This paper presents an alternative/refinement to the treasury bailout proposal for a much lower
price tag: $60-100 billion. Key ideas include: 1) focusing on healthy banks, 2) focusing most
government investment on banks below the top twenty, possibly even below top fifty, in asset
size since the large healthy banks have access to global financial markets and investing in the
weak would be a waste of scare government resources with very little credit creation, 3) an
emphasis on restoring bank capital and inducing banks to add more equity capital (which
leverages government dollars by more than twelve to one), 4) avoiding a more than twelve-to-one
loss magnification in credit reduction that could arise when bank assets are bought at a loss, 5)
having the government act as both a dealer and quick seller of mortgage assets in order to lower
investment relative to buy-and-hold purchasing.
This paper views the financial crisis as an issue of overall financial market liquidity with bank
mortgage assets being a significant part of the problem but equally important is the need to
restore investor confidence, especially foreign investor confidence, in dollar-denominated assets.
The growing government, trade, and payments deficits require that we induce foreign investors to
continue to hold our debt and stock and buy more dollar assets.
The next three sections summarize key facts, state assumptions, and list key principles. Then the
plan is outlined. The concluding section compares this proposal to the treasury proposal. The
crux of the difference is credit creation per dollar of expenditure. The initial treasury plan
proposed spending up to $700 billion. This plan should ensure more credit creation with a much
lower investment, hopefully less than $60 to $100 billion dollars. On every other dimension
(impact on deficit, value of dollar, inflation, distortion of competitive markets, etc), the proposed
extensions/refinements improve on the treasury plan.
After two years of assurances that the financial system is sound and that actions taken are
sufficient, and after a massive refinancing of FMAE and GMAE, Congress is suddenly told that
there is a financing crisis and that Treasury needs a $700 billion blank check to buy up the toxic
mortgages that are “clogging the financial system.” Immediate action is required, or it is argued,
there will be dire consequences for Main Street as well as Wall Street.
The Alleged Symptoms and Consequences
In both the Sunday morning talk shows and congressional appearances, Secretary Paulson
asserted “problems,” namely:
1. Inability to obtain car loans
2. Inability to obtain mortgages
3. Lack of adequate small business loans
4. Danger to 401-K and other retirement assets
In trying to avoid technical jargon, Secretary Paulson asserted that bad mortgages were
“clogging” the banking system and keeping banks from performing their normal financing role.
Brief Symptom Assessment
1. Car Loans. Most car loans are provided by the credit subsidiaries of the major car
companies and/or third party credit subs such as GE Credit. Given that a majority of the cars
sold in the U.S. are made by the foreign car companies, this financing is not even dependent
on U.S. financial markets. Car loans are down because car sales are down. However, even
borrowers with poor credit can get low interest car loans with a reasonable down payment.
Car financing is not a problem and has little to do with bad mortgage loans on the books of
3. 2. Mortgage Loans. Secretary Paulson told us that the $500 billion rescue of Fannie and
Freddie had restored their ability to finance mortgages. When banks originate loans for
Fannie and Freddie, they do not make loans that go on their books but rather act as mortgage
brokers in originating and processing loans that will be securitized and sold by Fannie other
Freddie. For this reason, neither bank asset quality nor even bank capital adequacy is
pertinent to ability to originate conventional mortgages for Fannie and Freddie.
3. Small Business Loans. The major sources of small business lending are community banks
and regional banks. The 5000 community banks have virtually no non-performing or in-
default mortgages. Most regional banks have sound balance sheets and adequate capital. In
the Mountain West, they are actively seeking small business loans. The big banks are not a
significant source of small business lending. Thus restoring big bank lending power does not
seem to be of significant benefit to small business lenders. In fact, to the extent that the $700
billion blank check incurs higher taxes, higher inflation, and/or higher interest rates, small
business would be hurt by the proposed bailout.
4. Retirement Savings. This assertion seems more like scare tactics than substance. Asset
managers like Fidelity and Vanguard have little to do with mortgages and bank asset quality
generally. Bank Trust departments should have trust assets well separated from bank assets.
Short-term ups and downs should not be used to scare long-term retirement savers. Once
again, all community banks and most regional banks are sound. The FDIC watch list is
asserted to be fewer than 200 banks. If there be a problem, it would be once again a problem
with big banks and a small number of problem regional banks.
PROBLEM ASSESSMENT AND BENEFIT-COST-RISK COMPARISONS
The need for quick action has not been made. Haste can result in poor legislation; Congress
should address real problems with a sound program.
The steps to obtaining a sound program are:
1. Correctly understand and state the problem.
2. Identify alternatives so that discussion/debate is focused on benefits-cost comparison of the
alternatives and not hasty legislation couched as either this plan or nothing. the alternative of
doing nothing may merit serious consideration.
