Edited by Dr. Ronald I. Miller and Dr. Elaine Buckberg. This report presents a summary of current thinking by academic economists and does not necessarily represent the views of NERA or any NERA economist.
Since we released our note on economists' reactions to the Paulson Plan on 26 September, events have moved quickly. The initial three-page proposal grew to a 110-page bill, the Emergency Economic Stabilization Act of 2008, and was rejected by the House of Representatives. The Senate then grafted the House bill, largely as-is, onto a popular tax bill, along with provisions concerning renewable energy, health care, and other unrelated matters. This bill, now weighing in at 451 pages in draft form, was passed by the Senate and the House and was signed into law by President George W. Bush on 3 October. This note updates our previous advisory with a description of what is new in the final version of the Emergency Economic Stabilization Act of 2008, and a discussion of some proposals by economists for additional measures that might be taken beyond the present Act.
What is new in the Emergency Economic Stabilization Act?
Though the heart of the Act remains authorization for the US Treasury to purchase up to $700 billion of troubled mortgage-related assets, Treasury now also intends to use the powers of the Act to recapitalize banks by making equity investments.1 The British government announced similar plans for bank recapitalization on 8 October. Much of the final version of the Act is given over to details of oversight and organization. However, it still gives wide latitude to Treasury and does not provide details on the mechanisms to be used to set prices and conduct purchases of the troubled assets. This section discusses the substantive changes and additions to the Act.
One important change from the original proposal is a broadening of the "troubled assets" that can be bought under the power of the Act to include equity and debt of financial institutions. The language of the Act allows the purchase of "troubled assets," including not only mortgagerelated assets, but also "any other financial instrument" whose purchase is identified by Treasury as "necessary to promote financial market stability." Congress need only be notified of such identification.2 During the House's debate on the bill, Congressman Barney Frank (D-MA), Chairman of the House Financial Services Committee, read into the Congressional Record that the term "assets" in the Act "is intended to include capital instruments of an institution such as common and preferred stock, subordinated and senior debt, and equity rights."3
Based on this broad interpretation of "troubled assets," Treasury Secretary Henry M. Paulson has announced plans to inject capital directly into US banks. As we noted in our earlier advisory, the failure of the original Paulson Plan to include bank recapitalization provisions was viewed as an important weakness by some economists. Bank recapitalization also has the merit that it can be done swiftly, whereas the auctions may take weeks to start and could take weeks or months to complete. The power to recapitalize banks now appears to be an important tool provided by the Act, though that was not obvious from the wording of the Act. Treasury has also stated that its ability to purchase assets may be extended to state and municipal government debt held by financial institutions.
Although the $700 billion headline figure remains intact, the Act stages the availability of Treasury funds to purchase troubled assets. Only $250 billion is initially authorized, with an extra $100 billion available if the President notifies Congress that Treasury needs it. For access to the full $700 billion, the President must submit a written report detailing Treasury's plan to use the full limit. Following such a submission, Congress would have 15 days to disapprove the request. Congress does not need to affirmatively approve the extension of asset purchases, but it gets a right of refusal. It is unclear what, if any, effect this change has had.
A Treasury spokesperson has been quoted as saying that $700 billion was not picked based on any particular data, but because "We just wanted to choose a really large number."4 However, the rationale for picking a "really large number" was that it would, by itself, stabilize expectations in financial markets. The staging of Treasury's access to funds may have weakened the immediate impact of the Act. After an initial boost when the Plan was announced, stock markets have declined sharply since the Act was approved, and two major banks, Washington Mutual and Wachovia, have failed. Most observers believe that the freezing of credit markets has continued to worsen and the Federal Reserve is now acting to shore up the commercial paper market.
The Act also includes an asset insurance provision similar to that proposed by House Republicans and discussed in our previous advisory. The provision stipulates that Treasury must develop an asset insurance scheme to accompany any asset purchase plan. The Act provides even less detail on the insurance scheme than on the asset purchase scheme. Many observers do not expect that the insurance component will be an important policy tool, given that such insurance was not part of the original Paulson Plan. Treasury may be able to satisfy the Act by nominally creating an insurance program, not necessarily immediately, and without actually selling any insurance. As we discussed in our earlier advisory, the insurance scheme would be at least as difficult to implement as the purchase scheme.
