Sunday, 9 November 2008

A right PRAT

























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 "hold-to-maturity" values (ie adding back any illiquidity discount), are significantly less than the book values at which they are recorded in the banks' published accounts, not least because mortgage debt has become more risky as US house prices have fallen.

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 hold-to-maturity value before it would be expected to lose money on each purchase. Unfortunately, the complexity of many of the troubled assets makes it difficult to determine their fair (ie properly allowing for default risk) hold-to-maturity values too. Also, paying more may give some banks more help than they need to return to reasonable health, meaning either that the cost to the public is greater than necessary or that fewer banks can be helped with a limited amount of money.

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 market-value separation of the troubled assets from the parts of the banks that provide banking services with preserving the existing bank shareholders' interest in the troubled assets. The basic idea is that, since it is the troubled assets that are hard to value, the existing bank shareholders should keep these while the rest of the bank is sold.

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 non-voting, but marketable to allow its shareholders to liquidate their stake if they wish. The gap remaining in the bank's balance sheet remaining after removal of the troubled assets would be filled by an injection of government bonds of sufficient size to bring the bank up to some highly prudent capital ratio. This safe bank, which should be relatively straightforward to value accurately, would be floated, ideally by auction, with the government receiving the proceeds to defray some of the value of their debt injection. The remaining liability, owed to the government, would then be assigned to the trust fund.

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.

14 comments:

Etz said...

Fraudulent securities are not "troubled assets". They're worthless pieces of paper.

TRAP: A confining or undesirable circumstance from which escape or relief is difficult.

Let them fail. period.

RebelEconomist said...

etz,

I suspect that you are right, and most of these securities will prove to be worth drastically less than their face value. My impression, which I alluded to in the post, is that many structured products were created precisely because their complexity and individual nature allowed the banks to sell bundles of relatively low value components for a high price to undiscerning customers. I would not be surprised if many of the banks were insolvent as a result of being left holding them, which is why the banks' portfolios of these securities should be spun off with the bank shareholders' equity, so that they can fail with the minimum of collateral damage.

What worries me is that the banks must represent only a fraction of the losses sustained on these securities, and that there must be many more of them in mutual and pension funds, or held by corporate and municipal treasurers, which have yet to be realistically marked.

By all means, any proven fraud should be punished, but as I said in a previous post, fraud or no fraud, to help pay for the clean-up I would levy a windfall tax on the bank staff who benefited from creating this mess.

etz said...

Rebel,

We are in complete agreement except maybe on the magnitude of the clean-up effort.

john c. halasz said...

Actually, rather than taxing the the sector-specific windfalls of financial "players", I would advocate a surtax on the net worth of millionaire households across the board for as long as required, since virtually every one in such a class, if they didn't lose their prior gains in the bust, has benefited from the asset inflation boom and from the imprudent/dysfunctional tax cuts on the highest incomes and unearned income, which helped to stoke the bubble, (since rather than such cuts incentivizing increased real investment, they actually largely just bid up the existing supply of financial assets). Aside from the equity/revenge factor with respect to the torches-and-pitchforks crowd, I'm functionally thinking of the paradox off resolving and replacing bad private debt with "good" public debt, at a time when a severe recession will be reducing fiscal revenues and straining deficits, and when a decrease in imports likely will reduce the dollars to be recycled by trade-surplus economies. If an inflationary monetization of debt is not to be attempted, a source of domestic savings needs to be found, and I can not think of any other viable source of raising domestic savings to lend international credibility to a depreciating dollar and prevent a $ crash with suffocatingly high interest rates. I would suggest taxing asset wealth and not income, since not only is it an accumulated stock, not a current flow, and hence has the "right" incidence, but the incentive effects of income in inducing needed inter-sectoral shifts, (e.g. bankrupcy specialists, who previously experienced lean years), should be preserved, (though I'm definitely not against increasing the progressivity of the tax system, though a progressive consumption tax would be better than the traditional income tax). Of course, enforcement problems aside, a net worth tax would tend to depress the prices of financial assets further, but that, to my view would be a good thing: i.e. decreasing the attractiveness of financial speculation vs. the formation of uncertain, long-run real capital formation in the productive economy, the sort of re-industrialization that I think needs to occur.

