Free-Market Financial Rescue v. 2.0by
It’s a problem vexing several corners of Capitol Hill: How can the government fix the financial markets without interfering in the free market?
The last proposal to avoid investing $700 billion of taxpayers’ money in the market — proposed by conservative Republican House members — didn’t get very far. A watered-down version, which gave the Treasury an option it didn’t want to insure troubled assets instead of buying them, was added to the bill that flopped so spectacularly on Monday.
Now it’s Democrats’ turn. Eight House representatives led by Peter DeFazio (D-Ore.) are offering up another plan: a handful of restrictions on short-selling, accounting-rule changes, a confidence-boosting measure and a program that hinges on having the Federal Deposit Insurance Corp. lend to otherwise sound banks facing short-term troubles. They attribute the concept to a proposal from economist William Isaac, a former FDIC head and chairman of the Secura Group, a financial-sector consulting firm, and have found support from the Service Employees International Union, which likes the fact that the ideas don’t risk rewarding Wall Street in the process of saving the markets.
It’s not clear how far the plan will go, given talk that the Senate on Wednesday could simply take up the failed bill with few or no changes, or that the House might tweak the bill just enough to win over the dozen Republicans necessary to pass it. But it’s also not clear that it would do much to solve the current mess. Here’s a tour of the proposal, with assistance from Anne Villamil, an economist at the University of Illinois at Urbana-Champaign:
- Have the Securities and Exchange Commission suspend fair-value, or mark-to-market, accounting.
- Make short-sales harder.
- Establish a "net worth certificate program" to shore up bank capital.
- Insure more personal savings.
Accounting rules now require most companies to carry many assets on their books at market value -- if an investment's value in the market declines, the company holding it "marks" it to the new price. That's ugly when asset-values are plunging, and it can weigh down the balance sheets of financial companies in particular, since they hold a lot of volatile investments.
As a result, the rule is a favorite whipping-boy of many on Capitol Hill, including some Democrats. Their solution? Get rid of the rule, or modify it at the least. In this case, the group of lawmakers says that, "where no meaningful market exists," companies should be allowed to come up with prices another way to reflect on their balance-sheet. Thus, when Merrill Lynch sold assets at a steep discount, to get them off their balance sheet, that shouldn't necessarily drive down the value everyone else lists for those assets on their own balance sheets, they argue.
But critics, including many investment professionals, say eliminating the rule does little more than encourage loose financial reporting -- and some see it as an attempt to shelter investors from reality -- it won't change the facts: The company's assets aren't worth what they were.
In fact, that's more or less what Japan did in the 1990s when its banks' balance-sheets were looking shaky. But investors lost confidence in the banks' financial statements and it took the better part of a decade for the country's economy to recover, Villamil says. While bailing out the savings-and-loan industry cost the U.S. 3.4% of GDP; Japan's "lost decade" cost it 24%, she says.
"For anybody who thinks we should start sweeping things under the rug, they should look at their numbers," Villamil says. "You really don’t want to paper over these problems."
Short-sellers have also been popular targets amid the stock-market's long slide this year. Generally, they bet on stock prices declining by borrowing shares and then selling them, in hopes of buying them later at a lower price and returning them to the original owner. It's a legitimate investing technique that market experts say is crucial to keeping markets working smoothly, particularly in a risking market.
But some argue that financial companies are so peculiarly dependent on the confidence of the market, that unfettered short-selling can force them into a death spiral. Lawmakers want to limit the practice, arguing -- as the SEC has -- that some short-sellers abuse the practice in a bid to manipulate share prices. (One such technique is "naked" shorting: selling shares without even arranging to borrow them first.) The proposal advocates rules against naked-shorting and says the SEC should reinstate the "uptick rule," which allowed short sales in a stock only when its price is rising and was repealed in mid-2007.
But naked shorting and market-manipulation are already already illegal, and were even before the SEC introduced a flurry of rules clamping down on naked shorts earlier this month. No friend to shorts these days, the SEC has required many to disclose their activity and banned shorting of financial stocks temporarily, but it has said the uptick rule is outdated; now that shares are traded in penny increments, any given up- or down-tick is much less consequential, and the rule would be ineffective.
Like most other economists, Villamil says short-selling makes up a vital part of market activity. When the markets are in crisis, reining in the practice can make sense, "but you want that to be as limited as possible," she says. "You really don’t wan to restrict markets unless absolutely necessary."
A key factor in the current financial crisis is that bank balance-sheets are in sorry shape, thanks to a slew of securities backed by shaky mortgages. Many institutions need additional capital -- regulators generally require banks to offset their financial obligations with assets, so as their assets fall in value banks need to raise money -- and others are suspected of needing it by investors who are skeptical that their balance sheets don't accurately reflect the dreck they own. Most of the proposals circulating on Capitol Hill and beyond either suggest injecting capital directly into banks or accomplishing much the same thing by taking those lousy assets off their hands in return for cold, hard cash.
But the GOP lawmakers don't want to put taxpayer money on the hook like that. Instead, they propose that the FDIC essentially grant the banks additional capital -- except those deemed unlikely to recover -- and in return take "net worth certificates" from the institutions. These certificates would appear to function much like promissory notes.
Ordinarily, a bank that takes out a loan doesn't improve its capital position -- the assets it may set against its obligations. That's because the additional cash it gets by borrowing is offset by the debt it takes on with the loan. The lawmakers' solution? Don't count the promissory notes as debt: "[T]hese institutions issue promissory notes to repay the FDIC, counting the amount 'borrowed' as capital on thir balance sheets."
Whether such a move makes sense may depend on the details, but "a lot of these things really seem to be accounting gimmicks," Villamil says. "Either we’re injecting capital in banks at the end of the day or we’re not."
Curiously, the lawmakers indicate that the additional capital banks received from the FDIC wouldn't require a cash outlay, suggesting that the whole thing would be a paper transaction: In return for the promissory notes, the banks could increase their capital, presumably making the FDIC's end of the bargain little more than an IOU (albeit one backed by the federal government). "It sounds like a nebulous way to give a piece of paper and say, 'This counts for capital,'" Villamil says.
The FDIC currently guarantees up to $100,000 in deposits (per depositor, per bank) under its hallmark deposit-insurance program. The lawmakers' proposal would raise that to $250,000 "to provide depositors confidence that their money is safe and help eliminate runs on banks which are destabilizing to the industry." (IRAs and some other retirement accounts are already insured up to $250,000.)
More deposit insurance is unlikely to hurt, but it also doesn't address the main problems in the financial markets, which start with defaults on mortgages and work their way up to defaults on mortgage-based securities and other corporate debt, Villamil says.
"The problem is with defaults," she says. "The problem right now is not that we’re having runs from commercial banks -- people on the street are angry, not panicked."