3. Evaluate benefits relative to costs and risks for each alternative.
The next sections of the paper summarize facts and assumptions, state principles for developing
alternatives, briefly outline step-by-step procedures for screening banks. The conclusion assesses
benefits relative to costs and risks.
How Changes in Equity Capital Magnify Bank Lending Capacity.
A dollar of additional equity capital increases bank lending capacity by about 12.5 times
(assuming 8% capital adequacy). Conversely, a dollar of reduced earnings (including especially
writing down overvalued assets) reduces equity capital. A dollar of reduced earnings means that
bank lending capacity is reduced by about 12.5 times.
The Impact of Asset Purchases on Bank Lending Capacity.
A dollar invested in buying assets at book value (accounting value) increases banking lending
capacity by one dollar. In contrast to investing a dollar of equity capital (12.5 leverage), there is
no magnification in lending capacity from an asset purchase. A dollar increase in lending is the
best case. There is a high likelihood that an asset purchase at fair value (that is less than
4. the accounting value on the bank’s financial statements) will actually reduce lending
capacity. Secretary Paulson has referenced taking “toxic assets” off the balance sheets of banks.
Senators have said “no bailout.” No bailout presumably means that the assets purchase price is
an estimate of the current fair value of the assets. The solution is to require that companies
restore equity to offset losses and to return to at least the statutory minimum equity capital. This
could be a government equity investment in the smaller banks without quick access to equity
financing but would generally be equity raised from the financial markets in parallel with toxic
asset purchases and as a condition for such purchases. This parallel financing is further leverage
of government investment.
.The table below summarizes the change in bank lending capacity (Δ LENDING in the table
below) when assets are purchased at a fair value that is a specified percent below the value at
which these assets are carried on the financial statements of a bank.
%LOSS 0% 10% 20% 30% 40% 50%
ΔCAPITAL 0.00 -1.25 -2.50 -3.75 -5.00 -6.25
ΔFUNDS 1.00 .90 .80 .70 .60 .50
ΔLENDING 1.00 -0.35 -1.70 -3.05 -4.40 -5.75
Consider the case of an asset purchased at a 20% discount from its accounting value on the
bank’s balance sheet. A 20% loss means a loss of $.20 per dollar purchased. This loss will reduce
equity capital and therefore reduce lending capacity by 12.5 times the loss, namely: -$2.50 per
dollar of bank assets, where the minus sign indicates a loss. Subtracting the $.80 fair value paid
for the dollar of assets results in a net change in lending capacity of $-1.70.
Leveraged lending is a double edged sword: an increase in equity capital means lending capacity
is magnified 12.5 times but a loss means a leveraged reduction by 12.5 times. If the government
purchases equity without a corresponding requirement in restoring equity capital, there is
real danger that the asset purchases could backfire, i.e., produce a large reduction in
Community Bank Health.
Most of the 5000 community banks have no abnormal problems with defaulted or
underperforming mortgages. As prudent lenders and careful managers of capital adequacy, they
are in excellent financial health. As a group, community banks are net lenders of Fed funds to the
FDIC Watch List.
5. The FDIC watch list of problem banks is less than 200. Unlike the thrift crisis of the 1980s
(insolvent industry with almost every thrift insolvent under mark-to-market accounting), the
current banking industry is solvent and most banks are healthy.
The nation’s 5000 community banks and the small and mid-size regional banks are the major
source of credit for small businesses and even many medium-sized regional companies.
Lessons from the Thrift Crisis.
The thrift crisis of the 1980s was a case of an insolvent industry that defied a decade of salvage
efforts. By 1980, the thrift industry was insolvent from the increases in interest rates from
1975-80 (and not from defaulted and underperforming loans) and from disintermediation (savings
deposits being withdrawn from the thrifts because they could earn higher rates in alternative
assets such as money market mutual funds . The $80 billion negative value in 1980 because
nearly a trillion by 1090 when the Resolution Trust finished the liquidation of the insolvent
institutions at a final cost of approximately $580 billion. The lesson is that it is almost impossible
to salvage an insolvent lender if it continues to operate inefficiently with overvalued,
underperforming assets and with a high cost of financing itself. On-going losses plus
compounding interest on the negative net worth interact to compound losses at an exponential
rate. Once insolvent, thrifts, banks, or other lenders should either be quickly liquidated or
else quickly forced into a rescue merger. In terms of minimizing costs to society and
damage to the financial markets, the guideline is: the faster the better
Lessons from the Japanese Banking Crisis.
By the late 1980s, Japanese banks had assets with significant losses. Allowing the banks to carry
assets at overstated values crippled these institutions and Japanese lending to smaller Japanese
companies for more than a decade. Letting big banks function with impaired capital hurts both
the shareholders and the economy.