As for TARP, it stuck me in it's initial formulation as a nonsensical, self-referential mush, MLEC 2.0. But the problem in general with any sort of ring-fencing of bad assets into a good bank/bad bank scheme, like the RTC, is that the bad assets have to be effectively dead to be distinguished from "live" assets, which TARP 1.0 obviously failed to do, and drawing that boundary, short of bank failure, is, in these circumstances, devilishly hard to do, even leaving aside the very large volumes of structured financial "assets" and the "lemons" problem motivating any sellers. I'd been puzzled by how slow it was taking for the obvious financial problems to register on the markets and the real economy before Sept., attributing it to the latitude involved in financial accounting, whereby lots of banks and other entities were delaying recognition of losses, which is probably the case, just as I've been astonished by the rapidity of the global contagion since. Last May, I advocated in comments on econ blogs preparing standby legislation for bank nationalization, though other than a few supporting comments, and some similar comments elsewhere by other commenters, I found little on-line discussion of the prospect. Until, "suddenly", it became what mainstream economists thought "all along". I would have put $500 billion into the FDIC, (a rough guess as to the "final" losses of core capital in the U.S.), beefed up the bank inspector corps, and sent them in to scour the books of every single bank, with fairly tough standards, quickly closing down the insolvent ones and re-capitalizing the ailing-but-solvent ones,- (thus far the losses on FDIC closures have been in the 35% range, and Lord only knows what's up with the BoA, WFC, and JPM "mergers),- while leaving be any actually sound banks, (most likely small community banks). Needless to say, top management and BoD's should be dumped and public trustees appointed in proportion to capital injections, though insulated from politicians and reputable experienced people, not just random bureaucrats. Only then could an adequate ring-fencing program be instituted, to sort out the live from the dead assets and get credit rationing/allocation restarted in functional ways. Further, with partial public control, the process of re-regulating the banking/financial system could be worked through, (without asymmetric information and lobbying), and banks broken up to eliminate the to-big-to-fail-or-succeed syndrome. As it stands now, giant banks are being merged to create still larger monopolists. Double ungood. But the ultimate aim should not be just to recreate "well-capitalized" banks, but to generate strongly capitalized banks, to withstand the process of taking down/de-leveraging the "shadow banking" system. (Right now, if one strips VAR from tier 1 capital, the actual leverage ratios of large banks is mostly less than 4%. IIRC, at the beginning of the 20th century, unvarnished core banking capital ratios was 20%). Raising capital ratio requirements and requiring solid assets for core capital would tend to disgorge "volunarily" a lot of the dead assets to be ring-fenced. That, of course, would require perhaps further injections of public funds and reduce bank profitability. But that's just the point: to shrink the financial sector as a whole and restore it to its "proper" functions in intermediating the real productive economy, instead of it's rampant misallocations of capital and mis-pricings of risks. When financials record 30% of corporate profits, that, to me, is prima facie evidence of the extraction of rents from the real productive economy, for which there is no functional justification in terms of efficiency, (unlike the rents that accrue to industrial oligopolies, which serve to manage the costs and uncertainties of high, long-run fixed capital investment).

RebelEconomist said...

Thank you for your substantive and clear comment, John. If you are an American, you seem surprisingly socialist (a term which in Europe does not have such negative connotations as it appeared to have in the recent US election debate)!

I agree that some of the burden of taxation should be shifted from income to wealth. It always strikes me as odd that, when discussing taxation, people associate "rich" more with income than wealth. I have not studied the subject in depth myself, but I would expect taxing wealth rather than income to be more economically efficient as it imposes less disincentive to making productive use of one's skills. Two wealth-related taxes that I would favour are (1) a land tax (I believe that the US already has significant local real estate taxes), which would also represent an economic automatic stabiliser and help to rationalise land use, and (2) inheritance tax, which would also counter the decrease in social mobility in the US or UK in the last twenty years or so. Of course, introducing or increasing either of these taxes would be unpopular, but I think that shows how appropriate they are – because wealth has been relatively lightly taxed and asset prices, especially house prices, have risen so much, increased property or inheritance tax would affect many people.

As my PRAT scheme suggests, I would rather avoid the forced nationalisation of banks that are neither definitely insolvent nor in default, because I believe that their shareholders deserve a chance to salvage something if possible. But I cannot understand why nationalisation should not be used (in the absence of a potential takeover) when bankruptcy actually occurs, as in the case of Lehman. The TARP was initially presented as a choice between rescuing banks and the disorder of bank defaults (eg interruption of the payment system), as if the possibility of nationalisation, followed by either orderly wind-up or recapitalisation and sale, was simply out of the question.

