Now that the Bailout Has Failed, How About Bebchuk’s Plan?

Thom Lambert —  29 September 2008

I’ve avoided saying anything at all about the bailout because (1) I’m not an expert on banking, finance, etc. and (2) events are moving so fast I can’t keep up with the latest proposal. Nonetheless, since the bailout bill has just failed, this might be an opportune time to consider an alternative to the plan the House just rejected. The most intriguing alternative plan I’ve seen is that set forth by Havard Law’s Lucian Bebchuk in this paper (which was produced in record time!).

Bebchuk contends that the approach that just failed in the House is flawed in that (1) it doesn’t make adequate effort to ensure that distressed securities are bought at fair market value and thus amounts to a giveaway to financial institutions; (2) it doesn’t directly address the key problem — undercapitalization — but instead improperly ties capital infusion to sales of troubled assets; and (3) it doesn’t adequately induce the provision of private capital to financial institutions. Bebchuk proposes an alternative solution that would remedy these deficiencies.

Bebchuk begins by diagnosing the current problem (or at least summarizing the diagnosis made by the Treasury Department). The problem is that the financial firms have on their books troubled assets (mainly mortgage-backed securities) that are causing creditor runs and making it difficult for the financial firms to raise additional capital to carry out their role in financing the economy. Now, one would normally think that the holders of troubled assets could just sell them, albeit at a loss, for a price resembling their fundamental value (i.e., the discounted present value of their “hold to maturity” value). But the prevalence of these assets on the books of the institutions whose professional money managers are most likely to buy them (at prices reflecting fundamental value) actually prevents those institutions, and thus their money managers, from attaining adequate investor capital to make the trades necessary to get prices to the level of fundamental value. (In other words, we are in a “limits to arbitrage” situation.) The basic problem, then, is a lack of capital, and the primary purpose of the bailout is to use public funds to induce a level of trading that will turn these troubled securities into liquid assets. The trick is to do this while protecting taxpayers as much as possible.

Bebchuk contends that Treasury’s now-failed proposal — i.e., government will buy up to $700 billion of troubled assets at prices established through reverse auctions — was not the best way to go about pursuing the twin goals of liquidity creation and taxpayer protection. He maintains that the defeated proposal (1) would have given Treasury a power it shouldn’t possess, (2) would have denied Treasury a power it should possess, (3) did not adequately specify how government purchases should be made, and (4) would have failed adequately to exploit private sources of capital.

First, the failed proposal would have given Treasury full authority to buy troubled securities without requiring that the purchases be made at a price approaching fair market value (so, for instance, Treasury might pay $700 billion for assets worth only $200 billion — a giveaway of half a trillion dollars from taxpayers to financial firms). Bebchuk contends that “[t]his freedom to confer massive gifts on private parties is highly problematic. It should be constrained: the legislation should direct Treasury to buy assets at fair market value.”

But wait a minute. How are we ever to determine “fair market value” in a “limits to arbitrage” situation in which the trades that will reveal willingness-to-pay, and thus fundamental value, really can’t occur? Bebchuk answers by proposing that Treasury be provided a power it was not given in the failed proposal: the power to buy newly issued securities in financial firms. Bebchuk explains:

Authorizing the provision of capital in return for newly issued securities is far superior to authorizing, as the current draft does, the provision of capital through overpaying for troubled assets. To begin, taxpayers would be better protected; they would get adequate consideration for the capital they are providing rather than nothing at all, as under the Treasury’s plan which provides capital through subsidized purchases of troubled assets.

Furthermore, the direct approach would do a better job in providing capital where it is most useful. If the proposed legislation were implemented, capital would be inefficiently channeled, as the amount of troubled assets sold by firms would not necessarily be related to the amount of capital that they need and should get from the government. …

Some financial firms [that] would like to sell a substantial amount of financial assets to the government do not need a governmental infusion of capital; and, conversely, some financial firms would need a capital infusion but would not wish to make significant use of the government’s willingness to purchase troubled assets.

In addition to requiring governmental purchases to occur at fair value and authorizing governmental purchases of newly issued securities, an optimal bailout program should, Bebchuk argues, harness competition to ensure that assets (either troubled assets or newly issued securities) really are purchased at fair value.

Treasury has, of course, indicated that it would seek such competition by utilizing such devices as reverse auctions. Bebchuk, though, worries about collusion (or oligopolistic coordination): “[I]n situations in which assets [to be purchased] are owned by a concentrated group or by repeat players that can implicitly coordinate strategies, such auctions may produce inflated prices.”

Bebchuk thus argues instead for a system in which Treasury conducts its purchases “through agents with strong market incentives.” For example,

Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5% of the profit its fund generates — that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value. … One could [even] consider taking the competitive idea one additional step: after a pool of candidates that pass threshold conditions in terms of expertise and lack of conflicting interest is selected, the selection could be based on [a] bidding process in which candidates would bid the profit percentage for which they would be willing to manage a fund.

Finally, Bebchuk contends that the government “should require financial firms that have substantial sub-optimal capitalization to raise capital through right offerings to existing shareholders.” In response to the argument that firms would do this on their own if it were in their interest to do so, Bebchuk offers two rejoinders:

To begin, … a ‘lemons’ problem — in particular, fear of negative informational inferences that the market may draw from a decision to make a right offering — might discourage a firm from doing so even if it needs capital. In contrast, when a rights offering is mandated by the government for a substantial set of firms, the market will not draw a negative inference about the managers’ private information from the existence of a rights offering. Furthermore, and importantly, the premise of the Treasury’s plan is that the existence of adequate capitalization in given financial firms has substantial positive spill-over effects on other firms in the economy. The existence of such effects might well make it desirable in the current circumstances to expand the capital available to financial firms even if financial firms’ existing shareholders would privately prefer not to do so in order to avoid diluting their earnings.

So what to make of all this? I’m still digesting it, but my initial hunch is that the first three prongs (limit purchase authority to fair value, authorize purchases of newly issued securities in the financial firms themselves, and set up a system for making purchases through properly incentivized agents) make lots of sense. The final suggestion seems quite heavy-handed and difficult to implement (which firms would be required to issue rights? how many? etc.). Fortunately, Treasury could adopt the first three parts of Bebchuk’s plan without the fourth. I’d probably also add some plan for ensuring that the government eventually divests itself of the equity stakes it takes in distressed financial firms. We really don’t want a People’s Republic of Wall Street.

Should be interesting to see what happens next.

Thom Lambert

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I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.