Recapitalizing the Banks is Not Enough

The infusions of equity in a score or so of major banks in the U.S., UK, and EMU will help prevent a deep and prolonged world-wide recession.  So will the Fed's new Money Market Investor Funding facility, which supports unsecured short term borrowing by top-rated financial institutions.  But these steps won't help most banks to get back to their main job -- lending to households and businesses. 

For banks to lend, they must borrow and doing so, unless you're a big player, requires collateral.  Collateral today is in terribly short supply because trillions of dollars in AAA or better senior structured credit securities, including top-tranche mortgage-backed securities, are no longer being accepted.  Even securities that will pay off under the most dire scenarios are being tarred, and thus valued, as "toxic" in today's marketplace. 

The best way for governments to restore the value of this "bad" collateral and truly jump-start the banking system is by selling insurance against default on the good toxics and buying up the bad toxics.

Secretary Paulson has a war chest large enough to purchase the bad toxics, which are selling for peanuts.  These securities are like tainted baby formula.  They need to be removed from the shelves in order to restore customer faith in all the other products for sale.   And no similar toxics should ever again be put up for sale by, for example, limiting the issuance of new mortgages to the safe, old-fashioned kind – 30-year, fixed-rate mortgages with at least 20 percent down.

Buying up the good toxics is a different story.  Doing so would require huge immediate government outlays.  In contrast, selling insurance on the good toxics requires no short-term outlays.  Nor need this sale of insurance policies drain banks of their badly need cash; governments could sell their insurance in exchange for preferred stock. 

This insurance would provide a government backstop on losses, making the securities once again easily traded and valuable collateral.  It would plug the wholesale funding gap without fully nationalizing the financial system. It would also reverse much of $1 trillion mark-to-market bank losses on US structured credit exposures reported in the current IMF Global Financial Stability Report.

A key to making this policy work is selling the insurance at reasonable prices; i.e., at premiums that would prevail in a mild recession.  This may sound like a give-away to bank owners, but if the premiums are set right, they would be cheaper than the private market now offers, but more expensive than will prevail once the economy returns to normal.  I.e., they should priced high enough in order to provide governments with a high expected return on their underwriting and low enough to actually deliver the goods, namely preventing a deep and prolonged global economic downturn.

The point of the proposed insurance is to put a floor under the value of the best quality structured credit products.  We suggest a maximum loss of 10 percent, so investors cannot lose more than 10 percent of their promised income stream.   This means that the securities being insured will sell for at least 90 percent of what a safe Treasury bond would cost delivering the same expected income stream.

There is good precedent for this proposal, namely the successful creation of Brady Bonds by U.S. Treasury Secretary Brady in 1989, which provided a range of U.S. government guarantees (and haircuts) on Latin American government- and bank-issued debt, which was in default and, thus, could not be used be solvent financial institutions to collateralize their own borrowing.  Once the Brady Bonds were swapped for the prevailing toxics, credit in Latin America because to flow again.

The current case is no different. Once existing credits start trading again, new credits will become possible, and as new credit starts flowing so too will the real economy start to recover.  Insurance can help here too.  In retrospect it is clear that insurance by the monolines and AIG was a key element in the system of structured finance before the crisis.  Insurance backstop by the government will be a key element in the system of structured finance after the crisis.  As private insurers re-enter the market, the government can allow them to insurer first-tier losses and leave itself to simply insure against a true cataclysmic, systemic risk.