Will The Bailout Work?
Michael Spence 10.06.08, 12:00 AM ET
The U.S. economy, and much of the rest of the developed world, is in the midst of the collapse of an asset bubble fueled, in the main, by excess leverage.
The collapsing asset values have led to damaged balance sheets in major financial institutions, capital adequacy problems and, recently, a drying up of credit. The last is the most serious. The unavailability and cost of credit have led to further collateral damage to assets, an inability (or, in some cases, unwillingness) to raise additional capital, and a widening of the credit problems.
Central banks have been injecting capital, taking on an ever wider and riskier array of assets as collateral. And there has been a sequence of interventions with respect to specific institutions that has been growing in terms of size and frequency.
Yet it became clear to the Fed and the Treasury--as panic developed and short-term credit dried up--that the case-by-case approach would be unlikely to solve the problem, or at least was a much riskier path than a more comprehensive approach. It was as if we had a very good and alert fire department, but too many actual and potential fires to make the fire-fighting mode by itself an effective resolution of the problem.
As the sequence of distressed or at-risk financial institutions extended, and the frequency of emergencies increased, investors panicked and credit markets locked up. Banks stopped lending to each other. The transparency fog surrounding derivative securities did not help. The locking up of credit markets dramatically increased the likelihood that the fear that every institution was at risk would become a reality--a case of self-confirming expectations. This led the Fed and the Treasury to conclude that dealing with emergencies case by case was, while necessary, far from sufficient. In this judgment, and in the need for action and speed over design fine-tuning, they were surely right. There is a real risk that the European economy is entering into a similar dynamic.
The pressing issue is the restoration of credit at a reasonable cost, so that the financial sector, the business sector and the housing markets can function. A failure in this regard would produce much wider and deeper damage than just the resetting of the values of assets and liabilities, the concomitant de-leveraging and the failure of a few financial institutions.
One should ask why a housing bubble caused by low interest rates and the inappropriate and excessive extension of credit has caused such a widespread financial crisis.
The short answer is balance sheets. Through securitization, the packaging and repackaging of mortgages (and securities backed by mortgages), the holding of the highly levered and now damaged securities was widespread--including in all the principal financial institutions that supply credit to the economy.
Insurance also played a role. Securities that looked risky were nevertheless rated highly and purchased in part because of the addition of credit insurance. But insurance only works when individual risks are substantially uncorrelated in the pool that is being insured. No one would undertake to provide hurricane insurance for a single town on the Gulf Coast. The problem is that when risk is as systematic as it has become in the financial sector, you can't provide insurance without an enormous capital underpinning. That was not there.
The profitable business of providing insurance until the risk materialized morphed into financial distress, and the insurance vanished, further damaging credit ratings and balance sheets. This is not to say that derivative products are not useful in moving risk around. They are. But major revisions in the way risk is assessed will be an important part of the aftermath of the crisis, and it will include considerations of appropriate capital requirements and regulations.
To deal with the credit lockup, capital has to be injected into these institutions and, if possible, a value established for some of the assets that they already hold. An important feature of the current situation is that pretty much all of the institutions that are the normal channels for providing credit have been damaged and have capital adequacy problems. Private and Sovereign Wealth Fund capital, which was injected earlier has not fared well, and, as a result has dried up. It is widely accepted that at this stage the only viable source of capital is the government.
The challenge, then, is to inject capital into the only channels we have for providing credit--to wit, existing institutions such as the major banks--without bailing out the existing investors. If by bailing out one means adding value--with the starting point being the current very depressed prices for equity and preferred stock in the financial sector--it probably isn't possible to inject capital and avoid bailing out unless the government takes ownership of a substantial fraction of the sector at least for a period of time.
The bailout legislation just passed would inject capital by allocating $700 billion to buy mortgage-related assets. Other provisions include limits on executive compensation, the ability to have equity in the form of warrants or options for institutions that sell assets to the Treasury, and a commitment to aggressively reset mortgage terms to limit foreclosures and to help households with debt service they cannot afford. In addition, deposit insurance in banks is expanded, and there are tax adjustments that have been added for political reasons in the second round. The additions, plus the huge market reaction to the first round rejection, were sufficient to get the altered plan passed.
One goal is clearly to help households whose mortgages are either under the current value of the house or who cannot pay the interest and principal on the mortgage. This is important politically, and can be accomplished through the purchase of bundles of mortgages, resetting the terms of the mortgages and avoiding foreclosure.
A second is to initiate a process in which something like market values are established for assets whose value is currently highly uncertain, or discounted dramatically, because of counterparty solvency, visibility and transparency issues.
The third is to inject capital into the existing system, by replacing highly discounted or under-priced assets with cash. There is a debate going on about what the "right" price is for these purchases. The argument is something like this: If the purchases are at current extreme distressed prices, not much capital will enter the system; and if they are at higher prices, the institutions are being bailed out and the taxpayer is footing the bill, or there is compensating warrant dilution.
The theory of the case, as outlined by experts like Bill Gross and Warren Buffett, is that the assets, when properly managed with ample capital backing, have intrinsic value that can be estimated with hard work and due diligence. Further, these assets can be
purchased at well below these intrinsic values because the holders and other potential buyers do not have adequate capital.
The assets should be purchased at a discount to intrinsic value so as to yield a reasonable return (7%) on the taxpayers' investment, but above the current market value (if there is one) of the assets. The sellers gain because they add capital and reduce distressed assets; and because markets that are currently closed for these mortgage-related assets begin to open, and prices are established, restoring both value and visibility to parts of the balance sheets.
This does not mean that solvency will return to all institutions, but a more realistic assessment of their value will emerge, and it will be easier in some cases to raise private capital. In other cases the institutions will be insolvent even with more realistic valuations for the assets and go into Chapter 11 and be dismantled.
The quality of the due diligence to sort through the wide spectrum of quality in the asset pool is crucial to the success of the program. Without it, the government could end up purchasing assets at the bottom of the quality spectrum, knowing less about the underlying quality than the sellers.
The government, with patient capital, then holds the mortgages, resets terms and waits for private capital to enter the system. If the due diligence was done well, market prices (including housing prices) will, over time, return to something like the intrinsic values, at which point the government will be inclined to sell the assets/mortgages at a measured pace. Will this work? It could. No one knows for sure. But $700 billion is not enough additional capital. The bailout will, therefore, stand or fall on whether it succeeds in causing private capital to return to the sector. It is even possible that if the strategy works, large external holders of treasuries will find the risk-return mix attractive.
Michael Spence, chairman of the Commission on Growth and Development, is a 2001 Nobel laureate for economics and a senior fellow at Stanford's Hoover Institution.