Another Perspective on, and Proposed Solution to the Financial Crisis

In the Financial Times, Martin Wolf objects to Paulson's proposed solution to the current crisis and offers his own ("Paulson’s plan was not a true solution to the crisis"). The charts above were published along with his column in the FT, and the first two of them illustrate the dramatic growth of leverage in the last few decades among households and in the financial sector.

One of Wolf's objections to the Paulson plan is that a lot of mortgage-backed securities are so difficult to value that the government will invariably overpay for them, thus "guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors"¹. He prefers an approach centered on recapitalizing the financial institutions:

The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.

The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions.

If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.

¹A simple way to avoid this, in my opinion, would be for the government to only buy mortgages themselves (at a significant discount to the value of the underlying properties), and not to buy the mortgage backed securities derived from them or the more complex CDOs derived from the mortgage backed securities. Once the prices of the underlying mortgages and real estate were stabilized, one would think the market for the more complex securities would stabilize as well. If not, then the same financial engineers who put those securities together could be tasked by their respective firms with unwinding them. Unfortunately, the bailout as currently proposed wouldn't limit itself to just buying mortgages.