The Hindu Business Line : Is the ‘rescue plan’ the best there is?

There are many simple questions one can ask of the Henry Paulson proposal… the same as a prudent father might ask of a profligate son who seeks more money for what seems to be a losing business

Rajesh Haldipur

During financial crises such as those in 1987, 1994, 1998 or the dotcom bubble in 2001, the losses and exposures of financial institutions (especially in the US) got increasingly larger. However, sustained intervention by the Federal Reserve through rapid interest-rate reductions, to the point of giving zero-cost (in real terms) funds to its banks, ensured that the US economy (and other economies fuelled by American consumption) bounced back to its profligate, free-spendin g ways, financed by cheap and easy credit.

It is now clear, though, that there are new poisons on which the old medicines don’t work.

Investment banks as standalone businesses have virtually disappeared. The survivors have either been subsumed by, or become, commercial banks and this hopefully brings them under stricter supervision by the Fed.

This will limit leverage and, hence, reduce the rate of return earned. The many institutional bankruptcies we are witnessing are due to rapid financial de-leveraging in the economy. The effect this has on the financial system is similar to what happens to the human body due to decompression as it rises rapidly to the surface after a long, deep dive.

The same metaphor holds the key to the solution. An experienced deep-sea diver acclimatises himself and rise to the surface in stages. He knows the value of this measured approach. His blood gases will expand slowly enough to not cause unbearable pangs of decompression. The financial equivalent of this would be to de-leverage the balance sheet in stages — based on the immediate needs of every major institution.

The rescue plan

Is the $700 billion proposal the best solution? There are many simple questions one can ask of the Henry Paulson proposal. They are the same questions a prudent father might ask of a profligate son who asks for additional investment for what seems to be a losing business: How did you arrive at this figure? How long will it take to consume this sum? What will the situation look like after this money has been exhausted?

What if this amount is not enough? What if it does not work? What will I get in return for this huge injection of liquidity? Other, slightly more sophisticated questions would include: What are you doing about liability-side crises (like runs by bank depositors)?

How much of this money will finance fancy executive salaries, stock options and golden parachutes that have already been signed? Are executives willing to take salary cuts and return the bonuses and option gains they got within the last 2-3 years — the period during which this problem has been building up? Some of these questions, doubtless, are being asked by the US lawmakers of Messrs Bernanke, Paulson & Co.

The rescue proposal as we know it now will let reckless investment and commercial bankers off the hook by relieving them of the “toxic waste” accumulated on their books, albeit at steep discounts, without giving Government — and thus taxpayers — the upside that may emerge from the massive risk the Government undertakes to save them.

Besides, it will perpetuate the moral hazard — you take bad decisions and the Government will clean up after your worst mistakes.

Further, if the plan does not work, the Government will have used up a huge cash hoard partially bailing out certain asset-side problems of banks — and run out of ideas and money to tackle any other crises.

An alternative approach

A more effective alternative would be a three-pronged approach that addresses both liability-side and asset-side problems. The underlying premise is that it is easier to change accounting norms than to accommodate volatility caused by the existing norms. On the liabilities side, to head off possible runs on banks, a large recapitalisation of Federal Deposit Insurance Corporations and a ten-fold increase in the limit of federally insured bank deposits to $1 million will reassure depositors and avert flight of deposits, especially of small businesses.

The cost of extra insurance cover can be passed on to banks in proportion to their deposit base, probably a minor cost. Raising FDIC’s capital involves contingent cash outflows. On the assets side, the growth in home loan defaults and the pressure to divest bad assets can be relieved thus:

a) Allow defaulting home loan borrowers to stay in their homes for rentals equivalent to their instalments, with a sweetener: if they pay rents regularly for, say, 1½–2 years, the rents paid will be adjusted against their principal dues, and homes re-transferred at the end of the period with low interest rates thereafter.

The underlying presumption is that homeowners would be glad for a chance to continue staying in their homes; and fall in home prices will be arrested by then. This could be accompanied by an accounting waiver to banks from recognising losses or incomes on such assets till the “rental” period is over. Writing off a year’s interest income will likely be much cheaper on risk-adjusted basis than the human and financial costs of avoidable foreclosures.

b) De-leveraging banks’ balance sheets through infusion of fresh capital. Recapitalising institutions is likely to work better than the “cash for trash” approach in at least three ways:

Capitalisation by Government will mean nationalisation — which gives the option to exit through de-nationalisation after restoring the institutions to health. The less help an institution takes from the Government, the lesser will be the owners’ stake dilution, thus creating strong incentive to reduce dependence on Government bailout. At the same time, the Government will benefit in proportion to the risk it takes, in the form of ownership stake, the value of which will go up as soon as the institutions recover. This value gain will help recover costs and impound some of the excess liquidity being injected into the financial system.

By recapitalising, institutions will suffer in proportion to their recklessness, because fresh capital is merely a cushion to help bear the cost of their own recklessness in investing. This will avoid perpetuation of moral hazard.

Much of the rush to sell securities is driven by leverage, resultant cash shortfall to meet margin calls and debt repayments, and mark-to-market accounting norms.

Cost of rescue

If leverage is reduced, the need to divest debt securities merely to generate cash will significantly reduce.

Further, if assured of adequate capital infusions in stages, institutions will divest at steep loss only those securities whose yield-to-maturity under going-concern assumption are likely to result in a large loss.

If, for example, a bond is inherently well-backed, and its current price has suffered only because of a general fall in bond prices, there will be no incentive to sell such securities. Hence, overall cost of rescue will be minimised. In addition, suitable relaxation of mark-to-market accounting provisions will reduce the incidence of purely notional losses and this, in turn, will reduce needless volatility in the income statements of financial institutions. In fact, it is worth considering a temporary shift to historical cost accounting instead of fair value accounting for the investment portfolios of financial institutions.

(The author is Dean and Professor, Finance, at SDM Institute for Management Development, Mysore. These are his personal views. blfeedback@thehindu.co.in)

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