You are right about the reduced capitalisation of banks. I was impressed by the chart showing this at the end of a recent Financial Times article by Martin Wolf. It is hard to believe that this decline represents an increase in economic efficiency as opposed to a gain in bank profitability at the cost of greater (partly socialised) risk. I also agree that the share of finance in the US economy seems excessive. Given that financial activity does have to shrink, I wonder whether there is presently too much concern with staving off recession. If contraction is largely confined to unsustainable activity, including surplus derivative structurers, mortgage brokers, realtors, builders, hedge fund managers etc, it might actually be most efficient (ie in terms of economic welfare) to get through the adjustment quickly.

lb said...

this is all great stuff gentlemen. you put solid economic reasoning to words of all my intuitive speculations of what is wrong with the current so-called 'solutions'.

i don't know if any of you are aware of henry george but back in 19th century, he advocated abolishing the income tax and instituting a tax on land.

he was no crackpot --- his book Progress & Poverty was the second highest selling book in America for a while (after the Bible) and he came 2nd (in front of Teddy Roosevelt) for mayor of NYC.

anyways, if you haven't heard about him, you might all enjoy his writings -- his ideas were definitely out of the box.

p.s. rebel: thanks again for patiently working thru the swap mess over at brad's blog with me today. much appreciated...

etz said...

Rebel,

I found this to be pretty insightful,

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

Global Chessboard said...

Rebel,
Your idea is great. However I think the real problem isn't the level of leverage of banks but the level of leverage of people. You've got 700,000 people receving late notices on home mortgages alone, per quarter. Plus there were 500K people losing their jobs last month.
Please consider including a summary on posts so that those who have less time can read the main points quickly and delve into the details at leisure .. this is more a suggestion and not a complaint on your excellent reasoning.

M.G. said...
This comment has been removed by the author.
M.G. said...

The idea of “good bank” comes from www.voxeu.org/index.php?q=node/2390#comment-363 and www.voxeu.org/index.php?q=node/2411#comment-370 (after Prof. Zingales article in particular) You can spread the links. Prof. W. Buiter is definitely more authoritative and is working out some details. Soros is also urging U.S. to go in this direction.

RebelEconomist said...

MG,

I am sorry that I did not read your comments before - I did read both VoxEU articles, but overlooked your comments because comments on VoxEU are so rare. You deserve credit for suggesting that public money be spent on setting up new banks instead of saving the existing ones, but my proposal is more detailed than that. In fact its motivation was how to get from where we are (were?) to where we want to be, and was designed to provide a solution of the problem of valuing the troubled assets that has stymied the TARP. What particularly irritated me about Buiter's piece is the way that it touts a good bank scheme as a solution to a problem that he had previously denied existed.

As for Buiter's article being "more authoritative" because of his academic reputation, I imagine that this is the kind of insider advantage that Buiter himself would be scathing of in other organisations.

M.G. said...

It's true that on VoxEU comments are either rare, not allowed or read at all.
My first comments were that actually we should have not got into TARP at all...and Prof. Zingales suggestions and article deserved also more attention.
Many, economists and policymakers, denied the problem, and they still keep doing it,they could not believe in the mess. I advocated for full disclosure and transparency of balance sheets as the only way to go about... With TARP or similar, including bad banks, we are still missing some 3 objectives: restore confidence, restart lending and get rid of bad assets in due course (no matter how much you price it as the market will tell us). Good banks can revitalize the markets and be competitive and will help also to get a price, perhaps higher, for bad assets as they are "frozen" or gradually disposed of or renegotiated by bad banks. If the latter fail, business will go to good banks.
I am not from academia nor banker (and I care less for reputation as any idea for me is assessed in its own merit) but I believe we can all work out the details of any "good" bank solution, or any better solution (than TARP...).

alphabetzoo said...

Bravo. I found your blog via someone's posting on guardian.co.uk - I was aware of Buiter's good bank posting so it's interesting to see postings by others who'd proposed it.

RebelEconomist said...

alphabetzoo,

Thanks for letting me know. I would to see what was written, but I could not find it on guardian.co.uk, so I would be grateful for a more precise reference or a link.