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R. Glenn Hubbard
When Henry Paulson, President Bush’s
Treasury secretary, first introduced the Troubled Asset Relief Program
(TARP) in Congress last September, we cautioned against using
government funds to buy mortgages and mortgage-related securities from
banks. After the Emergency Economic Stabilization Act was signed into
law in early October, the Treasury decided not to buy these assets.
Instead, it used the first $350 billion of TARP funds to inject capital
first into nine systemically important troubled banks, and later into
insurer AIG (as part of a refinancing) and auto makers General Motors
If Treasury pays close to par,
This approach seems to have achieved (albeit at a high cost for
taxpayers) its principal objective of avoiding a massive collapse of
the financial system. But it has not yet resulted in an increase in
bank lending or the attraction of new private equity to the banking
system, both of which are important to reviving the economy. There now
appears to be active consideration of using TARP funds to buy “bad
assets” from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime
crisis hit in the summer of 2007, the Treasury’s first response was to
encourage the private sector to create a fund–the so-called Super SIV
(structured investment vehicle)–to buy mortgage-related assets. This
proposal foundered due to the difficulty of setting a price for these
assets, which come in complex and incomparable varieties. If Treasury
pays close to par, it is paying far too much. If it pays current
prices, no one will sell because of the adverse impact on their
capital. If it pulls a price out of a hat, it will be acting
Initial discussions focused on using a reverse auction with asset
holders “bidding” to sell their mortgage-related securities to the
Treasury. Such an approach raises significant problems–most
significant is the risk posed by asymmetric information regarding the
value of these securities. Because the holders of complex and
incomparable mortgage-related securities have more information
regarding their worth than does Treasury, Treasury is at a huge
disadvantage and will likely overpay. Moreover, there will have to be
many auctions of very different securities. All of this will take
months to execute.
Reportedly, thought is now being given to only buying “bad assets”
and putting them in a fund (called a “bad bank”) owned by the
government. This new variation raises additional problems. First, how
should “bad assets” be defined? As the recession deepens, bad assets
have multiplied and will continue to multiply from mortgages and
mortgage-related securities to many other assets classes, including
credit-card portfolios. We see little sense in defining bad assets
simply as those that have been already significantly written down. The
bank may be more exposed to losses from assets that have not been
significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the
cost of purchase. Total mortgage-related securities and mortgages held
by banks alone are estimated to be $6 trillion, of which
mortgage-backed securities are $1.3 trillion. Total bank assets are
Another proposal is to guarantee the value of bad assets rather than
buy them. This outcome could be accomplished by a direct guarantee of
assets that remained on the balance sheet of banks (or were brought in
from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP
financing for Citigroup and Bank of America. In the case of Citigroup,
a $306 billion asset pool was created in which Citigroup absorbs the
first $29 billion of losses, the Treasury and FDIC jointly fund 90% of
the next $15 billion ($5 billion from the Treasury through TARP, and
$10 billion from the FDIC), and the Fed finally funds 90% of the
remaining losses. In return, the government received $7 billion in
preferred stock (with an 8% yield)–$4 billion to Treasury, $3 billion
to FDIC. Under this approach, the problem of valuing the assets has
been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would
surely demand, that finesse would not work. A conservative estimate
puts the value of the Citigroup option–i.e., the potential cost to
taxpayers–at $60 billion, taking account of the stock warrants the
government received. If one were to repeat this approach for all banks
the cost would be as much as TARP. And, if the market for toxic assets
were to fall further, the government could easily be responsible for
trillions of dollars of losses. Last but not least, having the Fed
become the residual risk bearer further undermines the Fed’s financial
stability and its ultimate independence, a concern recently voiced by
the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin
off the toxic assets into separate affiliated bad banks (as under a new
reported German initiative). Ownership of these two entities would be
allocated pro rata to all the financial investors as a proportion of
the most updated accounting value of these assets. So a bank with $30
billion of bad assets and $70 billion of good assets will see its debt
divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim
will become a $30 debt claim in the bad bank and a $70 debt claim in
the good bank. The same would be true for equity. To limit the exposure
of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt
should remain in the good bank to the extent there are sufficient
matching good assets. In addition, off-balance-sheet derivative
contracts remain off balance sheet for the good bank to avoid the
possibility that the failure of the bad bank would create systemic
risk. Furthermore, convincing evidence would be needed before
guaranteeing any of the liabilities of a bad bank because ordinarily a
bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the
injection of new, private-equity capital into banks by eliminating
regulatory restrictions, such as bank ownership by private-equity or
commercial firms, and providing protection against loss or dilution if
there were to be subsequent government intervention. A subsidy for this
private risk capital could even be given. As long as private capital
holds most of the risk, it will certainly be allocated more efficiently
than government money, minimizing the taxpayer cost of any subsidy.
This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks
with dangerously low, or no or negative capital, should be taken over
by the government through already established FDIC procedures, such as
bridge loans. Just as with the Savings and Loan crisis of the 1980s,
there is a significant risk that shareholders (and managers) with
nothing to lose will roll the dice and lose even more. Existing
shareholders with no equity should not benefit by government support.
Further, a government takeover (just like a corporate bankruptcy)
permits the restructuring of bank debt. As the S&L debacle shows, a
decision worse than a nationalization of the banking sector is a
nationalization of the losses, which still leaves the gains in private
With still solvent institutions, there is no affordable and workable
plan that will by itself assure that these banks will start lending and
that private capital will return. We have stabilized the financial
system against massive collapse, which is probably all the government
can do. While we hope some more improvement may come from the bad bank
or private-equity solutions outlined above, the road to further
recovery of the financial system now lies principally with the
economy’s recovery and the success of the fiscal stimulus.
R. Glenn Hubbard is a visiting scholar at AEI. Hal Scott is a
professor at Harvard Law School. Luigi Zingales is a professor at the
Graduate School of Business at the University of Chicago.
Purchasing “toxic” assets is no easy solution.
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