Concerns about the Treasury Rescue Plan

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

September 19, 2008

Amid continued tumult in financial markets, the Treasury Department has developed a systematic plan to stabilize the financial system. Observers have been worried that the huge losses suffered by both long-term shareholders and recent investors in financial companies have made it impossible for these firms to raise enough new capital to work their way out of the current crisis. In response, the Treasury plan would inject significant amounts of government funds into these companies.

Some have pointed to the Resolution Trust Company (RTC) of the early 1990s as an appropriate model for a government rescue. The RTC was created to sell assets that the government had acquired in the course of honoring federal deposit insurance at savings and loans. Pooling the illiquid assets collected from the hundreds of failed savings and loans, and selling them in a systematic manner, probably increased the government’s ultimate return.

However, the current policy challenge is different. Relatively few banks have failed to date, so the government has not acquired such a large collection of assets that it needs to sell. Indeed, the argument for systematic intervention at this point is that stabilizing the financial system should not wait until all of the affected institutions have gone bust. Thus, the challenge is not how to sell assets the government already owns, but whether the government should buy assets—and, if so, which ones, from which firms and individuals, in what quantity, and at what price?

Whether the government should purchase financial assets on a large scale at this point is difficult to gauge. Such purchases would involve the government even more deeply in the financial system and might well impose substantial costs on taxpayers. But inaction could also be very costly, because the spreading financial problems are an increasing drag on economic activity. Given the seriousness of the crisis, it is worth considering how government funds might best be injected.

One approach is to purchase mortgage-related debt or other troubled securities. This approach has the advantage of going to the heart of the current turmoil, which began and is still centered in mortgages, mortgage-backed securities (MBS), and derivatives of those securities. Yet this approach has significant disadvantages as well.

First, the affected debt instruments are quite heterogeneous, which makes setting appropriate prices and quantities very difficult. If all MBS were alike, the government could simply undertake a reverse auction, purchasing the cheapest securities on offer until the market yield was driven down to the desired level. But MBS differ in the probability of mortgage repayment and other characteristics. If the government said it would buy a certain amount of AAA-rated MBS at the lowest price offered, and a certain amount of AA-rated MBS at the lowest price offered, it would be placing undue weight on ratings that have been widely derided, and current holders would likely sell the government the lowest-quality securities within each ratings class. Derivatives of MBS are even more idiosyncratic, so running an effective reverse auction for them would be even more difficult. Instead of auctions, the government could consider buying eligible securities at a pre-set premium over current market prices—except that the illiquidity of financial markets now means that market prices for many of these securities do not exist. Alternatively, the government could use its judgment—or the judgment of a hired investment firm—to decide which debt securities to buy and from whom and at what price, but the potential for inefficiency, unfairness, and abuse in such a system is high.

A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions. Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a program, while banks that made the biggest commitments to low-quality mortgages and have delayed dealing with their balance-sheet problems would be the biggest beneficiaries.

Third, this approach saddles taxpayers with significant downside risk but limited potential upside gain. One crucial feature of the Treasury and Federal Reserve rescues of Fannie Mae, Freddie Mac, and AIG is that taxpayers received substantial equity shares in these companies and could receive solid returns if financial markets rebound.

An alternative to the government buying certain types of debt from financial institutions is for the government to make equity investments in a wide cross-section of such institutions. For concreteness, suppose that the government offered to make an equity investment in every firm regulated by a federal or state banking regulator equal to 10 percent of the market value of the company as of September 1st in exchange for a 10 percent equity stake in the company. (The 10 percent figure is illustrative. As with the first approach, a judgment about the appropriate total amount of government funds would need to be made.)

With this approach, the government would not need to determine the appropriate prices and quantities of individual mortgage-related securities, it would not be providing a greater reward to companies that have made the worst investments, and it would gain the opportunity for taxpayers to receive a higher return if the financial system recovers more strongly. Still, objections can be raised.

First, the even-handedness of these investments means that they would not focus on the firms facing the greatest stress, which might damp the immediate bang-for-the-buck. However, the even-handedness also means that the government would not be bolstering companies in trouble relative to those in better health, as under the first approach. Therefore, the crucial restructuring of the financial sector—away from institutions and business models that failed, and toward others that proved more robust—would continue. The financial sector might heal more slowly, but it would also heal more solidly.

A second difficulty would be choosing the companies that would be eligible for this offer. Limiting eligibility to banks would offer no direct help to non-bank firms that have suffered large financial losses, although they would benefit indirectly from the stronger financial condition of banks. Expanding the set of eligible companies would enhance the effect on financial stability, but would be hard to do in a way that distinguished between firms with significant and minor financial operations.

Third, firms that were optimistic about their future prospects without government assistance would likely decline this offer. But shareholders would be unlikely to hold out in expectation of a better deal from the government in light of the losses suffered by shareholders in the Federal Reserve and Treasury rescue operations this year.

A fourth objection is that the government would be a minority shareholder and could not control the institutions in which it invested. Therefore, this approach could not be used to help struggling mortgage borrowers directly; any additional assistance to borrowers would need to be channeled through the Federal Housing Administration or some other entity. In addition, the government could not dictate corporate strategies regarding asset accumulation or liquidation. This passive shareholder position creates some risks, but it avoids substantial risks associated with the government attempting to control and manage the entire financial system.

Whichever of these broad alternatives the government pursued—buying mortgage-related debt and other troubled securities, or investing in a wide range of financial institutions—the assets acquired would need to be divested over time. After the financial crisis has passed, the government would sell its holdings to private investors on a gradual basis over a period of years.

Editor’s Note: Doug Elmendorf also offered his cautions on the government plan in an op-ed in the New York Times.