Editorial: Bailout alternative through matched prefered stock plan

http://www.voxeu.org/index.php?q=node/1683
This column, posted 19 September on an FT forum, suggests a better way of ending the financial crisis. Instead of buying toxic assets, the US government should buy preferred stock capital in ailing banks that could raise matching private sector equity. This would avoid the intractable problems of how the government should value the toxic assets and directly address the banks' immediate problem – a lack of bank capital.


The US government is considering broad-based assistance to stem the financial crisis. Hank Paulson, Treasury secretary, and Ben Bernanke, Fed chairman, have proposed the establishment of an entity that would purchase subprime-related assets from troubled financial institutions.

A broad-based approach is needed, but this is not the best way of achieving policymakers’ objectives. Government injections of preferred stock into banks, advocated by Senator Charles Schumer, inspired by the Reconstruction Finance Corporation’s policies in the 1930s, would be a better choice. Pricing subprime instruments for purchase would be very challenging, and fraught with potentially unfair and hard-to-defend judgments. If the price were too low, that could hurt selling institutions; if it were too high, that could harm taxpayers. Who would determine how much should be purchased from whom in order to achieve the desired systemic risk reduction consequences at least cost to taxpayers? How would the purchasing entity dispose of its assets?

Preferred stock assistance would leave asset valuation and liquidation decisions to the private sector, but would provide needed recapitalisation assistance to banks in an incentive-compatible manner to facilitate banks’ abilities to maintain and grow assets. If executed properly, it would limit taxpayers’ loss exposure, and leave the tough decisions of managing assets, and deciding on how to allocate capital assistance from the taxpayers, to the market.

Preferred stock assistance would work best if it were required to be matched by common stock issues underwritten by the private sector, which would ensure the proper targeting of assistance, and force private parties rather than taxpayers to bear first-tier losses. Banks in need of capital would apply for Matched Preferred Stock (MPS) assistance. Initially, say for three years, there would be no dividend paid to the government on MPS. That subsidy would increase the net worth of the recipient and facilitate raising additional capital via common stock.

Any US-based financial institution could apply for US government-held MPS (foreign-based banks could also apply if foreign governments were willing to provide MPS financing). To ensure that MPS is only supplied as truly needed from a systemic standpoint, and to limit any abuse of the taxpayer-provided subsidy, the private sector would also be required to act collectively to help recapitalise undercapitalised banks, and share the risks associated with recapitalising banks.

Specifically, to qualify for MPS assistance from the government, a bank would have to first obtain approval from “the Syndicate” of private banks (including the major institutions who would benefit from the plan as well as others who would benefit from the reduction in systemic risk) to commit to underwrite common stock of the institution receiving MPS in an amount equal to, say, at least 50 per cent of the amount of MPS it is applying for (at a price agreed between the Syndicate and the bank at the time of its application for MPS). The Syndicate would share the underwriting burden on some pro rata basis. To support that underwriting, the Syndicate would have access to a line of credit from the US government (and from other countries’ governments, if non-US banks participate in the MPS system). By making the government’s underwriting support senior to the Syndicate, the taxpayer would be protected by the aggregate resources of the private financial system. For banks participating in the MPS plan that are based outside the US, foreign governments would have to provide the MPS investments. Presumably, those foreign governments would also provide the credit line commitment to the syndicate for its underwriting of common stock.

Crucially, matching ensures first-tier loss sharing by the private sector (in a properly diversified way), which in turn ensures that unless the bank is worth assisting for systemic purposes, and viable upon receiving assistance, it will not receive assistance. This arrangement also protects taxpayers (since they only bear second-tier losses – that is, the risk of loss on preferred stock, which is senior to the old and new common stock). First-tier private sector loss sharing alongside government assistance is a time-honored tradition, which incentivises the private sector to limit its requests for government assistance. In 1980, for example, the Bank of England was willing to assist in the bailout of Barings only on condition that the London banks bore the first tier of losses resulting from such assistance. In the US today, the FDICIA legislation of 1991 required that any bailouts of uninsured depositors or bank creditors must be paid for by a special assessment on surviving banks, as a pro rata share of their deposits.

Additional safeguards would also be needed. Any bank receiving MPS must suspend all common stock dividends for the period that the MPS is on its balance sheet (shockingly, the Japanese banks receiving preferred stock injections in 1999 continued to pay common stock dividends). Any bank receiving MPS would also devise a “capital plan” within six months of receiving MPS. The capital plan would be a plan for reducing leverage and credibly limiting risk taking during the period in which the MPS is outstanding. This capital plan would have to be approved by the Syndicate and the Treasury Department (as the government’s representative in this transaction). If a capital plan cannot be agreed within six months of receiving assistance, then the MPS would be payable immediately. Making the MPS callable would also be desirable; by doing so, and by limiting dividends and requiring a capital plan, banks would have an incentive to retire their MPS as soon as possible after the crisis passes.