Another addition to the Act is a requirement that institutions selling troubled assets to Treasury must also provide warrants or senior debt to Treasury in exchange for participation in the program. How this addition will affect the program in practice is unclear, but the language gives Treasury greater flexibility in dealing with the crisis. The Act does not specify the volume or value of the warrants. Treasury could effectively ignore this provision in conducting the auctions by making the warrants of minimal value. Institutions may be asked for bids that include both cash and warrant price components at which they will sell troubled assets. A potential problem with this approach is that it will complicate the problem of setting prices for troubled assets by requiring the seller to consider both the value of the assets and the cost of the warrants.
A few other provisions of the Act are also worth mentioning. The Act temporarily increases the limit on FDIC-insured deposits from $100,000 to $250,000. This provision is intended to help prevent bank runs on commercial banks. The Act imposes some limits on executive compensation, though these limits should not significantly change its overall impact. Finally, the Act gives authority to the Federal Reserve to pay interest on accounts of commercial banks held at the Fed, and to lower the legally required minimum cash reserves held by commercial banks. Paying interest on central bank reserves is a policy that has long been recommended by some academic economists, as the previous system of interest-free Federal Reserve deposits amounted to a non-transparent tax on the financial services industry. This increased authority gives the Fed one more tool to deal with problems in the banking system.
Additional policy proposals
Guarantees for interbank debt and deposits
Treasury is said to be considering proposals to guarantee short- and medium-term interbank debt. The UK government has proposed to guarantee all bank debt up to 36 months in maturity and urged other governments to do the same. The goal of doing so is to renew banks' access to funding longer than overnight via the interbank market, and to give capital markets the confidence to purchase commercial paper and short- and medium-term debts issued by banks.
In addition, Treasury is considering extending deposit insurance to all bank deposits, beyond the temporary insurance ceiling of $250,000. Deposits above $250,000 are estimated at $1.8 trillion, which would raise the amount insured by the FDIC from $5.2 trillion to $7.0 trillion. As with the increase of the ceiling to $250,000, if increased insurance prevents large deposits from being taken out of the banking system, it may prevent bank runs and actually reduce claims on the FDIC.
Joint federal-private sector purchase of assets
News reports indicate that Treasury is considering reselling stakes in the assets it acquires at auction to private sector investors. Such a plan to create joint ventures, in which the government would retain a stake, while selling a large stake to private sector investors would mirror similar deals implemented by the Resolution Trust Corp. using real estate assets from the savings and loan crisis. It would also enable the government to quickly recoup a substantial proportion of its initial outlay to purchase the distressed assets. While this would reduce the amount of debt the government would have to issue, that reduction would be offset by greater private sector liabilities. Warren Buffett made a somewhat similar proposal last week, in which Treasury would seek private investors to purchase distressed assets. The private sector investors would need to put up 20% of the purchase price. Rather than retaining an interest in the assets, the government would loan the investors up to 80% of the purchase price and receive first claim to the cash flows from the assets.
Federal mortgage refinancing
Some economists have suggested that even if the asset purchase plan is needed to temporarily stabilize financial markets, it does not address the underlying source of the current crisis: the housing and mortgage markets. Several different plans have been suggested that might complement or substitute for the security purchase plan and, according to the authors, lead to greater long-term stability. The concern behind all these proposals is a vicious cycle in housing prices and foreclosures: as long as housing prices continue to fall, more households will have negative equity in their homes and more owners will walk away from their mortgages; the resulting foreclosures will drive housing prices yet lower. Moody's Economy.com estimates that 16% of mortgages, representing 12 million households, now exceed the current value of the home.5
While the Act does not require specific actions directly relating to housing or mortgages, it does create broad authority that might be used to intervene directly in the mortgage market, including refinancing mortgages directly. The Act authorizes the Secretary of the Treasury to "purchase ... troubled assets from any institution,"6 where troubled assets is defined to include "residential and commercial mortgages."7 It further allows the Secretary to "enter into securities loans, repurchase transactions, or other financial transactions in regard to any troubled asset purchased under this Act."8 (Emphasis added.)
