Thursday, March 5, 2009

More banking bailout proposals - Bebchuk Plan

As all the semantic jugglery, witness the pre-privatization nomenclature, would appear to suggest, nationalization continues to remain anthema (Greg Mankiw sums up the reasons nicely) to policy makers.

In keeping with semantic play, Arindrajit Dube sums up the three options - Darwinian Liquidation (or "Natural Selection"), Organized Liquidation (or "Intelligent Design") and Bailouts with Temporarily-Soft Budget Constraints (or "Zombies on Life Support"). While the first, preferred by many of the market fundamentalists, may end up liquidating much of the economy itself, the third, being practiced as Geithner Plan, may only postpone the inevitable. Which leaves us with the second, which is nationalization (sorry, pre-privatization!) in some form or other.

The latest proposal (more details here and here) for bailing out troubled institutions comes from Prof Lucian Bebchuk of Harvard Law School. He has proposed a two-level plan to leverage private capital to facilitate price discovery and create a market for troubled assets. Instead of creating a large "aggregator bank", as is being planned under the Geithner Plan, the government should first focus on establishing many competing privately managed funds, financed with both private and public capital, to buy up the distressed assets. Then the bailout money can be allocated to these competing funds using an appropriately designed market mechanism, so as to ensure that the tax-payers get the best deal possible.

This could generate a competitive market at optimal cost to the tax-payers - the "profit share captured by the funds' private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets" and "the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets".

He proposes a market design where either "the participating public capital assumes more downside risk or captures less of the upside". One way would be to involve provision of non-recourse loan, to the extent of a specified fraction of the capital of each participating fund, with these terms - loan will be re-paid first from the payoffs of the private fund; will be paid only from those payoffs (being non-recourse); and will carry a low interest rate. He writes,

"Suppose that the government wishes ultimately to (purchase) $1 trillion in... troubled assets, it will begin with a "pilot" round in which private funds with an aggregate purchasing power of $100 billion are established. The government should invite bids from private managers seeking to participate in this round. Each bid should indicate first the maximum fraction of the fund's capital that the private side commits to contribute as private equity capital (rather than using debt financing from the Investment Fund for this purpose) and second, the size of the fund the private side seeks to establish... The government can also set... a minimum level of equity capital contribution, say 10% of capital, below which bids for establishing a fund may not be submitted.

Once the bids are made, the government will set the level of its participation under the program at the lowest level that can be set while still allowing for establishing funds that collectively have the total target capital for the program's initial round. Thus, for example, the government will set the equity contribution percentage at 40% and the government's debt financing at 60% if, given the received bids, the 40% level, but no higher level, will result in establishing private funds that collectively have the target level of aggregate capital."

It now appears, as Felix Samon points attention to, that the Obama administration too may be going along similar lines to the Bebchuk Plan.

Under the Financial Stability Plan (FSP), announced to spend the remaining $350 bn of the original TARP, the Treasury had already proposed a Public Private Partnership initiative to leverage private funds to clean up or create liquidity for the distressed assets. The Bebchuk Plan provides a model to implement this initiative.

In any case, it cannot be denied that the Bebchuk type proposals are an attempt to stave off what is perceived as the last resort measure - nationalization. While supporters are convinced that a market in such distressed assets can be created, opponents of such "half-measures" argue that such assets are virtually worthless and is only delaying the inevitable and prolonging and thereby exacerabating the pain.

Update 1
Lucian Bebchuk responds to critics of his plan.

Update 2
In many ways, the Bebchuk plan is a varaint of the "good bank" plans, floated by the likes of William Buiter, Paul Romer, and James Kwak. As Kwak rites, "Romer suggests using government capital to create new, healthy banks that can essentially compete with the existing banks, which can then be treated under existing rules and regulations - if they become insolvent, they get taken over; some of their liabilities (like FDIC-insured deposits) are guaranteed, and some aren’t - and that’s that. Buiter goes a step further and recommends taking away banking licenses from the legacy bad banks and making them institutions that just run off their existing assets, in part by selling their good assets to the new good banks.

Romer proposes creating wholesale banks (the kind that only have businesses as customers) because they can be created more quickly (they don’t need huge branch networks), which would then buy good assets from legacy banks. Buiter also says that the new good banks will buy assets, such as deposit accounts and presumably branch networks, from the legacy banks."

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