More bailout alternatives

Here’s two ideas that are already on the table and some other ideas I’d like to throw out there, with their pros and cons.

The Dodd Plan

There’s a decent summary here. The short version is that it’s the Bush/Paulson plan with several bells, whistles, and gongs added with the intention of fixing its more glaring flaws. I like the intent in broad strokes — it includes more congressional oversight, imposes penalties on the bailees to mitigate the moral hazard problem, and it contains safeguards against the very real possibility that the treasury will lose money in the process of recreating the market for mortgage-backed securities. I’ve got problems with the specifics, though:

• The warrants (stock options) the Dodd plan takes to guarantee the Treasury’s profits leave too much uncertaintly for too long. This negates much of the benefit of a bailout.
• The warrants don’t actually guarantee the Treasury’s profits. If a bailed company goes broke despite the bailout, its warrants will be worthless. The Treasury is more likely to make money under the Dodd proposal than under the Bush/Paulson proposal, but there’s still a chance that we won’t be getting the whole $700 billion back.
• The proposal contains too much subsidies for homeborrowers. This worsens the moral hazard problem, and is expensive.

On first hearing about the bill, I was worried that the executive pay clawback provision would be an unconstitutional ex post facto law, but upon reading the relevant section of the full text of the bill, I’m relieved to find it’s a going-forward provision which is imposed not by law but as a condition of acceptiong bailout money.

Federal Subsidies to Distressed Homeborrowers 

The fundamental problem with the mortage-backed securities is that too many people are defaulting on their mortgages. I’ve heard several proposals to bail them out with cash subsidizes and let the benefit trickle up to the institutions. This feels better than the institutional bailout propsals, as using tax money for handouts to the poor is less unpalatable than using tax money for handouts to the rich. The problems, as usual, are cost and moral hazard. We’re using money taken from people who didn’t take out loans they couldn’t afford and giving it to people who did so they can make their payments to banks that lent money to people who couldn’t afford to pay it back. And unlike the Bush/Paulson and Dodd proposals (where much, perhaps all, of the $700 billion would be repayed), not a dime of this grassroots bailout would get paid back.

Federal Refinancing of Distressed Homeborrowers

Subprime borrowers pay high interest rates because they carry a significant risk of not repaying their debts. The federal government is in a unique position to be able to lend to them at near-prime rates because they have a unique ability to ensure repayment.

Offer a one-time option to everyone with mortgage debt on a primary residence — refinance their debt from the Treasury (the current balance only — no cash-out option) as a 30-year fixed mortgage at Prime+1.5% (currently about 5.8%, the same rate as is available on the open market to borrowers with good credit ratings and 20% downpayments). The catch is that this refinanced debt would be nondischargable through bankruptcy and would be collectable through IRS wage garnishment.

It’s harsh, but nobody’s forcing you to take it, and I expect there’s a lot of people out there who would be able to repay their loans at this reduced rate who would lose their homes without this option.

There’s three problems with this that I see:

• The risk of people ruining their lives by taking on a nondischargable debt foolishly.
• It’s a de-facto nationalization of subprime lending, especially if it isn’t strictly a one-time emergency measure.
• It contains huge moral hazard for private subprime lenders, who will now be disinclined to protect themselves against systematic risk in the housing market because they expect the government to come in and refinance all the bad loans again.

Let Warren Buffett put our money where his mouth is

This is an outside-the-box idea that recently occurred to me. It may be a terrible idea, but less so than the Bush/Paulson proposal or even the Dodd proposal.

Quoth Warren Buffett:

“I bet they’ll make a profit,” said Buffett, who pointed out that hedge funds specialising in junk assets were already picking up mortgage-related securities with a view to making profits of 15% to 20%. He said a positive return was feasible if the government ignores the book value of instruments or the original cost to banks and instead pays the prevailing market rates for the bombed out assets.

“They’ll pay back the $700bn and make a considerable amount of money if they approach it like that,” said Buffett. “I would love to have $700bn at Treasury rates to buy fixed-income securities - there’s a lot of money to be made.”

Buffett thinks he could make a profit investing the $700 billion in mortgage-related securities. I’ve got a lot more faith in his ability to do this than in Paulson’s. Why not let him try, on the condition that he reach into his own deep pockets (estimated personal net worth of $62 billion) to repay us if he comes up short? Basically, have Buffett round up a group of like-minded multibillionaires who are collectively willing to put up several hundred billion worth of assets as collateral, and lend them $700 billion for two years.

Problems:

• It’s still a massive interference by the government in the market. And if Buffet &co manage to pull it off, they just made a huge profit on a sweetheart government loan made for political reasons.
• If they don’t pull it off, Buffett’s assets he’d put up as collateral aren’t cash, and neither are the assets of the hypothetical billionaires who’d be contributing additional collateral. If they come up short and need to forfeit collateral, the federal government is left with a large equity stake in Berkshire Hathaway, Microsoft, etc. Not a pretty picture for the vast majority of us who aren’t all-out socialists.

Or how about Warren Buffett puts his own money where his mouth is

Look at the details of how the previous option would work:

1. Treasury borrows $700 billion from bond investors
2. Treasury lends $700 billion to Warren Buffett and friends with their personal assets as collateral
3. Buffett et. al. buy distressed securities
4. ???
5. Profit!
6. Buffet et. al. repay Treasury
7. Treasury repays bond investors.

It appears to me that there’s a couple wasted steps here. How about this, instead:

1. Warren Buffett and friends borrow $700 billion from bond investors
2. Buffett et. al. buy distressed securities
3. ???
4. Profit!
5. Buffet et. al. repay bond investors.

This seems like a great idea — the market is stablized, no taxpayer money is risked, no creeping socialism, and no moral hazard due to government intervention becaus there is no government intervention. The only problem I see with it is that it only works if Warren Buffet actually does it, and so far he doesn’t seem to be showing any signs of doing so.

Update: House Republicans apparently have an alternative plan of their own.

Roughly half of all mortgage-backed securities (MBS) are insured by the government, and House Republicans have advocated that the other half also become insured by the Treasury Department.

“We can ensure the rest of the current outstanding MBS; however, rather than the taxpayers funding insurance, the owners of these assets should pay for it,” the fact sheet says.

The Republican proposal backs the removal of regulatory and tax barriers to help facilitate the use of private capital to produce liquidity; temporary tax relief provision to help companies free up capital; and temporary suspension of dividend payments by financial institutions.

The core of this proposal, federal insurance of mortage-backed securities, sounds like a repackaging of the Bush/Paulson proposal — the federal government would place a very large bet that a certain percentage of the MBSs will be repayed. Pricing the insurance has exactly the same problems as pricing the purchases of MBSs has in the Paulson plan.

The secondary provisions sound like a mixed bag. Facilitating private bailouts strikes me as a good idea. Suspending taxes seems silly — if a tax is unfair, it should be repealed permenantly, but if it’s fair, suspending it is equivilent to a subsidy. And I’m not sure what they mean by “suspending dividend payments” in the context of congressional actions — aren’t dividend payments up to the board of directors of each firm?

Related Posts:

The $700 billion Bush proposal to bail out lenders

Alternatives to the Bush/Paulson bailout plan

The AIG bailout

McCain blew it