Charles W. Calomiris
Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business

 

I'm not a professional in finance so I only take this as a high hobby. I'm very interested in the comments and opinions of those who do make a living off of this and it's related fields.

I thought what happened in japan was that the government through big banks tried to cover up bad debts (from construction loans and overvalued Japanese real estate) of smaller banks by injecting capital into them and keeping the appearance healthy assets. Thus there was this whole zombie bank phenomenon where none were allowed to fail even if they were truly insolvent and inefficient. They tried hiding their bad debt exposures and stagnation followed.

Now Sweden's economy is far smaller than Japan's let alone the US, but they did have some successes assuming control and then reaping profits when the situation stabilized enough for the banks to go public.


http://www.iht.com/bin/printfriendly.php?id=16375967
Can the U.S. learn any lessons from Sweden's banking rescue?
By Carter Dougherty
Monday, September 22, 2008

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

It does to Sweden, which was so far in the hole in 1992 - after years of imprudent regulation, shortsighted macroeconomic policy and the end of its property boom - that its banking system was, for all practical purposes, insolvent.

But unlike the United States, whose Treasury has made a proposal to deal with a similar situation, Sweden did not just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting equity from bank shareholders before the state started writing checks.

That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. Even the chairman of Sweden's largest bank got a stern answer to the question of whether the state would really nationalize his bank: Yes, we will.

"If I go into a bank," Bo Lundgren, Sweden's finance minister at the time, said, "I'd rather get equity so that there is some upside for the taxpayer."

The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm. And for all the differences between Sweden and the United States, Swedish officials say there are lessons to be learned from their own nightmare that Washington may be missing. Lundgren even made the rounds in New York in early September, explaining what the country did in the early 1990s.

A few American commentators have proposed that the U.S. government extract equity from banks as a price for the bailout they are likely to receive, as Sweden did. But it does not seem to be under serious consideration yet in the Bush administration or in Congress.

That's despite the fact that the U.S. government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and American International Group, the insurance giant.

Putting taxpayers on the hook without offering anything in return could be a mistake, said Urban Backstrom, a senior Swedish Finance Ministry official at the time. "The public will not support a plan," he said, "if you leave the former shareholders with anything."

The Swedish crisis had strikingly similar origins to the American one. Norway and Finland went through related experiences, and they also turned to a government bailout to escape the morass that bad policy had created.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Swedish banks, which spent too little time worrying whether the value of collateral might evaporate in tougher times. Property prices exploded.

The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden's currency, the krona, resulted in an incredible spike in overnight interest rates at one point to 500 percent. The Swedish economy contracted for two years straight after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures led to ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt opted for a clear-the-decks solution.

With the full support of the opposition center-left, Bildt's conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation's 114 banks. Sweden formed an agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

Lundgren, the former finance minister, recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden's largest bank. Wallenberg, the scion of the country's most famous family and steward of large chunks of its economy, heard from the finance minister that there would be no sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a bailout at all. SEB turned a profit the next year, 1993.

"For every krona we put into the bank, we wanted the same influence," Lundgren said. "That ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized vast swaths of the banking sector, and the agency had mostly fulfilled its tough mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

Indeed, more money may come into official coffers. The government still owns 19.9 percent of Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in Scandinavia and the Baltic Sea region.

The politics of Sweden's crisis management were similarly tough-minded, though much quieter.

Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country. A serious credit crunch was avoided. So the center-left opposition, though wary that the government might yet let the banks off the hook, made its points about penalizing shareholders privately.

"The only thing that held back an avalanche was the hope that the system was holding," said Leif Pagrotzky, a senior member of the opposition at the time. "In public we stuck together 100 percent but we fought behind the scenes."

Sweden eventually shelled out 4 percent of its gross domestic product, 65 billion krona, or $10 billion, to rescue ailing banks. That is slightly less, in terms of the national economy, than the minimum of $700 billion, or about 5 percent of GDP, that the Bush administration estimates a similar move would cost in the United States.

But enough was recouped through sales of distressed assets and bank shares that were sold later, that the cost ended up being less than 2 percent of GDP. Some officials believe it was closer to zero, depending on how certain rates of return are calculated.

Looking back, Swedish official say the tough approach toward the banks paved the way for success. It eliminated "moral hazard," the problem of relieving investors of bad decisions. And, much as it might be a shock in the United States, the demise of shareholders also underpinned the political consensus that help restore stability to financial markets even before the bailout was truly under way.

While government ownership of banks goes against the American grain, Lundgren worries that if the U.S. bailout rests on a thin reed, politically speaking, then it could fail.

The U.S. Treasury is now planning to purchase the distressed assets outright, without demanding equity. If it wants to restore the banking system's creditworthiness, it would have to err on the side of paying too much money to the banks that caused the crisis, Lundgren said.

"If the valuation is bad, from the taxpayer's point of view, you lose," he said. "And that decreases the legitimacy of the plan."