Improving the Rescue Plan

Though the Bush administration’s Financial Rescue Plan went down to a stunning defeat Monday, it appears likely that a few modifications will yield Financial Rescue Plan 2 and another vote in Congress, as soon as today.

Before FRP2 is offered, it is worth reflecting on why FRP failed. The most basic reason, I believe, was that it was a blank check for the Treasury Department to spend an enormous amount of taxpayer funds. It is a hopeful sign for our democracy that Congress has not written that blank check. Congress may yet live up to its role, under the Constitution, to govern, and not simply to pass all authority to the executive branch.

Of course, the House vote was driven more by fear of voter backlash than constitutional principle. Voters are justifiably outraged that the government might shovel out taxpayer dollars to rescue the very firms that caused the financial crisis. I share that outrage.

Yet, there really is a crisis that must be arrested. We must not permit financial collapse to bring down otherwise sound companies that provide employment opportunities for all Americans.

The idea that the federal government can deal with the financial crisis by buying up the bad mortgage paper is deceptively attractive. I am reminded of the widespread public support for wage‐​price controls in 1971. What could be simpler than passing a law to prohibit price increases?

Details matter. It was impossible to administer wage‐​price controls to yield the desired result, as demonstrated by several thousand years of experience with that approach. Can Treasury’s rescue approach actually work?

PRICE POINT

An essential detail is how Treasury will price the mortgage paper it will purchase. If the price is too high, taxpayers will end up providing a large subsidy to banks, and as that becomes obvious the plan will collapse politically. It has been said Treasury will employ “some sort of reverse‐​auction procedure” to ensure that it will not overpay. What sort? No one has yet pointed to actual experience to show how the reverse auction or any other pricing scheme will work. No one has even provided a reference to a journal article to show how the auction should be designed in these circumstances, with highly heterogeneous and risky paper to be auctioned.

We do have extensive journal literature on the market implications of asymmetric information. Banks know more about the paper they hold than Treasury can know. Banks will sell the worst paper to Treasury and hold onto the better paper. It appears the plan will create a market rigged against the taxpayer.

PROPERTY MANAGER?

How is Treasury going to administer the assets it buys? Will Treasury not foreclose on hopelessly delinquent mortgages? Is it prepared to hire and oversee hundreds of contractors to manage properties seized through foreclosure? Someone must keep the vandals out, the furnace on and the roof intact to prevent hopeless deterioration of the properties. Everyone knows that contractors do not administer themselves — I doubt that Treasury has the resources to perform the necessary oversight.

A rescue plan that collapses politically because of Treasury administrative failures may make the financial crisis worse, just as the collapse of wage‐​price controls in the 1970s made inflation worse. Are there sensible options to supplement or replace FRP?

It is a mistake to suppose that there exists a single grand plan that will restore financial stability. The current process of merging or liquidating failed banks should continue, as should the provision by the Federal Reserve of ample funds to solvent banks through the discount window.

TAX TWEAKING

The federal government should examine approaches through the tax system. Companies with losses this year might get a cash refund of corporate taxes paid in prior years, using this year’s losses to offset prior income. About 70 percent of individual tax returns take the standard deduction. Perhaps, this year and next, individuals who would otherwise take the standard deduction could take the mortgage interest deduction as well. These tax provisions would direct some federal cash directly to some pressure points, and administration would be relatively simple.

BUY BANK EQUITY

A more radical proposal would be to permit Treasury to buy equity in any bank with a large portfolio of distressed assets. The Treasury could buy common stock at the closing price Friday, say, in an amount up to 3 percent of a bank’s assets. A bank could participate or not, as it thought best, in any amount up to the ceiling. The distressed assets would remain in the private sector, which would almost certainly mean better management of them than the Treasury could provide. There would be no taxpayer giveaway, as the Treasury would buy stock at a recent market price.

To me, a combination of steps has much greater promise than a single grand plan with unknown and perhaps unworkable details. I hope that during this election season both the Treasury and congressional staffs will be hard at work on Plan B, whatever it might be.