Wednesday, October 1, 2008

Modify Paulson’s plan!

Do not offer to buy bad assets from financial institutions but offer them capital infusion, Mr. Treasury Secretary! Cannot you invent any fiscal incentives for the first-time homebuyers that would re-vitalize housing market?

Events of the current financial crisis unfold very quickly - during those days and weeks spent abroad or in the outback, in particular. That is why I have had no comparative advantage over financial press to comment the process.

Paulson’s rescue plan rejected by the House would have given the bureaucrats broad powers to buy mortgage backed securities from distressed financial institutions at deeply discounted prices. That is, the bureaucrats would determine in casu how big a hidden subsidy each deal would involve for the seller institution.

Why cannot the banks and other financial institutions themselves trade such assets at market prices? They lack strong enough financial muscles.

The idea of recapitalizing financial institutions in the April 21st post stated that only equity injections and other sources of tier I capital will truly convey the banks over the “death valley”.

Since nationalizing Freddie Mac and Fannie Mae less than a month ago, the US Treasury has been subject to wide criticism for rewarding short-term players, short sellers, by nullifying the existing long-term value investors’ equity stakes. On this chosen road no private sector investor will participate in the recapitalization of any US financial institution.

US Treasury must do it itself by offering convertible notes which would count as tier I capital for the institutions. All banks subject to federal regulation should be eligible for accepting such an offer of capital infusion in proportion to their size, measured by their risk-weighted assets and off-balance –sheet commitments as stipulated by the BIS standards. The total of the capital offering of the size of 200 billion dollars, about 1.5 percent of the GDP, is roughly needed.

And, the terms should such that the offering would be attractive enough even for the most solvent and most liquid banks: a seven-year note, the first two years at the current interest rate on the 2-year US treasuries (about 2 percent), the third year interest rate at Libor, and thereafter each year at rising penalty rates above the Libor.

Such terms would buy time for settling the crisis. The offer of capital would provide the strongest institutions enough power not only to acquire assets at market prices from the weaker ones and to raise additional tier I and tier II capital in financial markets, but also would offer them an incentive to pay back the notes to the US Treasury before the convertibility carver threatens their independence.

Instead, the taxpayers’ money should be directed towards attracting buyers to the housing market. Buyers flee the market if they expect home prices to further fall. The most obvious target group, mentioned most often, is the first-time buyers, whether they intend to buy new or existing homes. There must be ways of temporarily granting a more generous mortgage relief or deducting one-off expenses from taxable income.

The above scheme would represent a market solution to the current crisis of financial markets in contrast to Paulson’s plan of giving power to the bureaucrats, i.e. to the central planners.

(Incidentally, I happened to participate in settling the Finnish banking crisis as deputy member of the board of the Government Guarantee Fund)

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