The Protection of the Financial Aristocracy - Berkeley …

The Protection of the Financial Aristocracy - Berkeley … Financial Aristocracy? *Ross Levine 2/11/09 The Financial Stability Plan unveiled by Treasury Secretary Timothy Geithner yesterday is neither an incoherent, shaky hodge-podge of programs as critics contend, nor does it yet articulate a clear strategy for restoring the long-run health of the financial system. Let’s review the rationale and structure of the Plan along with its weaknesses and risks. First, there are sound economic reasons for using massive amounts of taxpayer money to fix the banking system. The economy rests on the foundations of private entrepreneurship, which itself requires a well-functioning financial system. That system is currently broken and it would take an exceptionally long time for the financial system to recover without government intervention. While the economic stimulus plan winding its way through Congress will help, the economy will not soon enjoy sustained economic growth unless the government fixes the financial system. Second, the Financial Stability Plan will rigorously audit banks to ascertain the financial condition of banks. While it is difficult to understand why this type of assessment was not done much earlier, given that the problems in the banking system first arose in the summer of 2007, these audits are necessary for identifying which banks are potentially solvent and which are hopelessly broken. Third, the Plan calls for the creation of the Public Private Investment Fund (PPIF), which will be jointly run by the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). With financing from private investors, the PPIF will purchase low-quality, illiquid assets from banks. Although the details are vague, private investors will probably be encouraged to participate through official guarantees that insure investors against large losses. These guarantees will increase the price of banks’ assets with a commensurate boost to the equity value of the bank. By replacing the toxic assets on banks’ balance sheets with up to $1 trillion of cash, this “bad bank” will recapitalize and hopefully revitalize banks, creating more opportunities for banks to lend to firms and households. Fourth, the government will directly inject up to $350 billion of taxpayer money into the banks using the funds remaining in the Troubled Asset Relief Program (TARP). By further enhancing banks’ balance sheets, the Plan seeks to encourage lending. At this point, the Plan is vague about whether the government will receive warrants, common stock, or some other security in return for these funds. Fifth, the Plan will facilitate lending through non-bank financial institutions, which account for almost half of credit issued in the United States. The Federal Reserve will * James and Merryl Tisch Professor of Economics, Brown University, and Director of the Rhodes Center for International Economics and Finance. vastly expand is Term Asset Backed Securities Loan Facility that encourages the financing of car loans and credit card debt, and also extend this Facility to include commercial and residential mortgage-backed securities, as well as small business loans. This component of the Plan could expand to as much as $1 trillion. Furthermore, Geithner announced steps to reverse the dramatic decline in Small Business Administration (SBA) lending by increasing the federally guaranteed portion of the loans and giving the SBA more discretionary power to expedite loans. The Treasury also indicated that next week it would detail a $50 billion initiative to facilitate the renegotiation of mortgage terms for millions of homeowners facing imminent foreclosure. Thus, the Plan successfully sketches a strategy for rapidly creating well-capitalized banks with clean balance sheets and well-functioning securities markets. There are potential problems, however. First, as currently constituted, the Financial Stability Plan will enrich existing owners and senior managers of banks. When taxpayers guarantee the value of bank assets, those assets become more valuable to investors. This taxpayer-induced increase in the price of bank assets translates virtually one-for-one into higher bank stock prices, profiting existing owners. This will add to earlier taxpayer support for bank shareholders. In November of 2008, the Treasury paid a 40 percent premium for banks shares. And, by expanding the insurance of bank liabilities, the Federal Reserve has boosted the value of bank shares, enriching current shareholders. Senior managers also benefit because some of their compensation is tied to bank stock prices and the bailout of existing owners will enhance the security of current bank managers. Many of the same people who helped orchestrate the current crisis will be directly rewarded by taxpayers and kept in their current leadership roles. The issue is not vindictiveness; it is the fairness and legitimacy of the system and hence the willingness of the public to finance the reconstruction of a sound financial system. As President Obama accurately noted, “We don't disparage wealth. We don't begrudge anybody for achieving success, and we certainly believe that success should be rewarded. But what gets people upset, and rightfully so, are executives being rewarded for failure." When the government uses its power to refill the coffers and bolster the power of a financial aristocracy, this weakens faith in the integrity of the system. Second, and perhaps most importantly, by rewarding and protecting leading architects of the current financial crisis, the Plan will hurt the future operation of the financial system. Although official regulators can and should play a major role in supervising banks, sound banking also requires the rigorous oversight of private equity and debt holders. Owners and debt holders with lots to lose have greater incentives to scrutinize bank managers than those without much financial exposure. If the government bails out the existing owners and debt holders that enjoyed extravagant profits while failing to exert adequate governance over their banks, this will reduce the incentives of future owners and managers to operate prudent banks. Put differently, if the current Plan saves the existing equity and uninsured debt holders in the name of financial stability, it risks undermining the very financial system that we need for sustained growth. Although it is essential to use taxpayer resources to save the banking system, this does not mean saving existing bankers. Indeed, to save and strengthen the system, existing shareholders, bond holders, managers must face the financial losses commensurate with their devastating failures. Within the boundaries of the Financial Stability Plan, there is sufficient scope to rectify these weaknesses. Specifically, when injecting capital into insolvent banks, the government should receive common stock and uninsured debt holders should receive a “haircut” on the face value of their securities. When the PPIF supports the purchase of toxic bank assets from banks at above market prices, the government should receive common stock from the banks. Since many of the major banks are insolvent, this will make the government the majority shareholder in many banks. These shares can be sold to private investors. Just as the government is seeking to coordinate the purchase of trillions of dollars of toxic assets, it can coordinate the purchase of a few hundred billion in bank stocks, where these banks will have extraordinarily clean, transparent balance sheets once the Plan is implemented. This amendment to the Plan is fair and helps rebuild and fortify the foundation of a sound financial system. It is fair because people take responsibility for their actions. It starts the rebuilding process by incentivizing owners and debt holders to oversee banks more prudently. It is true that this amendment could create even greater disruptions in the short-run. There might be disruptions as bank owners are diluted, uninsured debt holders take a “haircut,” and banks are re-privatized to new owners that instill their own managers. The evidence, however, suggests that there are far greater risks associated with undermining the legitimacy of the financial system, creating a financial aristocracy, and reducing the incentives for bank owners and debt holders to operate banks prudently.