01 10 08 A Solution To The Credit Crisis
No matter which way you turn, somebody has serious problems with the Paulson 'bailout' plan as proposed and amended by the house and senate. Our own view is that the situation is too far gone to just let the chips fall where they may. But we also agree that the Paulson proposal has serious flaws and may not work at all. We would like to propose a far simpler plan which addresses the immediate problem while also attempting to protect the taxpayers.The Financial Gedanken Experiment
- Immediate elimination of mark to market accounting for those assets which were originally booked as 'hold to maturity'.
- Immediate formation of a Mortgage Trust to purchase, at historical cost, up to $1.5 trillion of mortgage securities and associated securitizations such as CDOs
- If purchases by the trust fund are oversubscribed, it shall fill orders uniformly based on the largest percentage of total assets which absorbs the fund and no single firm placing more than $100B until all others have had their entire request fulfilled.
- The Mortgage Trust will hold to maturity for the benefit of each institution the securities tendered.
- Each institution shall be responsible for any net loss, accounting for recoveries, on securities sold to the Mortgage Trust.
- Each institution will pay back any net loss amortized over a period of 20 years, payable in full at any time.
- Each institution participating in the program agrees they will not pay any dividend on common stock or new preferred shares until such a time as their account with the Mortgage Trust is cleared and any losses are repaid.
- Each institution agrees no top managers will be paid more than $500,000 in salary per year and any bonus shall be in equity with a value of no more than $1 million at the date of the award with 50% of any shares restricted until the account with the Mortgage Trust is cleared and fully settled.
- Each institution shall pledge its remaining assets against its obligation to the Mortgage Trust.
So what does this plan accomplish? First off, it recapitalizes the financial institutions by allowing them to book their non-impaired hold to maturity securities at historic cost as was done pre-Enron. Second, it allows them to remove from their books impaired securities or those which are not yet impaired but likely to be in the near future. But it is not a free ride. Unlike the Paulson plan(s), the taxpayer is not on the hook for the losses. Instead, each firm participating will be required to make good on the net losses over a 20 year period. By allowing a lengthy period, the government enables the firms to continue their normal operations without a gun to their head of a single large payment due in a short time. However, to accelerate the process, no dividends will be paid to shareholders thus preserving cash which can be used to pay off these debts. Likewise, the mega bonuses of the past will be eliminated. It would be in the institutions best interest to clear these obligations as soon as they are financially able so as to once again pay their shareholders dividends as well as have more flexibility with executive compensation. As a backstop, the government will have first claim on the assets of any firm unable to meet its obligation to pay the ultimate losses on the securities sold to the Mortgage Trust.
This, to our thinking, is a far better way to proceed. It frees up significant capital immediately, allows firms flexibility in whch assets to sell, allows firms to spread potential losses out over a long period of time if need be, allows the government to receive any income paid on the securities, puts the firms on the hook for any future losses, and places some constraints on the institutions to prevent 'rewarding' bad management. All these combined will allow firms to go back to normal operations (lending) and eliminate much of the counter party fear gripping the credit markets.
Beyond this initial proposal, which we see as the most pressing, we would enact a follow on which looks to some of the other problems. We wouldn't dally too long here either:
- Restore the uptick rule.
- Complete ban of naked shorting except by a market maker providing liquidity to facilitate an investor purchase.
- Institutions selling total return swaps are not exempt from the uptick or naked shorting restrictions.
- No shorting of any stock with a price under $15.
- A complete investigation and review of the credit ratings agencies.
What remains is the issue of credit default swaps. This is a bit more tricky. The most significant problem with CDS are counter party capitalization and pure speculation. As CDS are at their heart insurance, institutions selling these contracts should be regulated in a manner similar to existing insurance operations. This would prevent a holding company taking excessive risk underwriting CDS contracts without commensurate capital in place. Likewise, it would also prevent hedge funds from being a writer of CDS as few, if any, have sufficient capital to make good on any contract which is exercised.
Speculation in CDS must also be addressed. The current notional outstanding far exceeds the debt they are written against. Simply put, too many people have an economic interest in seeing companies fail and thus default on their debt obligations. Going forward, restrictions can be put in place which required the buyer of CDS to own the underlying security and in the same amount. That, however, does not eliminate the looming present day problem. With no better solution at hand, we are inclined to suggest the nullification of all contracts where the purchaser does not own the underlying. Contracts would be settled at original cost with all periodic and up front payments returned to the buyers, with interest. This is preferable to allowing the sellers of the CDS contracts the opportunity to cherry pick those contracts they wish to negate. It is hardly a beautiful solution but we see no other practical way of eliminating this very large ticking time bomb.
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