October 6, 2008

The Governments $700 billion asset purchase plan has passed both the House and the Senate and will shortly become law. This article compares it to an alternative loan plan, which would be more effective and cost much less. 

Summary

The core feature of a financial crisis is a contagious unwillingness to lend to almost anybody but Government because of fear that borrowers may fail, making it impossible for many solvent firms to meet their cash needs. To cure the crisis, the confidence of creditors must be restored. 

There are two major ways to do this. The proposed asset purchase plan will relieve the cash needs of firms holding mortgage-related assets by buying the assets. An alternative loan plan will relieve cash needs by allowing firms to use mortgage-related assets as collateral for loans.  

The advantage of the mortgage asset purchase plan is that it increases the net worth (or capital) of selling firms because the assets are sold for more than they are worth. A loan plan does not. In all other respects, and on balance, a loan plan would be more effective.  

Because of limitations on the types of assets covered by a purchase operation, along with caps on the total amount of purchases, potential creditors will not know whether a potential borrower can raise cash from a sale until it actually happens. A loan program, in contrast, could be made available to every firm with acceptable collateral defined broadly, and total lending would not be capped. Potential creditors will be willing to lend to borrowers they know have the capacity to borrow from the Government, whether or not they actually use it.  

An asset purchase program will cost Government hundreds of billions of dollars, whereas a loan program will probably generate profits.  

There are no existing Government facilities to implement an asset purchase program. Because the book has to be written as it is executed, the potential for waste, favoritism and fraud is enormous. In contrast, a loan program would follow well-developed lender-of-last-resort principles, which could be implemented through the existing Federal Home Loan Bank System), acting as agent of the Treasury or Federal Reserve.  

What Exactly Is the Financial Crisis?

It is a loss of confidence in the capacity of firms to meet their cash needs. In a normal state, firms raise the cash they need by selling assets in the market, or (more often) by borrowing. Markets for mortgage-related assets have disappeared because of fear by potential purchasers that the value of the assets will decline after they buy. In addition, the willingness to lend to almost anybody but Government has fallen precipitously because of fear that borrowers may fail.  

In a vicious circle characteristic of crises, firms that typically borrow from more than one source may be shut out because each potential creditor fears that other creditors will not participate. No one wants to lend $2 million to a firm that is unable to raise the remaining $8 million it needs to survive. This is the “contagion” feature of a crisis. 

Curing the crisis thus means restoring the confidence of creditors.

What Are the Options For Dealing With the Crisis?

There are two. The Treasury/Federal Reserve asset purchase plan will relieve the cash needs of firms holding mortgage-related assets by buying the assets from them. The alternative is a loan plan that will relieve cash needs by allowing firms to use mortgage-related assets as collateral for loans. The remainder of this article is directed to the differences between these approaches.

Which Option Is More Effective?

The mortgage asset purchase plan increases the net worth (or capital) of selling firms because the assets are sold for more than they are worth. When a firm borrows, in contrast, its assets and liabilities increase by the same amount. The firm acquires the cash it needs, but is no wealthier than it was.

Presumably the impact of an asset purchase program on the net worth of sellers is the reason the Government selected this approach. Since this approach is incredibly costly while a loan approach is revenue-generating (see below), the issue of relative effectiveness requires a closer look. This reveals that despite its favorable impact on the net worth of sellers, an asset program will be less effective than a loan program in restoring creditor confidence. 

The positive impact of an asset purchase program is reduced by unavoidable limitations on the scope of the program, which create uncertainties regarding whether or not any particular borrower will succeed in selling assets. Potential creditors will not know whether a potential borrower can raise cash from a sale until it actually happens.

One limitation that is almost bound to arise is the need for Government to specify the characteristics of the assets it will buy in any one phase of the program. Those who own assets that don’t meet these specs will not be able to sell, or will have to wait for another round. In addition, because of the cost, Congress will impose limits on the total amount of purchases, which means that some firms that need cash will be shut out.

A loan program, in contrast, could be made available to every firm with acceptable collateral, which can be defined very broadly. The specific collateral offered by each borrower will be valued separately to determine the allowable loan amount for that borrower (see below).  Since the loan program generates income rather than costs, furthermore, there is no need to set a cap on total lending, or restrict eligibility.

