Do you think you have the solution to the current U.S. financial system crisis? Would you like to take it for a test drive?

Our latest tool puts you in today's hottest seat! We've borrowed a hypothetical balance sheet from Zimran at winterspeak, and worked up an interactive version of it so you can see the impact of the choices you might make to solve the credit crunch threatening some of the biggest financial institutions in the U.S. and world economy! We've input data that might be representative of an overleveraged institution, or number of institutions, and incorporated various options that you might choose to pursue (running the default data will produce a "current" balance sheet.) From here, it's all up to you. Choose wisely!....

A Quick Guide to the Bailout Proposals

The Paulson Plan: We'll let Zimran explain how Treasury Secretary Henry Paulson's plan would work:

The Paulson plan takes those $25 of bad assets, and substitutes them for $25 of good assets (or maybe $20 of good assets). The point is, for the bank to re-capitalize, he *HAS* to pay more than the assets are worth. By swapping good for bad, the balance sheet does not have to contract, and part of the Paulson/Bernanke plan is to combat deflation, and keep balance sheets from shrinking so lenders can keep borrowing.

Zimran makes an excellent point here. To avoid deflation (the destruction of money in the U.S. economy), the U.S. government and Federal Reserve would need to pump a considerable amount of money to fill in the gap that would result from writing off the bad assets now on the most distressed financial institutions books. We've previously noted that the Federal Reserve had chosen inflation as a means to pump up housing values to support their housing bubble induced valuations, but with the fall of high oil prices, that job has become much harder. For his part, Federal Reserve Chairman Ben Bernanke has been encouraging the distressed institutions to mark down their books as quickly as possible to minimize the gap for most of the past year, but they failed to heed his advice soon enough.

Swapping Debt for Equity: Luigi Zingales of the University of Chicago has proposed that transforming the debt owed by these highly leveraged institutions to their bondholders, customers and counterparties might be a more effective solution to restoring the distressed institutions to solvency. Zimran explains the details ("GS" refers to Goldman Sachs):

Zingales, to my understanding, says that instead of public gifts of cash, bondholders should have their debt converted to equity. If shareholder equity was say, -$10 (GS did not lose that much money) then this would work, and such a debt to equity conversion would reduce debt to $5, bring equity to $0, and debtholders would take an immediate 67% haircut and now have participation in any upside. I can see how this works if debt was larger than negative equity, but I don't think that's the case as firms were so leveraged, and floated on equity cushions that were so tiny. At any rate, I can see how that *might* be the case, which, to my understanding, would render the Zingales option as not feasible.

I also cannot see GS reducing liabilities by going after that "counterparty" line item, as that would trigger exactly the kind of contagion that Paulson & Co. wants to avoid.

New Market Investment: Marginal Revolution's Alex Tabarrok proposes something similar to the Paulson plan, but one that doesn't involve mass transfusions of taxpayer dollars into the institutions. Instead, he proposes establishing a new investment vehicle that would bolster the good assets held by distressed institution by directing millions of tax-free IRA contibutions from millions of individual investors toward them, with the incentive that the returns on these IRA investments made over the next twelve months would then be forever tax free for the investors.

Alex argues his case:

The increase in savings will help deal with our current problems by offsetting any credit crunch. (Some of the savings will also help to recapitalize banks.) In addition, the U.S. needs a higher savings rate regardless. During the 1990s as measured savings rates declined to zero commentators argued that rising asset values compensated. Well asset values are now falling so true savings are negative - thus we need to increased savings.

A big benefit of this proposal - lower taxes, higher savings and a savings bonus to those with lower incomes - is that it should appeal to both the right and the left.

As an added bonus, Alex's proposal would also have the benefit of being the least costly and least risky option for the U.S. taxpayer.

Frankly, our best guess is that whatever solution is adopted to alleviate the emergency in which the U.S.' major financial institutions find themselves in this week will be a combination of the first two options, although we believe Alex Tabarrok's new market investment proposal would be the most desirable as it would preserve the other options should it itself not be fully sufficient.

That consideration alone should drive the policy being made in Washington D.C. this week.

Labels: bankruptcy, economics, inflation, investing, liquidity, tool

- posted by Ironman at 9:08 AM | Permalink | |