Designing the Garbage Pail Agency: percentage proffering

Make each institution that wants to sell assets to the Garbage Pail Agency sell a fixed share in its entire asset book. Let an auction set the price.

Jonathan Zasloff, I think, gets it only half-right when he describes the growing liberal consensus against the Paulson “blank check” proposal.

The propsal is pretty damned bad. But is it worse than a financial melt-down? I think there is now strong evidence that a melt-down might be imminent in the absence of some drastic action to restore investors’ confidence in financial institutions and financial institutions’ confidence in one another. If so, we face, in Galbraith’s phrase, a choice “between the distasteful and the catastrophic.”

So no one wants to be in the position of saying “We don’t trust George W. Bush, so we’re going to allow a financial panic that will wreck the real economy.” But the same applies to the Administration. If the Congress passes some sort of Garbage Pail bailout, it’s going to be very hard for Bush to veto; even if the voters would hold still for it, the money guys won’t.

That leaves Reid/Pelosi/Frank/Dodd with two problems:

1. Designing the right plan, in the face of the Treasury’s refusal to do so.

2. Getting it to pass, in the face of a possible filibuster.

The second problem, I think, is easier. Write the Democratic plan. Get it passed in the House. Introduce the same bill in the Senate. If the Republicans filibuster, immediately substitute the Treasury bill as a “strike all after the enacting clause and substitute” amendment, and pass that. Stack the conference so it reports back the House bill. Pass the conference report in the House, and dare the Senate Republicans to filibuster it, promising to keep Congress in session until there’s a signed bill. Don’t move for cloture; make the Republicans take that step if some of their dead-enders are filibustering.

That puts intolerable pressure on McConnell, in two different ways. First, he has more vulnerable Senators up this year, and can’t afford to have them either trapped in Washington (or back home campaigning and looking as if they care more about re-election than about avoiding economic catastrophe). Second, any hint that an actual financial panic is developing as a result of the delay means that McConnell has the “last clear chance” to avoid a meltdown.

Now, what sort of bill to pass? It has to be one that all Senate Democrats, including Landrieu and Ben Nelson, will support; I think we can count on complete Republican solidarity against whatever the Democrats want to do in the way of “New Deal” stuff, though some of them (Hagel, for example) might support putting limits on the blank check. That basically means that it’s up to Landrieu and Nelson how much of a vehicle for broader economic reform (e.g., capping executive compensation) the bill can be.

Since the amount of “New Deal” that Reid and Dodd would prefer is presumably much larger than the amount Nelson and Landrieu will tolerate, we don’t have to debate how much we’d like; the only question is how much we can get. Executive compensation, maybe. Homeowner relief, maybe. Stimulus package, maybe. S-CHIP expansion, probably not, just because it doesn’t look relevant to the underlying purpose of the bill.

On the “no-blank-check” side there are two broad options, as I see it: either limit what can be done, or change who gets to do it.

“Who gets to do it” is the easier problem, so let’s start there.

The Treasury Secretary serves at the pleasure of the President and is subject to his orders. This President is not to be trusted with blank-check authority. The Fed chairman does not serve at the pleasure of the President and is not subject to his orders. So merely moving the authority from the Treasury to the Fed would remove one big objection to the bill. On the other hand, the Fed’s lack of political accountability would create another big objection.

Or we could give the authority to either official but subject to approval by an oversight board: three members named by the Congressional leadership, three members named by the President, four votes needed to approve each class of transactions. That doesn’t prevent folly, but it does prevent some forms of gross abuse, in particular meddling by the Mayberry Machiavellis.

As to what can be done, first things first: the non-reviewability clause has to go. That’s a Constitutional issue, and not negotiable.

But Congress could go further and insist on at least outlining the mechanism by which the assets are priced when the government buys them. Here’s my non-expert suggestion; I’ve run this past some experts, and no one has (yet) told me why it won’t work, but it’s offered subject to the correction of the very large class of people who know more about this than I do.

As I see it, the basic problem to be solved is information asymmetry. The institutions may not know much about what their mortgage-backed securities are worth, but they probably know more than the Garbage Pail Agency will know. So if, for some defined class of MBS, the Garbage Pail Agency sets a price of thirty cents on the dollar, the institutions will try to sell to the GPA those instruments of that class that they think are worth less than thirty cents on the dollar, holding the rest, which means that on average the GPA overpays for whatever it actually buys.

One way to fix that would be to eliminate cherry-picking. Each financial institution has a portfolio of financial assets on its balance sheet. Instead of being able to proffer specific assets, require each institution to proffer a percentage of its total asset book. (Presumably we’d want to set an upper limit on the percentage.) As each obligation it holds is sold or repaid, the institution gives that percentage of what it realizes to the Garbage Pail Agency, which means that the GPA needs only auditing staff rather than having to staff up to manage a pile of assets.

Percentage proffering simplifies the pricing problem in that it means that the Garbage Pail Agency only has to set one price per institution, rather than one price per security. But more important, it means that the proffering institution can’t take advantage of what it knows about which of its assets are better than they look and which worse than they look.

There remains the problem of pricing each institution’s asset book. Here an auction mechanism ought to be feasible. Say Citigroup proffers 5% of its book. I’m not sure how many zeroes that is, but many. Some share of that amount &#8212 either a fixed percentage, or a sliding scale involving smaller fractions of larger proffers, or a fixed amount such as a billion dollars &#8212 is put up for auction, with the price paid at auction setting the price the GPA pays for the balanced of the proffer.

[What sort of auction? English? Dutch? Second-price? Open-outcry or sealed-bid? Should the proffer be binding, or should the proffering institution have the right to refuse once the price is set? Should institutions be allowed only one proffer each, or can they keep coming back as the situation unfolds? Above my pay grade, but this is the precisely the sort of thing Congress could reasonably delegate to whoever runs the GPA.]

In order to guarantee that there will be bidders at each auction, the rule might be that every proffering institution must use X% of whatever it gets from the GPA to bid on proffers from other institutions, either directly or by contributing to one of the pools the investment banks will presumably create to bid on those assets.

With that sort of mechanism in place, I’d expect the GPA not to make out too badly on the deal, and at the same time the proffering institutions could expect to get reasonable, rather than fire-sale, prices for what they sell.

Some institutions would turn out to be insolvent anyway. But the markets would learn that in a hurry, and the solvent institutions could resume the normal business of borrowing and lending to and from one another and the rest of the economy.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: