Friday, November 14, 2008

US bailout changes course again?

What started as a plan to bailout financial institutions in the US by purchasing their troubled assets like illiquid mortgage-backed securities in order to free up banks to resume normal lending, Troubled Assets Relief Program (TARP), is undergoing changes at breakneck pace. The purchase of troubled assets was soon abandoned in favor of a British style direct injection of cash into ailing financial institutions (bank capitalization) in return for equity stake and restraints on executive compensation and dividend payouts.

This change in strategy, coupled with the decision to guarantee bank deposits and inter-bank loans, have increased the willingness of banks to lend to each other. But it has had limited effect on de-clogging the commercial and retail lending markets. The uncertainty surrounding counter-party risk has ensured that the market for commercial debt backed by consumer and business loans has remained at a near standstill since Lehman Brothers collapsed in September. Borrowing costs for credit card issuers are at least five percentage points higher than they were before the credit crisis began. Financing costs for automobile lenders are even higher. Even student loans that are guaranteed by the federal government have been difficult to finance.

Now, in the latest course correction, Treasury Secretary Henry Paulson, has announced that that apart from banks and thrifts, companies that issue credit cards, make student loans and finance car purchases could expect equity injections. It is expected that such interventions would unlock the frozen consumer credit market and enable consumers to directly benefit from the bailout. This assumes importance in view of the increasing feeling that counterparty risk wary financial institutions have shut off their lending taps, despite the substantial infusions from Treasury.

Under the original plan, the Congress had approved a total amount of $700 bn, of which $350 bn was approved for immediate use and the remaining $350 bn to be cleared on fast track as and when required. The Treasury has already committed about $290 billion, with $125 billion allocated to the nation’s nine biggest banks and investment banks, another $125 billion for publicly traded regional banks, and $40 billion to expand the existing bailout of American International Group (AIG), the insurance conglomerate that collapsed in September.

There are a growing number of influential voices, including from the camp of President-elect, who are calling for expanding the scope of the bailout even further to include distressed automakers like GM and Ford, and refinance the mortgages of homeowners facing foreclosures. Though the Treasury has so far strongly resisted these suggestions, for fear of diluting the bailout and furthering moral hazard, it may be only a question of time before these too get included into the bailout.

The imminence of an expansion of the bailout to include corporate America raises serious questions about the role of tax payer bailouts as against bankruptcy filings. Robert Reich argues that such situations, where major private firms need to be bailed out, are best handled through Chapter 11 bankruptcy protection laws. Under it, creditors take some losses, shareholders even bigger ones, some managers' heads roll. Companies clean up their books and get to make a fresh start. And taxpayers don't pay a penny. He is correct in arguing that even if these firms are bailed out, their executives, shareholders and creditors should accept losses similar to that under Chapter 11, so that the burden on taxpayers are minimized.

Bankruptcy offers numerous other advantages over government equity injected bailouts. Government equity stake is likely to reduce the flexibility for the management in pushing through important decisions. Further, bankruptcy filing will keep a lid on unions and wage increase pressures. Further, as companies in industries like airlines, steel and retailing have shown, bankruptcy can offer a fresh start with a more competitive cost structure to preserve a future for the workers who remain. And it contains moral hazard concerns, besides reducing the cost for the tax payers.

Update 1
Joe Nocera outlines a plan by Jim Grosfeld to assist troubled home mortgage holders and prevent foreclosures, without modifying mortgages and without violating contractual obligations to bondholders. The proposal is to provide a 2 or 3% subsidy on the mortgage repayments to the distressed homeowners burdened by the most risky and unaffordable mortgages ever issued (FDIC chairwoman Sheila Bair estimates this number at about 3 million), so as to lower their monthly interest payments and incentivize them to stay on. If the subsidy were 2%, the total subsidy would be a small amount of $9 bn. Grosfeld proposes providing this subsidy for 5 years, which would cost a total of $45 bn.

Another proposal is that put forward by Daniel Alpert, outlined here.

Update 2
Some developers in the US are already offering a Rent Now, Buy Later plan, which is a version of the Daniel Alpert Plan.

Update 3
Glenn Hubbard and Christopher Mayer of the Columbia Business School, lend their weight to a plan to lower interest rate mortgages (to say 4.5%), indexed to the Treasury yield so as to prevent bubbles.

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