It is hard to come up with the right solution if you are addressing the wrong problem. Which is why Hank Paulson’s US$700bn, Troubled Asset Recovery Plan (TARP) is the wrong solution for US credit woes. The best thing that could be said about it is that in these febrile markets agreeing to any plan may help to restore confidence and buy policy-makers enough time to find a better solution that would cost tax payers less and be more likely to succeed.
What is the problem we are trying to solve it and what is the better solution?
After an eighteen month cycle of write downs of assets, forced sales and further write downs, banks have travelled from illiquidity to the borders of insolvency. Banks asset values can no longer support bank liabilities. Capital is insufficient. Swapping troubled assets for cash - the essence of the TARP - may strengthen asset quality, but by crystallising the current distressed price of assets, it does nothing to address the problem of asset levels being too low relative to the level of liabilities. This was the right course 18 months ago, but not now. It is fighting the battle of illiquidity not insolvency.
The TARP prayer is that by strengthening asset quality, banks would be able to raise fresh capital, but there is no guarantee of this. Investors will be mindful that even if the quality of the existing assets improves, banks are on the edge of insolvency, their current business models of securitisation, mortgage lending, equity short-selling and prime brokerage need to be rethought and other investors with as deep pockets as the sovereign wealth funds are nursing large losses for stepping in early. Tax payers may easily find themselves on the hook for another round of cash. Recall that Lehman Brothers, one of the smaller investment banks, went bankrupt with US$639bn of assets.
TARP also manages to save the blushes of bank creditors by putting tax payers at risk. This is not the time for moral outrage to cloud clear thinking, and it should not be forgotten that policy-makers share much blame in this crisis, but it does seem a little perverse to protect those that were paid to take the risk of banks failing, and instead to tax those that were not.
The appropriate analogy is a Chapter 11-type debt restructuring of a bankrupt country or company. By swapping a bank’s debt for equity, and hence reducing bank liabilities to match the lower level of assets, a bank can stay in business without State control or money. It is done all the time for insolvent companies, though I am not underestimating the difference of today’s crisis in terms of the systemic nature of the loss of confidence in the financial sector and the sheer pace of developments. Moreover, corralling creditors to abandon their contractual rights is not easy at the best of times.
Debt for equity swaps: A better plan
When all creditors are desperate for cash, none may be willing to give up a bit to ensure all end up with something. However, as Anne Gelpern of Rutgers University points out, loan agreements are sacred but they are not suicide pacts. In my plan, once a bank declares that its minimum regulatory capital level is in danger of being hit, it can appeal to the government to facilitate a debt re-organisation where debt is swapped for equity so that bank liabilities fall back below back assets with some buffer.
The government can apply a carrot and a stick to support agreement and confidence that the problem will be solved. Where debtors refuse to swap sufficient debt into equity, the central bank’s extended liquidity arrangements could be withdrawn for that institution. I am not convinced that it is required, but if it would support confidence in the debt markets, the government could also offer to co-invest in the equity with the creditors, through a parallel purchase of preference shares up to a maximum level that would put tax payers in hock for $70bn, say, rather than $700bn. Under this plan, managers and shareholders take the largest proportional hit. Bond holders share in the pain. The government’s principal role is as facilitator of debt re-organisation, not as the guarantor. Losses by creditors will help to re-introduce investment discipline, not reward indiscipline. Those with a capacity to diversify risks through time are not forced to crystallise losses today. In a world that has become capital-short, fresh capital is not required. By closing the asset-liability gap, the Damocles sword of potentially large asset sales now is removed, supporting the market recovery. And creditors and tax payers may even end up gaining from their investment in stability as the equity of these smaller, s recover.