right.

    • Fidel's dirt nap says:

      ” Danny, get in there and fix the goddamn country ! “

    • Another skeptic says:

      I think it is a mistake to compare this financal crisis to any other.

      This one involves so many varieties of complex financial instruments that FDR’s solution, which made things worse, not better, and Sweden’s which involved another culture and form of government as well as another time and magnitude, are interesting but irrelevant.

      We are lucky to have Hank Paulson, a veteran Wall Street CEO who knows deal making and the markets, and Ben Bernankee, an academic expert on Hoover’s and FDR’s missteps, in leadership positions.

      We are unlucky in that the guys who helped create and perpetuate the Fannie and Freddie  mess despite warnings from Bush in 2001 and 2003 and Greenspan in 2005, leading the congressional effort to bail out the financial markets.

      Barney Frank, Chris Dodd and Chuck Schumer were the leading defenders of and advocates of Fannie and Freddie, and they have the campaign contributions to prove it. They are the go to guys in Congress. They are putting their interests first, not the country’s, and we’re at tremendous risk.

      Is the Paulson plan perfect? Hardly. It was a starting point.  It was written to start the debate and give Congress something to work with.

      The same guys who promoted Fannie and Freddie’s policies of buying subprime mortgages now want to expand the bailout to cover auto loans and commercial real estate loans. Even bad credit card debt. And more earmarks are in the works.

      If this bailout fails, it will be because these three guys are playing politics, grandstanding and trying to cover their behinds.

      • Danny the Red (hair) says:

        Don’t have one other than let everything fail and more deregulation?

        As to Fannie and Freddie–the mistake was privatizing them. They worked exceptionally well for decades as full Government sponsored entities.  It wasn’t until they were partially privatized that the problems began.  McCain’s “regulation” plan you site so often was actually a deregulation plan, one that his campaign manager was probably pushing while he was taking $2 million from Fannie and Freddie

        I always look to history as a starting point.   You are correct that it is not an ending point.  History doesn’t repeat, but it does echo and you are foolish not to look at the past when constructing policy.

        I know your partisan heart makes the reason centers of your brain immune to fact and logic, but don’t repeat things you’ve heard and expect to get a pass.

        • shrubsrock says:

          starting wars, they’re lots of time history is important.  I always thought that we had to learn all that crap so we wouldn’t repeat the fuck up.  How much of our money went to teaching AS history?  What a horrible waste.

      • Ray Springfield says:

        It was clear in August that financial conflicts of interest existed for law makers to delay passage of legislation. By delaying, the market crumbles in key stocks and the  Republicans played it to perfection.

        Investigations of all members of Congress that destroyed the deal yesterday should be conducted in the Obama administration regarding lifestyle v. expenditures.

        Follow the money

  2. ohwilleke says:

    couldn’t resolve these cases quite satisfactorily.

    The Lehman Brothers bankruptcy has illustrated just how quickly it is possible for the courts to act to preserve value when necessary.  Large chunks of that business, which are time critical, have been quickly auctioned off, allowing for the disposal of toxic assets, like mortgage backed securities, at a more deliberate pace, and compensating private bondholders and shareholders only to the extent that asset values justify it.

    Bankruptcies can be conducted in a way that preserves the ongoing busines and the health of the financial markets.

    • If I read the current MBS market and the way that those instruments are distributed through the market, the McCain-backed Gramm-Leach-Bliley reforms have allowed this massive debt (and it is truly massive) to get hold of not just investment firms, but also banks and insurance companies.  If investors lose confidence altogether in these securities, then the whole house of cards collapses in a not-friendly way, taking pensions, 401ks, and other companies with it.  That was the rationale behind saving AIG, and given the side-effects of an AIG collapse, I have to give some credence to it.

      I think Danny’s got the right idea, and somehow hope that some receptive and influential staffer just happens to be reading it.

      These MBSs appear to be highly over-valued; getting investors to write off losses and devalue these securities to a more rational level has to come before the government starts paying money to gain either the securities or equity in troubled companies.  

      Apparently, the current CW in Washington is that these securities have already tanked, and so the government will be getting a decent value by purchasing them from troubled lenders/investors.  I’m not sure I believe that, but at least they’re considering the value of these investments in their plan.

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