In the eyes of potential creditors, a loan program will increase the creditworthiness of every borrower with acceptable collateral, even though it does not increase their net worth. Potential creditors are much more willing to lend if they know that their borrowers also have the capacity to borrow from the Government, whether or not they actually use it. This is critical to breaking the contagion effect referred to above.

Cost Differences

An asset purchase program will cost Government hundreds of billions of dollars, depending on how much is ultimately authorized by the Congress for purchases, and how much of it is recovered in later years. The original amount requested was $700 billion. 

A loan program, in contrast, will be a source of profit to the Government, because (in line with traditional lender-of-last-resort principles) it would charge borrowers a penalty interest rate that would be substantially higher than the Government’s borrowing rate. As an example, it might lend at 10% and have a cost of 4%, which would provide a spread of about 6%.  

However, to make the program work, the Government would have to liberalize its rules regarding the assets acceptable as collateral, and the percent of value it will lend. This will result in losses in cases where the borrower eventually fails. On the other hand, Government could (and should) take an equity position in firms where the required loan is a high percent of collateral value, which will generate additional income if the firm is successful. Even if the Government eventually closes its books with a loss, the loss will be much smaller than with an asset purchase program. 

Implementation

As an entirely new type of operation for Government, little is known about how an asset purchase plan would be implemented. It has been suggested that a reverse auction might be used where sellers would bid a price they would accept, Government would array the bids with the lowest-price bid at the top, and accept all those that add up to the total amount committed to the auction.  

Any purchase program including this one will have to operate in the absence of a generally accepted procedure for establishing a “true value” of mortgage assets. The prices that are bid would have to be defined as a percent of face value (the total balances owed), or as a percent of their value on the balance sheet of the seller – their “book value.” In either case, the prices bid would have little relationship to the true value of the assets. This means that there is no way that the Government could establish how much of what they pay is a gift that will increase the wealth of the seller – which is the objective of the program.  

Perhaps more important, some sellers will make out much better than  others for no better reason than that their assets carry a face value or book value that is high relative to their true value. If A and B both carry a block of assets on their books at $100 but A’s assets are actually worth $50 and B’s only $30, B will win with any bid of $50 or less. Yet there is no reason to believe that B needs the cash more than A. This element of arbitrariness in the distribution of benefits has no counterpart in a loan program.

There are no existing Government facilities to implement an asset purchase program. Whether the program is contracted out to the private sector or undertaken by an existing or new Federal agency, the book has to be written as it is executed. The potential for waste, favoritism and fraud has got to be enormous.  

In contrast, a loan program would follow well-developed lender-of-last-resort principles, liberalized to meet the crisis-based exigencies, which could be implemented through the existing Federal Home Loan Bank System (FHLBS), acting as agent of the Treasury or Federal Reserve. The lender-of-last-resort function has already been extended to cover investment banks and insurance companies, and this program would be a further extension.

The 12 regional Banks that make up the FHLBS have been in the business of making loans collateralized by mortgages since 1935, and they have all the required systems, including systems for valuing and safe-guarding mortgage collateral. Each batch of mortgage assets posted as collateral would be valued to determine the maximum loan available to the borrower.

Under existing conditions, the Banks lend only to their member institutions. Under the new program they would lend to a larger list which should include any firm (including hedge funds and foreign-based firms) that can post acceptable collateral.

This type of operation would not be without its problems. Perhaps the largest would be in acquiring effective control over collateral posted by firms which have not previously had any relationship with the lending Banks. Some short-cuts might be needed to avoid serious delays, which would open the door to fraud. But this problem is trivial compared to those involved in implementing an asset purchase program.

Secondary Consequences

Because an asset purchase program would provides a taxpayer gift to every selling firm, it created irresistible political pressures to provide equivalent gifts to distressed borrowers, authorization for which is included in the law. There is no way that Government can pay a premium price for the mortgage on which widow Jones is two months behind in her payments, and then foreclose on her. But how about widow Smith who is in the same position except that her mortgage was not purchased by Government? Can Government give Jones a pass while allowing the private owner of Smith’s mortgage to foreclose on her? I don’t think so, even though the wording of the law is ambiguous on this point.

There is a real danger that the asset purchase program, on top of its enormous cost and limited effectiveness in building creditor confidence, will initiate a train of events that will erode the value of the lien that secures home mortgages. This could raise mortgage rates across the board for an indefinite period.

 Copyright Jack Guttentag 2008