We briefly describe some of these proposals:
R. Glenn Hubbard and Chris Mayer, both of Columbia Business School, have proposed that all mortgage holders be allowed to refinance their mortgages into 30-year fixed-rate mortgages at 5.25% interest that would be placed with Fannie Mae and Freddie Mac with no subsequent refinancing allowed. Interest rates would be higher for riskier borrowers. Their proposal is premised on the notion that housing prices have already fallen below their longer-term equilibrium level and that intervention in the housing market is needed to stabilize the spiral of lower housing prices that lead to tightened credit and further decreases in housing prices. Lower interest rates in general lead to higher housing prices. Dr. Hubbard and Dr. Mayer point out that the federal government already effectively controls 90% of the mortgage market via Fannie Mae and Freddie Mac, which makes such intervention feasible. Homeowners with negative equity would be allowed to write down their mortgages by up to $75,000. Senator John McCain (R-AZ) has announced that, were he to be elected President, he would propose a mortgage refinancing program similar in some ways to the Hubbard-Mayer proposal, though focused on failing mortgages only. Dr. Mayer has been quoted as saying that he thinks this limitation would prevent the plan from working as intended.
Jonathan Koppel and William Goetzmann of the Yale School of Management have proposed a similar plan. They propose that Treasury should simply pay off all delinquent mortgages by offering 30-year refinancing at a fixed 6% rate to everyone who received a mortgage in the last five years. They argue that this would have the advantage of making mortgage-related securities worth something close to their face value as existing mortgages would simply be paid off. Mortgage borrowers who still could not meet the refinanced payments would be allowed to reduce their principal in exchange for a federal government equity stake in their house.
Martin Feldstein of Harvard University recommends that the federal government offer to refinance 20% of any existing mortgage at a low interest rate, up to a maximum of $80,000. Dr. Feldstein proposes that the loans be at the government's cost of funds, putting that rate as low as 2%. The federal mortgage component would be a full-recourse loan, secured not by the home, which would remain as security for the remaining private-sector mortgage, but by all other household assets or income. The original mortgage lender would have to accept the 20% loan repayment and reduce monthly service by 20%, as if the loan had been refinanced to a 20% lower base. While Dr. Feldstein's plan would reduce the amount of mortgage debt held by private sector creditors by 20%, it would reduce the monthly mortgage burden of borrowers by something less than 20%. While many refinanced mortgages would no longer exceed the current home value, this plan would still leave many households with combined property-related debt exceeding their current home value. Homeowners could also risk losing not only their house, but also their car, other assets, and future income if they are unable to service the government loan.
The broad wording of the Act may well allow these proposals, and more, to be implemented at the discretion of Treasury. The government-private partnership approaches could be attempted quickly to establish their feasibility. The mortgage refinance programs may be given serious consideration once the basic operation of the banking system has stabilized. In the very brief history of the Act, one thing is clear: Treasury has very wide discretion in its actions to stabilize the financial system.
We will continue to offer updates on these issues as events warrant.
1. Technically, the Act allows Treasury to hold up to $700 billion of troubled assets. In principle it could purchase more, were it able to resell some assets.
2. H.R. 1424, 110th Congress, § 3(9)(B).
3. US Congress. House. Emergency Economic Stabilization Act of 2008. 110th Cong., 2nd sess., H.R. 1424. Congressional Record. 154, no. 161, daily ed. (3 October 2008): H10763.
4. Wingfield, Brian and Josh Zumbrun, "Bad News for the Bailout," Forbes.com, 23 September 2008.
5. Hagerty, James R. and Ruth Simon, "Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water,'" Wall Street Journal, 8 October 2008.
6. H.R. 1424, 110th Congress, § 101(a)(1).
7. Ibid, § 3(9)(A).
8. Ibid, § 106(c).
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