At a lectern in a room of venture capitalists, Silicon Valley executives and professors at the Stanford Institute for Economic Policy Research last week, Larry Summers, former Treasury secretary and now Harvard professor and hedge-fund adviser, was at his gloomiest.
In the audience, Myron Scholes -- Nobel laureate in finance, veteran of the Long-Term Capital Management hedge-fund debacle and now chairman of his own hedge fund -- was listening and scribbling on a yellow legal pad. His conclusion, one gaining momentum, is that the government eventually will spend a lot of taxpayer money to clean up the current credit mess and prevent economic catastrophe...
Wall Street would love what Treasury Secretary Henry Paulson derides as "a bailout," a way to unload its mistakes onto taxpayers. But unless the tide turns soon, the severity of the housing bust and fragility of the financial system may force even his hand.
There's all sorts of talk about ways for Washington to buy mortgages, essentially purchasing assets of the financial system. The Fed is trading some U.S. Treasurys for mortgage-backed securities to arrest the decline in prices that is pushing up mortgage-interest rates. Several leading Democrats are calling for a new government entity or an enlarged Federal Housing Administration to buy mortgages from lenders and investors, and to offer more-favorable terms to beleaguered homeowners.
Mr. Scholes takes a different tack, seeking ways to leave the assets (mainly mortgages) in the private sector, which he says can manage them better, and get capital flowing into the banking system so banks don't dump assets at distressed prices and worsen an already bad situation.
Mortgages and other bank assets aren't worth what banks thought. The losses erode the banks' capital cushion. Bank leverage, described in last week's Capital column, magnifies the effect.
In response, banks either (A) reduce lending and sell assets or (B) raise new capital on terms that dilute existing shareholders. Provided they can find investors willing to bet that bank assets eventually will be worth more than they are today, shareholders tend to prefer option A, the smaller bank. But that market solution could destroy value and produce a crippling credit crunch. Society prefers option B, hence exhortations from Messrs. Paulson and Summers for banks, Fannie Mae, Freddie Mac and others to raise capital.
Raising capital privately would be best, but what if that doesn't happen? What might government do? If a bank collapses, the government wipes out shareholders, owns everything and pumps in money. That's what the United Kingdom did with Northern Rock this year, and it's pretty much what the U.S. did with Continental Illinois in 1984.
Should the government (the U.S. government, that is, not foreign governments' sovereign wealth funds) put capital into banks?
"I think they should be considering it, at least thinking about it," Mr. Scholes said. "It seems to me that recapitalizing these entities would give us an opportunity to preserve the assets -- as opposed to dissipating their value through liquidation or foreclosure -- and provide a way for more capital to be infused into them without destroying value."
As John Lipsky, No. 2 official at the International Monetary Fund, argued in a speech yesterday: "Policy makers . . . need to 'think the unthinkable.'" He called for government "contingency plans" in case "investors aren't willing, as they have been up to now, to provide capital injections" to banks.
But there's a conundrum. If the government guarantees or buys debt from the bank, it makes the equity holders better off. If it buys equity and dilutes existing shareholders, it makes debt holders better off.
Mr. Scholes's solution: Let government invest both in debt senior to existing debt and in preferred stock senior to existing shares. Neither is advantaged versus the other. The bank doesn't dump assets and expands lending. If all goes well, the government gets out with a profit. One big caveat: This works only if assets truly are worth more tomorrow than they'll fetch today.
The practical wrinkles are many. ("I'm a theorist, not an institutionalist," Mr. Scholes quips.) He acknowledges the risk that some banks will take the taxpayers' money and bet it on risky assets to make a profit. He suggests auctioning off this government capital broadly to all banks, not just the sickest.
There are reasons to be skeptical. Banks do need new capital, said Hyun Song Shin, a Princeton finance professor. "It took the Japanese 10 years to learn this lesson." But he calls the Scholes notion "self-serving" for existing shareholders. They should be wiped out before the government puts capital in any bank, he argued. (What would he do? For starters, advise Mr. Paulson to summon the nation's top bankers to his office and strongly suggest they conserve capital by suspending dividends.)
-Brainstorming About 'Bailouts'
2008 SIEPR Economic Summit (highly recommended, include lot big names like David Walker, George Shultz, Summers and even Ben Stein)