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A Second Chance



The vote on Monday, September 29 in the House of Representatives to reject the
$700 billion Paulson troubled asset relief plan (TARP) was regrettable—not because the design of the TARP is flawless but rather because a failure of the US administration and the Congress to agree on an effective systemic approach to managing this increasingly worrisome financial crisis can only depress confidence further. The historic decline in US equity markets following that negative vote—the difficulties at Wachovia Bank notwithstanding—was hardly a coincidence.

Fortunately, there is still time to agree on a modified TARP that can help to lessen the duration and severity of this crisis. That plan should deal with four key aspects of the current difficulties: illiquidity for certain mortgage-backed securities, undercapitalization of the financial sector, an interruption in the flow of credit to households and nonfinancial businesses, and a rising foreclosure rate that threatens to produce a downward overshooting of housing prices.

Rather than spend the entire $700 billion on government-financed purchases of troubled assets and aim for a purchase price (based on hold-to-maturity arguments) that is significantly above recent market prices, the Treasury should conduct auctions for only about a fifth of the authorized amount (say, $150 billion). That ought to be large enough to establish greater transparency about the fair market value of such assets. Such transparency should in turn make it easier for counterparties and bank supervisors to evaluate the balance sheets of financial institutions and to distinguish healthy from less healthy ones. Better credit assessment is a prerequisite for reducing excessive hoarding of liquidity. Trying to "tilt" the results of the auctions in either direction is a mug's game: A "low" price will provide little relief to banks' balance sheets while a "high" price will make it less likely that taxpayers can avoid a significant loss from such asset purchases and their subsequent resale. Since the government needs to promote both financial stability and to minimize costs to the taxpayer, it should let the (auction price) chips fall where they may.

Once the auctions are completed in an expeditious way, the authorities should have regulators and supervisors apply a uniform set of standards and make a fresh evaluation of the solvency and capital adequacy of all systemically important financial institutions that are currently subject to federal regulation. Those institutions that are found to be undercapitalized in light of the tougher market scrutiny now directed at all large financial institutions should be encouraged to make up at least half of that capital shortfall by reducing or suspending dividends and by raising additional capital from the market. Those institutions that were confident that they can do this would then apply to the TARP for a "matching" capitalization loan that would make up the other half of the capital shortfall. In exchange for this loan from the TARP, the participating institution would agree to grant the Treasury warrants so that taxpayers could share the benefits of any subsequent improvement in performance.

In addition, the participating institution would agree to expand its lending to households, to nonfinancial businesses, and to other financial institutions so that the flow of credit in the economy could be revitalized. This would make the link between Treasury assistance and a resumption of private lending more predictable and assured than with the design of the existing TARP. In cases of severe undercapitalization where the institution was not able to raise capital from the private markets (at sustainable interest payments), a capitalization loan from the TARP could also be requested, but the terms of Treasury assistance would be more onerous—akin to the recent Treasury loan to AIG (with a penalty interest rate, a pledge of all assets as collateral, and a dominant share of the existing equity going to the Treasury). If that institution subsequently failed, a search would be undertaken for a stronger institution to purchase and assume the "good" assets and liabilities from the TARP, while the "bad" assets would be transferred to the TARP for subsequent resale. Because recapitalization of the financial sector is a pressing priority, up to $350 billion of the TARP's authorization should be allocated for such a purpose.

Last but not least, the remaining $200 billion of the TARP's resources would be made available to restructure troubled mortgage loans that were in danger of imminent foreclosure. This could be done by contributing funds to one of the existing government mortgage restructuring programs (with its existing eligibility requirements) or by setting up a separate but equivalent mortgage restructuring operation within the TARP itself. As noted earlier, the aim here would be to relieve some of the downward pressure on housing prices exerted by a sharply rising rate of home foreclosures (expected to hit roughly three million units this year). A decline in the foreclosure rate would also have positive feedback effects on the market value of mortgage-backed securities. And with a significant share of the TARP's financial resources allocated for foreclosure prevention, any perception of "unfairness" as between treatment of Wall Street and Main Street would be reduced.

The remaining features of the existing TARP—ranging from constraints on executive compensation for plan participants, to review of TARP operations by an independent oversight board and phased authorization of funds by the Congress, to inclusion of a mortgage insurance option (with premiums to be paid by participating financial institutions)—could be retained in the revised TARP.

In sum, if they act quickly and in a spirit of bipartisanship, there is still time for the US administration and the Congress to make something positive emerge from the delay in passing TARP legislation. Without changing the ultimate objectives, a revised and improved TARP bill can be designed and agreed upon that will increase the liquidity of mortgaged-backed securities, while allocating more resources (than did the original TARP) both to recapitalization of our financial institutions and to mitigation of rising home foreclosure rates. If Congress wants to rebuild market confidence rather than destroy it, it needs to get its act together.

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