Wednesday, October 1, 2008

Yet another plan (Soros)

George Soros makes his suggestion in an article in the Financial Times (Note: free subscription required). An extract is below. He proposes that the government (TARP) look over the banks' books, figure out how much capital they need, and then inject capital to make them whole, while taking an equity position... Presumably this involves also valuing the toxic assets so that they can be marked to market (otherwise how do you know how much capital it would be necessary to inject?) while leaving the banks in ownership of those toxic assets. Far be it for this blogger to argue against a proposal from someone who knows this stuff inside and out (and is worth billions), but he thought that one of the huge criticisms of the administration's proposals was that it is very difficult to get to the value of the toxic waste (thus the concern that the TARP would overpay...). Under this plan, if the bank examiners undervalue them, then the TARP has to inject more money, while if they overvalue the toxic assets they risk not injecting sufficient capital! Also, this blogger's impression is that the value of the toxic assets is a moving target, as time goes by and mortgage defaults and delinquencies continue to increase the toxic assets continue to go down in value.

Thus, under the Soros plan, when the examiners come in, check the books, inject capital and take an equity position in the bank all is well. However, what is to prevent this from having to be repeated in six months?

Soros Article Extract:

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve - effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp’s terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

A revised emergency legislation could also provide more help to homeowners. It could require the Treasury to provide cheap financing for mortgage securities whose terms have been renegotiated, based on the Treasury’s cost of borrowing. Mortgage service companies could be prohibited from charging fees on foreclosures, but they could expect the owners of the securities to provide incentives for renegotiation as Fannie Mae and Freddie Mac are already doing.

Banks deemed to be insolvent would not be eligible for recapitalization by the capital infusion programme, but would be taken over by the Federal Deposit Insurance Corporation. The FDIC would be recapitalised by $200bn as a temporary measure. FDIC, in turn could remove the $100,000 limit on insured deposits. A revision of the emergency legislation along these lines would be more equitable, have a better chance of success, and cost taxpayers less in the long run.