A Warranted Buy-In

Speaker Pelosi on Sunday finally figured out the right rhetoric to describe a good rescue plan for the financial system: It needs to be a buy-in, not a bailout.

Unforunately, the Paulson/Frank/Dodd bill defeated on Monday might well have ended up being almost entirely bailout with only a token buy-in element.

To the extent that there was any buy-in element in Monday’s plan, it came through a provision that was added at the insistence of the Democrats. The added element involved the possibility that the Secretary, at his discretion, might conceivably be willing to consider using taxpayer money to purchase “warrants” for nonvoting shares in any firm that wants to dump its subprime assets on the Treasury. (Essentially, a warrant is an option to sell a share at some future date at a prespecified price; it’s a bit more complicated than that, but you can think of it as roughly equivalent to the taxpayer getting nonvoting shares in the firm. Details have been described more fully elsewhere).

Adding even the option of buying warrants amounts to a crucial ideological concession by the Secretary, because the taxpayer would be getting an ownership stake in the financial industry (even if that stake is nonvoting); given the near-religious fervor with which some convseratives oppose any government stake in the financial industry, the Secretary displayed a welcome flexibility by agreeing to add the possibility of purchasing warrants to his plan.

But in practice, whether to actually purchase any warrants was left entirely to the judgment of the Secretary. Since the original Paulson plan did not involve warrants, it is pretty clear that the Secretary’s true preference would be to use as little as possible of his $700 billion kitty on acquiring warrants. He might buy none at all.

The near-unanimous opinion of non-Wall-Street economists (liberal, moderate, and conservative) is that a plan that is mostly or entirely buy-in would be much better than the Paulson plan, either in its original 3-page incarnation or in the modified version that was defeated on Monday.

But a very quick way to convert Monday’s plan into a much more palatable real buy-in plan would be simply to mandate that a certain (relatively high) percentage of the taxpayer money spent went toward warrants. For example, Congress could mandate spending 90 percent of the money on warrants and only 10 percent acquiring the troubled mortgage-backed securities (the “toxic waste” that is undermining our financial system).

If we were designing the optimal “buy-in” system from the ground up, it would probably be better to have a comprehensive plan along the lines of what Sweden did in 1992 when it faced a crisis quite similar to our current crisis. And there is very good reason to suspect that somewhere in the bowels of the Federal Reserve or the Treasury there exists a comprehensive plan for a Swedish-style rescue. The Fed and Treasury have been war-gaming this crisis for months if not years, and it be very surprising if at no point did they even contemplate a Swedish-style buy-in plan. My guess is that this plan has not seen the light of day because Secretary Paulson preferred a bailout to a buy-in. Congress should make vigorous inquiries to determine whether a draft of such a plan exists, and if so demand to see the details immediately.

Even in the unlikely event that no such plan exists, I have been assured (by people in position to know) that a crude but effective buy-in plan could be executed in a matter of days. One version would be simply to offer firms with subprime assets a take-it-or-leave-it deal, in which the government would purchase warrants of a value equal to, say, 20 percent of shareholders’ equity as of the last audited financial statement, and in exchange would purchase toxic assets from the firm in with a value of 10 percent (or 20 or 30 percent) of the value of the warrants. Better schemes could probably be invented, but this one should work. This plan would increase the firm’s capital by a dollar for every dollar of taxpayer funds spent, thus recapitalizing distressed firms and moving them back from the financial brink.

But the crucial element is that the amount of warrants to purchase must not be left to the sole and unchallengable authority of a Treasury secretary who clearly prefers to purchase none of them.

My sense is that there are at least two reasons that a plan like this might not fly with Congress.

First, it may be that anything built on the Paulson plan’s overt structure is now politically dead; we may need a plan that, at least in name, cannot be tarred with the charge of being just one more minor modification to the Paulson plan. So perhaps Congress should call the revision the “Pelosi” plan (since she came up with the “buy-in, not bailout” rhetoric). Or perhaps, in reference to Warren Buffett’s recent “buy in” to Goldman Sachs, it could be called the “Buffett Plan for America.”

Second, Congress is concerned to do be seen as doing something for “Main Street,” not just for Wall Street. So maybe a deal could be struck with the Administration to persuade them to reverse course and support the “stimulus” package that Democrats have recently proposed but which has so far met with White House and Republican opposition. If the events in the stock market, combined with the White House relaxing its opposition to a stimulus plan, could persuade a few Republican lawmakers to support the combination of the stimulus package and the Pelosi plan, we’d actually end up with a much better outcome than if the Paulson/Frank/Dodd plan had passed on Monday. And indeed, the Pelosi/Buffett plan paired with a stimulus bill and with full White House backing (for political cover) might be able to pass with little Republican support, because it should be much more appealing to those Democrats who voted “No” on the Paulson plan on Monday.

It’s worth thinking about. Hard.