Henry Paulson's Troubled Assets Relief Program (TARP) is designed to alleviate the disruption of the US banking system caused by its holdings of various assets of dubious value (ie "troubled"). In RebelEconomist's opinion, the TARP tackles the problem the wrong way round by trying to remove the troubled assets from the banks. As an alternative, this post proposes the Partitioned Residual Assets Trust (PRAT) scheme, which approaches the problem from the opposite direction by selling off the safer parts of the banks.
The troubled assets comprise various structured products, typically including mortgage debt, which the banks mostly came to hold by accident, either when they were left with securities created for sale just before the market dried up, or when they took them back from off-balance-sheet investment vehicles that could no longer attract funding. At first, the banks' problem was seen as a lack of liquidity, with the complexity of the troubled assets making them hard to value and therefore difficult to sell to raise cash to repay creditors or for new lending. More recently, however, it has begun to appear that the problem is that the banks' existing and potential creditors are refusing to renew or increase lending to them for fear that some banks are insolvent. The creditors suspect that the troubled assets' realisable market values, and maybe even their
In its original form, the TARP was supposed to restore confidence in the banks by buying their troubled assets, partly to remove them from the banking system and partly to revive the market for the troubled assets by establishing transacted prices and guaranteeing a backstop bid. In doing so, however, the TARP faces the same valuation problem as potential private sector buyers. It has been suggested that the TARP could determine market prices by reverse auctions, offering a progressively higher price for troubled assets until willing sellers emerge. Unfortunately, the securities concerned are typically highly idiosyncratic, partly because of the large number of different pools from which mortgages may be drawn, and partly because they were individually structured to achieve designated credit ratings and to appeal to particular buyers, so there may well be only one seller of any particular security. And their complexity would make it difficult to design a formula to reduce several variables to a single common standard of value (eg as yield is used to compare bonds with different cashflows) that would allow a range of assets to be admissible in each auction without giving any an inherent advantage. The danger is, therefore, that the TARP would pay more for individual assets than the minimum price that a bank would accept in each case.
Even if a way of determining competitive market prices for troubled assets could be found, the outcome might not raise confidence in the banks holding them. Although the availability of transacted prices should reduce uncertainty, any bank that had been assigning higher book values to such assets would have to report a revaluation loss and correspondingly reduced capital, and it is not inconceivable that using market prices for many assets would show some banks to be insolvent. It could be argued, however, that the TARP should pay more than market value for troubled assets, because it can hold them indefinitely and could therefore forego the illiquidity discount reflected in their present market values, which would give the banks some extra help. In fact, the TARP could afford to pay up to
An alternative way for the authorities to help the banks cope with bad assets, as used in previous banking crises in other countries, is to recapitalise troubled banks by buying common or preferred shares in them. This gives each bank involved additional assets to absorb losses, in return for which the public gets some claim on the bank's future profits if the recapitalisation is successful. Preference shares rank above common stock in the creditor pecking order, ensuring that losses are borne first by the banks' existing shareholders, but typically pay a fixed dividend, so that unless they are convertible into common stock their return does not increase with the profitability of the bank. The TARP was amended during its passage through Congress to include the option to buy stakes in the banks as well as their troubled assets, and following the British government's lead in taking stakes in British banks, the facility was used in the USA. The main problem with capital injections is how to set the terms to be fair to both taxpayers and existing bank shareholders. To be more precise, for a given amount of cash, how many shares should the TARP receive (note that it would not be appropriate to pay the market price of existing shares, because injecting cash makes default less likely and therefore reduces the value of the implicit option represented by the shareholders' limited liability), and, in the case of preference shares, what dividend should they pay? Only in the extreme case where a bank is definitely insolvent would it be reasonable to simply write down the value of the shareholders' equity to zero before injecting fresh capital – in other words, to nationalise the bank – as Sweden did with some banks during its banking crisis in 1992. If there is any doubt that the nationalised bank was insolvent, its shareholders can be expected to claim that the government is appropriating their property. Also, taking a public stake in a bank is a blunt instrument to deal with problems emanating from a troubled minority of assets. If the stake is held in the form of common stock, it is necessary for the government to decide whether, and if so how, to exercise shareholders' control rights, and owning shares of any kind exposes the public to all kinds of fresh business risks not necessarily arising from the troubled assets.
A better solution, it occurs to RebelEconomist, would be to combine a
The details of the plan are as follows. In order to decide which banks ought to be partitioned, and which of their assets should be retained by their existing shareholders, a rough conservative valuation of each bank's assets and liabilities would be made, together with an estimate of how uncertain these valuations are. If this valuation suggests that the bank is, or has a significant probability of becoming, less capitalised than some minimum standard, the bank would be partitioned. The assets with the most uncertain values (ie the troubled assets) would be assigned to a trust fund to be passively managed on behalf of the existing bank shareholders by government-appointed managers. In other words, after partitioning the bank, the residual assets are placed in a trust, hence the acronym PRAT. Each bank share would be converted into one share in the trust. PRAT shares would be
The PRAT scheme has the following notable features:
(1) The safe bank should be regarded as highly creditworthy, and be trusted by the public to provide typical banking services. While subject to banking regulation and supervision as normal (albeit probably tightened in the light of recent experience), it would be free of government control. Beyond the standard deposit insurance, it should not be necessary for the government to guarantee any of the safe bank's liabilities.
(2) Because the safe bank should be readily marketable, the existing bank shareholders should receive a fair value for it, meaning that they cannot claim that they have been cheated by the government. The value of the government debt injected into the bank to make it safe should be reflected in its flotation price, and so its generous capitalisation should not increase the debt burden on the PRAT. Although the valuation of the troubled assets used in the process was rough, these values determine only whether and how to partition the bank and are not used as transactions prices.
(3) Since the existing bank shareholders retain the troubled assets through their equity in the PRAT, they bear any losses these generate in future. Besides being cost-efficient from the public point of view, this solution also minimises moral hazard. This is not unreasonable, given that the shareholders were supposed to be in control of their business and therefore ultimately responsible for its mistakes, and were well rewarded during the boom years, not least for bearing the risk associated with being at the bottom of the pecking order. And if the troubled assets do come good, the PRAT shareholders benefit fully. In effect, the trust concentrates the risky part of the bank's balance sheet in a vehicle which, unlike a bank, does not perform a vital function in the financial system.
(4) While the PRAT should begin with positive equity based on the book values of the troubled assets, if their market values are more realistic, the trust might actually be on the edge of insolvency. This is why the PRAT is established as a trust rather than under shareholder control – to prevent the shareholders "gambling for redemption" in the hope of generating enough return to cover the trust's liability to the government. The potential cost to the taxpayer is limited to the PRAT's debt, plus its administrative expenses. Since separation from the troubled assets can be expected to give the existing bank's junior creditors a windfall gain in the value of their claims, it would be appropriate for them to bear some of the cost of the solution, which could be achieved by swapping some of their claim for PRAT equity. Bank employees' unvested stock bonuses from previous years could also be converted to PRAT shares.
To sum up, instead of removing the troubled assets from the banks, it would be better to remove the banks from the troubled assets. The PRAT scheme could achieve this in a way that is fair to both existing bank shareholders and taxpayers.