We just passed the first anniversary of an important, if little noted, meeting where the plans for what would become the government’s attempted bailout of the banking system were first hatched. One year ago, a group of venture capitalists, Silicon Valley executives and professors at the Stanford Institute for Economic Policy Research met to discuss the looming crisis in finance and debate a possible bailout.
It was early for such talk. Bear Stearns had not yet collapsed. Hank Paulson was still deriding the notion of a bailout and knotting his brow about moral hazard. But the group gathered at Stanford, which included Larry Summers and Long-Term Capital Management veteran and Nobel laureate Myron Scholes, saw what was coming: the government would eventually spend a lot of tax payer money in an attempt to clean up the credit mess.
“I think they should at least be thinking about it,” Myron Scholes said. “If you’re going to do it anyway, why not do it sooner?”
- A Debate Over Which Bailout And When
It wasn’t a radical view. At the time, 32 of the 51 economists surveyed by the Wall Street Journal were predicting the some kind of government action to ease the credit crisis. But what is striking is how close Myron Scholes came to outlining what tactics the government would actually employ in the bailout.
The mainstream view of those favouring a bailout was focused on mortgages and mortgage-backed securities. The idea was that the government might step in and buy up “illiquid securities” and mortgages, ease onerous terms for borrowers and arrest the decline in the value of bank assets. People thought something as minor as a slightly more robust Federal Housing Authority might be able to accomplish this. In retrospect, it’s clear to see how this view vastly underestimated the size of the mortgage crisis.
- Scholes Proposed Capital Injections
After scratching on a yellow pad while Summers talked about the state of banks and credit, Myron arrived at the idea a different idea for meeting the challenge facing the economy from the precarious position of the banks. He wanted to avoid having the government buy the mortgage assets held by banks, believing they would be better managed in private hands. Instead, he thought the government should make direct capital injections into banks.
Here’s how the Wall Street Journal described the view at the time:
Mortgages and other bank assets aren’t worth what banks thought. The losses erode the banks’ capital cushion. Bank leverage…magnifies the effect.
In response, banks either (A) reduce lending and sell assets or (B) raise new capital on terms that dilute existing shareholders. Provided they can find investors willing to bet that bank assets eventually will be worth more than they are today, shareholders tend to prefer option A, the smaller bank. But that market solution could destroy value and produce a crippling credit crunch. Society prefers option B, hence exhortations from Messrs. Paulson and Summers for banks, Fannie Mae, Freddie Mac and others to raise capital.
Note that even this view is too optimistic. The “market solution” of selling mortgage assets at prices that were above March 2008 was was unavailable because many investors feared–quite correctly, as it turns out–that those assets would be worth less. Option B was attempted for a few months but it too quickly became unavailable as investors learned that the financial health of banks was far worse than the talk of “illiquid assets” had let on.
Scholes proposed having the government invest in both debt senior to existing debt and in preferred shares senior to existing shares. This would balance the interest of the debt holders and the equity holders, avoiding advantaging one versus the other. What’s more, Scholes proposed that the government make the capital available to all banks, not just the sickest.
This is, actually, very close to what happened. The government did wind up buying preferred shares instead of buying mortgage backed assets directly. The program was extended to a broad range of banks, albeit not through an auction. And while the government didn’t put new debt into banks, it guaranteed new debt from others coming into banks.
- A Give Away To Shareholders?
At the time, this plan had its critics. Hyun Song Shin, a Princeton finance professor, called Scholes plan “self-serving” for existing shareholders, who he believed should be wiped out before the government put capital in any bank. The first move, he said, should be for the Treasury Department to summon the nation’s top bankers to his office and strongly suggest they conserve capital by suspending dividends.
And over at DealBreaker, I warned that the urge for a bail out was based on the dubious premise that the market was incorrectly pricing mortgage assets. The idea that selling assets in March of 2008 would “destroy value” was largely nonsense that could only be believed if you didn’t understand that housing prices were coming down and mortgage assets linked to the housing bubble were going to be distressed for the long-term.
“Selling assets does not ‘destroy value’–it reveals it, by providing a market price for the assets sold,” I wrote. “All of the bailout solutions basically amount to attempts to avoid this price discovery.”
The commenters at DealBreaker weren’t so kind to my view. “In a market with asymmetrical information (swaps sold to Alabama towns), when the percentage of goods that are crap surpass a certain threshold level, the market no longer works to “discover prices.” It collapses,” one wrote. “Good and bad securities alike stop being traded. Pretty contrary to what you learn in undergrad economics. Myron Scholes knows more than you.”
- Liquidity versus Solvency
At the heart of this early debate over the bailout were different views about the size and duration of the problem. The FHA bailout people believed that only a small percentage of financial assets linked to the very worst subprime mortgages were the problem. Many thought we were in a liquidity crisis rather than a solvency crisis. Others, including Scholes, thought that asset prices would rapidly recovery after banks were recapitalized. Some of us weren’t so sure.
As it turns out, however, Scholes did know more than me about one thing: he correctly predicted that the government would wind up making direct capital injections rather than buying up assets. He just seems to have over-estimated the efficacy of that program.
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