The primary problem is maintaining overall financial market health and liquidity. Increasing bank
lending capacity is a subproblem of ensuring healthy, liquid financial markets. An equally
important need is to induce foreign investors to continue to hold trillions dollars of both
government and private debt and equity and, given our prospective government, trade, and
payments deficits, to buy more than a trillion dollars more over the next year.
Attracting Foreign Investors.
Given that foreign governments already hold trillions of dollars of U.S. debt and given on-going
government and payments deficits, we must be sure that dollar investments in both debt and
equity remain attractive. The key factors include their expectations for the value of the dollar
relative to their currency, future inflation, and the overall health of our economy.Particularly
important here is future expectations about the level of the government, trade, and payments
deficit and the overall payments deficits.
Negative Impact of Additional Government Spending.
Every dollar of government spending adds to our already large deficit. To the extent that
government bailout financing increases inflation expectations and weakens the dollar, the net
6. effect could be to reduce financing available to qualified U.S. borrowers, especially small
businesses and credit worthy individuals.
Minimum Market Distortion
Except for issuing treasury securities and Fed open market operations, the government role in the
financial markets should be as a regulator and not as a long-term investor in either equity or debt
assets. In those extreme cases that require that the government acquire private sector assets, it is
imperative that competitive distortion of the financial markets be minimized. These objectives
can be achieved best by adhering to the four principles stated below.
1. The government act as much as possible like a private sector player with respect to fees
and the price paid in purchasing either equity or debt assets.
2. There should be no bailout in the sense of paying more than fair value for either
distressed debt, especially to preserve unhealthy institutions.
3. The government should minimize dollars invested for a given level of credit creation.
4. The government should minimize time in the market.
The need for minimum investment cited above becomes even more crucial when we recognize
trade-offs in the joint goal of increasing bank lending capacity and simultaneously avoiding as
much as possible further damage to financial market liquidity. Not further damaging financial
market liquidity requires minimizing any increase in the government deficit with its associated
fears of greater inflation and a weaker dollar.
Rather than a scatter-gun approach that entails buying all trouble assets and/or restoring all
trouble institutions to capital adequacy and financial viability, any government investment should
be focused to ensure the maximum increase in lending power per dollar spent. The government
should not waste scarce resources in buying equity in or assets from those institutions that already
have efficient access to the financial markets, namely: the largest commercial banks, investment
banks, and insurance conglomerates.
Too Big and Too Complex for an Unnecessary Government Rescue
If healthy, the largest banks, investment banks, and insurance companies have access to financial
markets. They do not need an investment of scarce government funds. If not financially viable,
then our experience with both the thrift crisis and the Japanese banking crisis tell us that they
should be quickly liquidated, reorganized, or forced to merge into a healthy institution.
One problem in dealing with the largest financial institutions is lack of transparency in their
financial statements and the associated difficulty in arriving at an assessment of the fair value or
market value of many of their assets. This problem is illustrated in the failure of both the Fed
and Treasury to understand the financial situation of Bear Sterns, Lehman, and especially AIG.
Once key facts, assumptions, and principles are stated, the plan can be summarized succinctly.
We address two cases:
1. All but the largest banks.
2. Big banks and other financial institutions.
8. Community and Regional Banks: Equity Capital1 and Asset Purchases for All But the
The following summarizes the steps in a bank-by-bank review. The data for this review are the
well-standardized call reports filed by most banks with the FDIC.
1. Liquidate quickly any insolvent institutions.
2. Require that any severely undercapitalized institutions restore capital adequacy by raising
new equity capital on their own or else require that they merge into a healthy institution.
3. Put capital in only healthy regional and community banks. Invested capital will be magnified
by at least 12-to-1.
4. Once These banks are well capitalized, the government lending restoration agency may act as
a mortgage dealer by being willing to both buy and sell standardized mortgage assets at a
The mortgage dealer function requires little capital.2 Assets are bought and quickly sold with
minimum inventory. Liquidity is restored from the government role. The primary purchase
should be with full recourse so that neither party gains or loses from misevaluation.
Exhibit 1 (on the last page) summarizes the flow logic for this bank-by-bank process.
Big Banks and Other Financial Institutions
Big bank means at least the top 20 commercial banks. Determining the cut-off for defining big is
a policy issue to be determined. In my view, it is at least the top 20 commercial banks. It could
go as far as the top 50.
1. Commercial Banks. We have often heard the assertion “too big to fail.” In the context of the
current crisis, big here means too big for government rescue. If a big commercial bank is
solvent and even close to financial viability, it can restore capital adequacy on its own since
it has access to the financial markets. While raising equity in an adverse market involves a
dilution cost to the current owners, the current owners are the risk bearers who should logically
incur this cost in our free enterprise system. Citibank is a case example. It wrote off bad assets,
recognized its loses, and then restored its impaired asset-to-capital ratio by obtaining on its own
equity capital, about $20 billion without government help or guarantees, by a combination of
private placements and a dividend cut of $4.5 billion per year. Large institutions can increase its
equity capital by a rights issue to existing shareholders, a PIPE (private issue of public equity), a
secondary issue, a dividend cut, and/or an asset-for-equity sale.
2. Investment Banks. Morgan Stanley and Goldman Sachs are the two remaining big
investment banks in the United States.. Both claim to have adequate capital and no need for
additional financing. In a matter of days, Goldman has just raised $5 billion via a private
placement from Berkshire Hathaway with another $5 billion in process. Despite a recent decline
in the market value of Goldman’s stock, it can easily raise equity and additional debt for buyouts
and other asset expansion on its own as evidenced by the amount and speed of this financing in
just a few days. This quick private-sector financing is strong support for the contention that the
Equity should not be viewed as common stock. Details are to be developed; however, equity is more
logically preferred stock without voting rights and a call privilege that would allow these otherwise healthy
banks to call back this preferred equity when financial markets return to normal valuations. The cost to the
banks on call (and the return to taxpayers) should amount to a fair interest rate.
Of course, exotic derivatives, credit default options, and other insurance options do not fit a dealer
market-making function. However, given the objective of ensuring credit efficiently to main street and
given our exclusion of the largest institutions, these exotic mortgage assets are excluded but they reside
primarily in the excluded large financial institutions as well as hedge funds and foreign institutions.
9. big healthy financial institutions can raise capital efficiently and quickly on their own without
government help including no guarantees, explicit or implicit.
3. Insurance Companies. Most insurance companies are well capitalized and do not need
rescue. The insurance conglomerates that have written exotic mortgage insurance options like
AIG lack the financial statement transparency to be easily valued by a third party such as the
Treasury or a government rescue agency. If insolvent, they should be quickly liquidated. If
solvent and financially viable, they can restore any capital deficiency by asset sales and/or by
raising equity on their own in the financial markets.
CONCLUSION: COMPARISON OF ALTERNATIVES
Both the Treasury proposal and this alternative seek to restore normal lending and liquidity to
banks in particular and financial markets overall. They differ in two respects in terms of
1. Institutional Focus. This alternative focuses on the community and regional banks and
assumes that the larger and healthy institutions can finance/refinance themselves. The weak
but solvent can arrange to be acquired as has been the case in recent months. The insolvent
should die a quick death.
2. Capital verses Assets. Increasing capital is a leveraged way to increase lending capacity.
Given that the financial market views capital as the protection for lending and given an
explicit regulatory requirement of at least 8% capital, there is no effective increase in lending
capacity until there is additional equity capital beyond the statutory minimum. For these
reasons, this alternative focuses first on adding to the capital of healthy community and
regional banks. Asset purchases from the community and regional banks occur only after, or
along with, capital adequacy. In purchasing assets, the government should act primarily as a
mortgage broker quoting a bid-ask spread. In this role assets are quickly bought and sold so
that very little capital is required compared to purchases for long-term holding. To the extent
that mortgage assets are bought with full recourse to the original seller, the mortgage dealer
function can be extended to all healthy institutions including the big banks and insurance
companies. Thus healthy large banks, investment banks, and insurance companies may sell
their assets at a fair bid price as long as they have sufficient capital to ensure legal meaning to
the idea of full recourse.
The big difference in these two alternatives is cost per dollar of credit created. Equity invested in
healthy institutions leverages government dollars by more than 12 to 1. Thus $60 billion can
create more than $700 billion of increased credit, in this case focused on small business fund
providers. In contrast, asset purchases provide at best a dollar-for-dollar increase in credit. To
the extent that assets are purchased at fair values that are less than book values, they can actually
cause credit to contract. Other dimensions for evaluation relate to the willingness of foreigners to
continue to provide financing. These include the impact on our deficit, strength of dollar, and
inflationary expectations. The table below summarizes these.
This paper has structured the ideas developed here as an alternative to the treasury
proposal, which has itself undergone considerable change and refinement by Congress.
The ideas developed here could be viewed as well as ideas and guideline for
Plan Cost Change Market Deficit Strength Inflation
Alternative in Credit Distortion of Dollar Expectations
Paulson $700B Negative High $700B negative negative
10. Stone $60B >$700B Low $70B positive positive
11. Exhibit 1
Logic Summary for the Stone Plan
No FDIC liquidation
or forced merger
No Severely undercapitalized banks
Close to Capital
should be merged or else should
raise equity on their own.
No Additional Equity Required
Yes Adequately capitalized banks do not
Is Capital at or
need additional equity. They may opt
to acquire some. They are qualified to
Asset Purchase Offer
Once fully-capitalized, banks do not
Require More Equity need to sell mortgages or other under
• Rights offering performing assets. However, the
• PIPE issue Government Recapitalization Agency
• GIPE issue can act like a private sector merchant
bank-dealer to restore mortgage asset