Financial Stability: Plan Z

New York City - In the two weeks since floating by Treasury of a financial stability plan, markets have fallen almost every day, culminating in new lows on Friday that have wiped virtually all the gains of the last expansion.  Hardest hit have been bank stocks which on Friday plumbed new depths.  Over the weekend, the New York Times endorsed bank nationalization and Citi evidently approached the government about more aid. Besides the banks, the big losers are the American middle class who placed their nest eggs in the stock market.  The financial stability plan has unsettled markets because uncertainty exists over whether it will work.  In the spirit of thinking creatively about difficult problems, here is plan Z.

First, a brief recap. Plan A was the Super SIV, a fund to be created by the banks themselves that fell apart over sharing the cost.  Plan B was for the Fed to extend its lending in unconventional ways.  Plan C was to seize problem institutions such as Freddie and Fannie.  Plan D was selling faltering banks to strong ones as in the forced sale of Bear to Chase.  Plan E was let the market decide as in allowing Lehman to fall.  Plan F was to rescue AIG or one off rescues.  Plan G was to extend Fed credit to banks.  Plan H was the TARP to buy up all the troubled assets, which fell apart over pricing the assets.  Plan I, which was carried out, was to inject capital into the banks to shore up their solvency.  Plan J was to announce that the TARP would not be used to buy up assets. Plan K was to imply that the government would be ready to bail out any troubled institution.  With many wrinkles in between we get to the two current plans, the Treasury plan and bank nationalization.

The Treasury plan calls for creating a public private partnership to buy up the toxic waste.  The private participation is needed because Congress is not inclined to appropriate the one or two trillions needed to buy the troubled assets and recapitalize the banks.   The question is whether the private investors will step up to the plate.  Nationalization, the other proposal, would give the government a freer hand in sorting assets into good and bad.  It would not necessarily cost less assuming the government honors the debts of the banks, however.  And it comes with negatives, the shock of nationalization, cost to common shareowners  and the prospect of state ownership of risk taking institutions.  So what to do.

Here is Plan Z.

There is one player left in the world with a lot of buying power. The Federal Reserve.  As Congress sweated the details last year of the $700 billion TARP, the Fed was guaranteeing and lending larger sums against unconventional collateral including commercial paper and mortgage-backed paper through the TAF, TSLF, MMIFF, TPLF and similar programs.  This underscores the fact that the Fed is comparatively unconstrained by politics.  

The Fed, like other banks, has a balance sheet.  In normal times its assets consist of very high quality stuff, including gold, deposits at the IMF, and cash.  In the last year, it has doubled its balance sheet by adding unconventional things.  Wouldn't it be worth adding another trillion to solve this crisis once and for all?

Let the Fed issue fully guaranteed credits to the banks in exchange for their troubled assets.  For clarity, the trouble assets should go into a separate tank, shares of which the Fed would hold.  This instantly makes the banks sound as a pound (forgive the metaphor). The Fed ends up with a lot of troubled assets that may be worth from 10 cents to 90 cents on the dollar.  Time will tell.  But the point is, this simple stroke would allow the banks to resume lending with confidence.  And it would transfer risk to the one party in our financial system best able to handle it. 

The downside is that the Fed is the one party that you don't want to take risk under ordinary circumstances.  Make no mistake, while being in effect an accounting entry at the Fed, this would be one huge entry, increasing its balance sheet by about 50%.  So the next question is how to minimize the risk to the Fed.

Once sequestered within the Fed, the trillion or more of bad assets could be gradually sold off to investors, (not to banks) and any shortfall between the face value and the market (which should eventually recover) be paid for by appropriations as insured by a government guaranty.  However, rather than requiring the taxpayer to put up 1 trillion at once, plan Z would retire the shortfall over time, perhaps over ten years of annual appropriations. 

This plan, by the way, is not that different from the one used by China a decade ago to escape a raft of bank failures.

Since these toxic assets happen to be exotic mortgages, the final way to reduce the ultimate losses would be to refinance them with a 4% government guaranteed mortgage or, at a minimum, standard fixed rate Fannie Mae mortgages now going for about 5-6%.  This would have the benefit of ending the uncertainty over exotic mortgage resets and freeing up demand in the economy.

It's not the first thing one would try.  But by addressing the problem in one fell swoop it may beat all others.