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The Stone Plan draft v 10

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  • 1. THE STONE PLAN: A COST-EFFECTIVE ALTERNATIVE/ REFINEMENT TO THE TREASURY PROPOSAL Bernell K. Stone, Ph.D.∗ + ABSTRACT 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 scarce 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 requires that we induce foreign investors to continue to hold our debt and stock and buy more dollar assets. Focusing on healthy banks below at least the top twenty in asset size means a dramatic reduction in required investment by the government. In addition to lowering the dollars required to restore liquidity, the largest financial institutions are able to access global financial markets. If strong, these institutions can finance themselves quickly and efficiently. They can also acquire and reorganize the weak. Those that are unhealthy would be a dollar sink with little credit restoration. Thus, the view here is that the weak institutions (such as Wachovia and Washington Mutual) should be acquired by the healthy institutions, generally without government interference and without government guarantees implicit or explicit. Recent multibillion dollar equity financing by healthy institutions and acquisitions of weak banks are both strong evidence that this view is correct. The most important point of this paper is to recognize that banks must maintain capital at 8%. This capital requirement means that the asset-to-capital ratio must be at least 12.5 to 1. To the extent that banks are induced to raise equity capital it means that government dollars in creating credit can be leveraged by at least 12.5 to 1. To the extent that banks incur losses without also restoring offsetting equity, bank credit capacity would be reduced by this same 12.5- to-1 leverage factor. Thus, it is critical that any rescue plan require that banks return to capital adequacy and be induced to add equity. The conclusion compares just toxic asset purchases with the extensions and refinements outlined here. The suggested focused combination of required equity with government asset purchases being as a dealer and quick seller of mortgage assets requires significantly lower government investment (possibly as low as $60 billion and almost certainly no more than $100 billion). There is less risk from lower required investment and a focus on the healthier banks. This also means less distortion of financial markets including especially the much lower volume of government financing. By reducing the government investment and the government interference in the market, the confidence of foreigners in the value of the dollar should increase, and all other things being equal, foreign investors should be more likely to hold and to acquire more dollar-denominated assets.  Bernell K. Stone (http://marriottschool.byu.edu/emp/employee.cfm?emp=bks) is the Harold F. Silver Professor of Finance, Marriott School of Management, Brigham Young University. He is an acknowledged world expert on the payment systems and cash management with particular expertise in both money and banking and the short-term money market. He previously taught at Wisconsin, MIT, Cornell, and Georgia Tech. He was the founding editor of The Journal of Cash Management, the founding executive director of The National Cash Management Association (now renamed The Association of Finance Professionals), and the founding editor and principle author of The NCCMA News Letter. He has served as an associate editor for five of the major finance journals. He was an adjunct scholar for the Heritage Foundation, 1978-88, was a charter-founding member of the National SDI committee (“star wars”). He served at the SEC (Securities and Exchange Commission), 2003-2004.  © 2008 Bernell K. Stone. All rights reserved. Permission is hereby granted to freely reproduce and/ or quote subject only to the requirement that this document be referenced as the source document.
  • 2. INTRODUCTION-OVERVIEW 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. BACKGROUND 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 some banks. 2
  • 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. FACT SUMMARY 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 3
  • 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 (12.5XLOSS) 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 lending capacity. 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 larger banks. FDIC Watch List. 4
  • 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. Small Businesses. 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. ASSUMPTIONS Market Liquidity. 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 5
  • 6. effect could be to reduce financing available to qualified U.S. borrowers, especially small businesses and credit worthy individuals. 6
  • 7. PRINCIPLES 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. Minimum Investment 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. PLAN SUMMARY 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. 7
  • 8. Community and Regional Banks: Equity Capital1 and Asset Purchases for All But the Largest Banks 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 bid-ask spread. 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 1 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. 2 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. 8
  • 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 approach. 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 implementation. Plan Cost Change Market Deficit Strength Inflation Alternative in Credit Distortion of Dollar Expectations Paulson $700B Negative High $700B negative negative 9
  • 10. Stone $60B >$700B Low $70B positive positive 10
  • 11. Exhibit 1 Logic Summary for the Stone Plan Start No FDIC liquidation Solvent? or forced merger Yes No Severely undercapitalized banks Close to Capital should be merged or else should Adequacy? raise equity on their own. Yes No Additional Equity Required Yes Adequately capitalized banks do not Is Capital at or need additional equity. They may opt Beyond Adequacy? to acquire some. They are qualified to sell assets. No 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 liquidity. 11