Plan C

Give banks the option of getting a federal guarantee for their interbank borrowings, up to some limit, in return for equity and tight regulation.

I know it’s a little late to be having ideas, but why wouldn’t this work:

1. Pass a law that allows any publicly-traded bank or bank holding company, or other financial entity that can get approval from bank regulators to convert to bank status (thereby going under bank regulations) to sell up to half (let’s say) of its equity at current market prices to the Treasury. [There would have to be some discretionary power in the Secretary of the Treasury or other official to reject a deal where the stock price seems artificial.] No employee of such an entity could receive compensation in any form exceeding twice the salary of the President of the United States. All dividends on common and preferred stock must be suspended as long as the Treasury owns its stake.

2. New bank regulations allow banks and bank holding companies to take deposits and make loans, just like the good old days, but not to buy and sell MBS’s, CDO’s and other impossible-to-value pieces of paper or to engage in credit default swaps and other casino activities other than unwinding their current positions. Any entity that wants to keep playing such games is welcome to, using its owners’ own money and not ours.

3. In return, the bank gets “deposit insurance” on its new interbank borrowings up to some limit, set as a multiple of the equity investment. That makes that bank’s overnight paper (up to its limit) as good as T-bills. We also take the $100,000 limit off federal deposit insurance.

4. The bank pays the Treasury an insurance fee of (to make up a number) 100 basis points on those borrowings.

5. The law makes the new, insured debt senior to all other debt. (Of course, depositors and CD holders are already insured.)

6. When and if the institution is back on its feet and doesn’t need the federal guarantee, it can buy back the Treasury’s equity stake at the greater of cost plus 10% per year or market (or allow the Treasury to offer it as a public stock offering at the current price, again as long as it’s greater than cost plus 10% per year) and reliquish its “deposit insurance.” At that point it can pay its employees whatever it wants to. That will create a strong incentive for every institution that can to get off the public teat as soon as possible, which means we haven’t actually nationalized the financial-services sector.

It looks to me as if the taxpayers are pretty damned safe, and in fact likely to make out like a bandit. Yes, we’re sortakinda expropriating the other debtholders and counterparties, but no worse than any bankruptcy proceeding would; the difference is that going under the scheme woudn’t trigger all those cross-default clauses. As a class, the debtholders and counterparties are probably better off as a group letting the institution try to stay afloat rather than fighting like hyenas over the corpse. If you don’t believe me, ask the Lehman creditors and counterparties; Lehman debt is trading at 19 cents on the dollar.

It’s more than likely that the banks (and converted-to-banks) with all that new equity plus the capacity to borrow at, in effect, the T-Bill rate plus 100 basis points or whatever the fee is, will do quite nicely, thank you, thus ensuring that their creditors and counterparties aren’t actually expropriated after all and making the Treasury’s half-stake worth more than it cost.

The underlying idea is that, as long as there are people with money to invest who want safety and people who need to borrow money with some reasonable chance of paying it back, there’s money to be made in the middle. In addition to their gambling enterprises, the banks and other financial institutions have relationships and capacities to borrow and lend, and there’s social value in keeping those relationships intact by freeing them from the dead hand of past bad decisions.

Again, I’m a mere amateur in these matters, so I write subject to correction by those who know more. But this seems cleaner to me than trying to price all those crazy assets. It leaves the government doing what it is supposed to know how to do: regulate, not manage an asset portfolio. That means no massive fees for the investment banks.

Update Reader SamChevre points out that selling mortgage-backed securities helps banks fix their term-mismatch problem: they borrow short and lend long. Fair enough, though we still need new rules to ensure that the originating lender is on the hook for defaults and to avoid splitting a single mortgage or pool of mortgages into hard-to-value pieces. But I can’t see an justification for banks to buy MBSs rather than holding their own portfolio of loans.

Update An expert friend responds. (I paraphrase his points):

1. You don’t want to give every bank a perpetual “put” on half its equity; too much adverse selection.

Right. It would have to be a one-time opportunity.

2. MBSs are valuable for diversification.

Okay. But at least require them to be MBSs based on whole mortgages and not hard-to-value “tranches” of risk.

3. You can’t easily distinguish risk-hedging from risk-increasing derivatives trades.

If that’s true, then I don’t see how any sort of bank risk regulation can be made effective. That’s almost as big a problem with current deposit insurance as it would be under Plan C.

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: