donsutherland1

This afternoon, CNBC reported that Treasury Secretary Paulson was working on an RTC-type solution. Details were not yet available, but stocks soared on the news.

I suspect that the solution will involve a temporary government entity that would take at least the most toxic paper off the balance sheets of the nation's financial institutions. Purchases of such instruments would entail a "haircut" or discount, but that discount would not be so large that it would merely exacerbate the liquidity challenges facing the nation's financial institutions.

In establishing such an entity, I believe the federal government should impose an across-the-board reduction in spending in all discretionary areas so as to reduce the borrowing that might otherwise be needed to finance such a mechanism. More aggressive deficit reduction would be preferable and I cannot overstate the adverse impact the breakdown in fiscal discipline has had on the federal government's flexibility to respond to challenges such as the one that is now confronting the U.S. Unfortunately, given the recent lack of priority given to fiscal restraint, I expect that all of the financing for such an entity would be borrowed.

In my opinion, in order to overcome the moral hazard associated with such an entity, I believe that legislation that would create such an entity should also lay down some firm risk management mechanisms including:

1) A drastic reduction of financial institutions' ability to maintain off-balance sheet vehicles. This would increase disclosure and improve the quality of market information.

2) Increased capital requirements to be phased in over time.

3) Loan portfolio diversification e.g., no institution could have let's say more than half of its loans associated with any single asset class e.g., real estate. I believe IndyMac had 75%-80% of its assets tied up in mortgages. That led to an excessive concentration of risk.

4) Better maturity matching (e.g., the breakdown of short-term/long-term assets should be reasonably similar to the breakdown of short-term/long-term liabilities). For example, if one examines the December 31, 2007 balance sheet of Washington Mutual, one finds:

Assets:
Short-Term: $21.081 billion (6.4% assets)
Long-Term: $306.832 billion (93.6% assets)

Liabilities:
Short-Term: $251.929 billion (83.1% liabilities)
Long-Term: $51.400 billion (16.9% liabilities)

Short-term liabilities are essentially those that need to be paid within a year or the operating cycle, whichever is longer. WaMu's balance sheet revealed that the bank had about $0.083 for every $1 of short-term liabilities. That is a recipe for a liquidity crisis.

Furthermore, given the bank's structure, it was subject to considerable interest rate risk. Essentially, the bank is structured to received a fixed interest rate from its assets while paying a variable interest rate on its liabilities (given the disproportionate share of short-term liabilities).

5) Substantial reduction, if not elimination, of the practice of "marking to model." The earlier rule of marking to the lower of cost or market should apply. Where markets are illiquid, steep discounts should apply. Marking to theoretical models did not provide the kind of useful information that decisionmakers needed to understand their firms' risk exposure.

6) Increased transparency.

7) Indexing the ceiling on Fannie's and Freddie's conforming mortgages to nominal economic growth and ultimately breaking up these institutions into smaller entities and privatizing them. Indexing conforming mortgages to nominal economic growth would reflect the reality that incomes are key to financing mortgage payments. Allowing the ceilings to rise more quickly would allow for a greater accumulation of debt and increased risk of a new credit-driven housing bubble in the future.

8) Requirement of income and asset verification for all mortgage applicants.

9) A minimum downpayment requirement for all mortgages.

10) A comprehensive review of the type of financial instruments that can be constructed, in part, from securitized mortgages. Perhaps Europe's covered bonds would offer a good model.

When it comes to balancing the risks associated with moral hazard and those related to systemic financial system failure, policymakers will need to err on the side of addressing risks tied to systemic failure. If systemic failure occurs, in the resulting economic carnage, moral hazard becomes essentially an academic issue. Smart, though not excessive, regulation can constrain moral hazard.

Mach

You'd think they would have already done this sort of thing.

Your suggested solutions all seem to capture the key points that just seem to make sense from a high-level look at this problem. Fund it, but pay for it by making cuts rather than debt (especially considering debt was a key component of this crisis). Transparency (key to enforcement), smart regulation, and breaking up those "too large to fail", so they can indeed be allowed to fail. You captured everything currently in my head.

The unforunate part is whatever happens, be it some quick stock market recovery or a quick end to the "toxic paper", the economy will still suffer significantly in the short term.

It seems like debt, using debt, using debt, is just like that old check writing scheme that people do. They write check from BANK-A, and pay for it with a check from BankB, and C, and so forth. And they can keep this up sometimes. But when it hits a snag, the whole chain unwinds and a lot of people lose money. Basically we're letting financial institutions participate in this sort of fraud when we don't regulate them (and enforce it), in our market. From what I read it's been bad sub-prime loans (debt), lended via debt, insured via more debt, all from institutions themselves which carry enormous amounts of debt, supported by a government mired in debt...

-Mach

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SouthernDemocrat

What is your opinion of having some kind of banking / finance / insurance institutional "superfund"? Basically, have a system in place for bailouts like we do for hazardous waste cleanup. With the Superfund, we require (although the Bush Administration ended this requirement) that hazardous waste producing companies contribute to a fund that pays for the cleanup of hazardous waste contaminated sites. This took the primary responsibility of cleanup off of the taxpayers and onto the industries that contaminated the sites in the first place (that is until the Bush Administration shifted the responsibility back to the taxpayers).

Could something similar not be setup for the financial industry? Basically a fund that all banking / financial / and qualifying insurance companies would be required to contribute to, and that trust basically be held in the event of a crisis where bailouts must occur. Therefore, taking the primary burden off of the taxpayer and onto the industries that made the poor decisions in the first place. What are your thoughts on this?

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donsutherland1

SouthernDemocrat,

I believe an insurance-type premium/surcharge imposed on mortgages that are originated in the future could be useful in financing an FDIC-style insurance fund that could complement some of the other reforms I described at the beginning of this thread. Such a premium/surcharge would have a modest impact in increasing the cost of mortgage financing in exchange for reducing overall risk.

I don't believe one can impose a superfund-type arrangement now, as such an arrangement would probably risk exacerbating the liquidity challenges that are already facing the nation's financial institutions. If the firms were liquid and profitable, I think the case for such an arrangement would strong.