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The Bernanke-Paulson proposal to spend $700 billion to shore up the financial system can be helpful if done wisely. That will require only purchasing assets at prices reflecting their medium-term value. Doing so would provide much needed liquidity while promising minimal costs to taxpayers.
Subprime mortgage-backed securities outstanding have a face value somewhere on the order of $1 trillion (IMF, 2008). Their composition is approximately two-thirds AAA, one-fifth AA, and about 8 percent each for A and BBB/ BBB- (Fender and Hordahl, 2008). The current prices range respectively from about 90 cents to 15 cents on the dollar, for 2006 and earlier vintages, and about 60 to 8 cents on the dollar for 2007 vintages (Markit ABX index; figure 1). (PENAAA is a special category above triple-A.) About three-fourths of the volume outstanding is AAA or better for 2006 vintages, and about two-thirds for 2007 vintages. A rough estimate is that the overall weighted ratio of current market value to face value is about 70 percent for the 2006 and earlier vintages and about 50 percent for the 2007 vintages.
Figure 1 Current prices on Subprime Mortgage Backed Securities
Source: Markit
As the Brady Plan for Latin American debt in the 1980s demonstrated, crisis resolution based on security and liquidity in exchange for a haircut can restore market stability. The challenge is for the Federal Reserve and Treasury to develop internal reference prices applicable to each rating class and vintage of mortgage-backed securities that reflects reasonable medium-term values. These should be based on default probabilities and loss given default. The default probabilities should be based in part on prospective housing prices, for example taking account of the Case-Shiller housing prices futures. Application of this type of approach will tend to generate medium-term (e.g. three-year-horizon) prices that exceed the fire-sale levels of today’s prices on these securities.
The Treasury should then be prepared to purchase at auction substantial blocks of each class and cohort of this paper, but only at prices that are no higher than the internal reference price estimates. The result will be to restore liquidity and some upward price movement to a market currently frozen at crisis price levels. Moreover, when prices are established in such sales, financial institutions not actually selling should be permitted to mark-to-market over a phased period such as three years, for purposes of regulatory capital. Otherwise the cure could be worse than the disease for them, because they might be forced to mark down to prices that are below medium-term values even though they plan to hold the assets for appreciation.
Implemented in this way, the program would not bankrupt the US government. Gross US debt today is $9.6 trillion, but after taking account of claims held by one part of government on other parts, the debt held by the public is $5 trillion, or 36 percent of GDP. The government added somewhere between $1.5 trillion (direct) to $5 trillion (including guarantees) when it essentially nationalized Fannie and Freddie, but it gained an (almost) equal amount of assets, leaving the net debt little changed. Against a benchmark of some $11 trillion to $14 trillion total gross debt, another $700 billion is not enormous, and the rise in net debt would be minimal if the assets are purchased at prudent prices so they can be resold in the future at little loss or even a profit. The challenge is to keep any prospective losses to a minimum while restoring market liquidity and confidence. The approach outlined here would seem capable of achieving this objective.
References
IMF, Global Financial Stability Report, April 2008
Ingo Fender and Peter Hordahl, "Overview: A Cautious Return of Risk Tolerance," BIS Quarterly Review, June 2008.
