Toward a Better Bailout: Bringing the Market Back In

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The government has spent hundreds of billions to bail out banks, but the financial system is still sinking, and so is the broader economy.

Under the Troubled Asset Relief Program (TARP), Congress authorized the Treasury Department to purchase up to $700 billion in “troubled assets,” defined as “residential or commercial mortgages.” The Bush Treasury Department, under the leadership of Secretary Henry Paulson, used elastic program provisions to veer far from this mandate. An initial allocation of $250 billion was spent buying preferred stock and warrants in commercial and investment banks, including Citigroup ($50 billion, two injections), Bank of America ($50 billion, two injections), AIG ($40 billion, and still bleeding), JP Morgan ($25 billion), Goldman Sachs ($10 billion), Morgan Stanley ($10 billion), and others. The Treasury advanced another portion to General Motors ($10 billion), General Motors Acceptance Corporation ($3.4 billion) and Chrysler ($4 billion) as an emergency short-term fix to the auto industry; Ford abstained. It is not easy to value the notes, private issue preferred stock (non-voting) and warrants that Treasury has received in exchange for its cash, but the government faces the probability of large losses. Unfortunately, the program has not stimulated lending, though it did head off the panic that would have followed more large scale financial institution collapses such as that suffered by Lehman Brothers. By and large, though, many of the troubled assets still remain on the books of the bailed-out institutions, a toxic molasses.

It is beneficial to the country that our major financial institutions continue to operate and particular that they resume and expand lending. However, the best way to do so is to help lenders clean up their bad balance sheets by removing distressed assets, including non-performing residential and commercial mortgages.

There is talk that the Obama Administration is considering changes to the bailout program. Various alternatives have been discussed in the press, by economists and by advisors to the new Administration. The following set changes and enhancements, fitted together as a coherent market-oriented program, make sense to me:

• Assets should be received from financial institutions on consignment rather than purchased outright. These assets should be sold off to private investors in an expeditious but well-organized fashion. The government should go into the moving business, not storage.
  
• Any FDIC guaranteed institutions could be required to participate in the facility, under the guidance of FDIC examiners, until such time as overall asset quality is deemed acceptable in relation to capitalization.
  
• The government should organize pools of each institution’s assets and carry out an orderly Dutch auction process, similar to the way US Treasuries are sold, with plenty of lead time for investor due diligence.
  
• The government should leverage its allocated funding by offering a floor or guarantee for a percentage of the purchase price, and the buyers should seek any needed financing privately. I would suggest a government-provided floor of 50% of the purchase price as a last loss. That is, if a bidder successfully buys an asset for one million dollars, he has a “put” back to the government lasting for an agreed term for one half of that amount, or $500,000. The government should look to the market to take a substantial first loss position, but at an asset value that is competitively established.
  
• When the government provides a floor guarantee, it should receive in return warrants on the common stock of the seller. These should be granted on terms equivalent to the assessed economic value of the guarantee.
  
• Proceeds of asset auctions would flow back to the selling institutions, if solvent, or to FDIC if in receivership. Banks as going concerns will need to raise fresh equity capital privately, which should be facilitated by having cleaned up balance sheets. Some banks, if they cannot raise adequate capital, may fail. The priority then should be orderly liquidation.
  
• Some TARP funds, rather than being spent, should be sequestered as a reserve against possible losses under the program from potential exercise of the put by disappointed buyers. Where possible, the government should seek to lay off its risk through insurance policies purchased privately from international reinsurance syndicates or through public syndications offered by the investment banks.
  
• Further government funds that would have been invested in banks can be released through changes in taxation and payroll deduction, for a more immediate stimulating effect.
  

Under these rules, the government would get the private sector involved in valuing, investing in, and lending against troubled assets. There would be less total government borrowing need, meaning less crowding out of private borrowers. The US government’s creditors—those who buy our Treasury Notes and Bills—would have less to fear. The capital needed to make such investments or loans would form in the private sector—probably in part through private investment vehicles such as hedge funds and private equity. Skeptics might question whether that capital would really be forthcoming, but I maintain that part of the genius of our capital markets is that the opportunity will be seized by many enterprising investors. Some of these investors will indeed make great fortunes taking such risk, and the prospect of riches is the fuel that makes markets work.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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