Insurance would work much better

As I explained in my previous post, sucking all the capital out of the world in order to meet the demand for treasury issuance would allow the Fed and US politicians to play the role of central planners in the allocation of capital. There are very few powers which carry more significance than the power to arbitrarily allocate capital. This of course invites abuse from officials seeking to take advantage of populist constituents and promote the kind of spending that is not necessarily good for the economy but that which is favorable to his re-election chances. To avoid this scenario, I propose an alternative to direct purchases of debt and other assets: utilizing Federal guarantees and insurance.

Back on Sept. 24 of last year, I proposed this insurance plan to recapitalize banks:

Just spent some time thinking about my proposal and I want to clarify some points.

One, instead of being a party that borderline resembles an investor/creditor for these distressed financial institutions, the government should instead act in the capacity of an investment banker on both the buy-side and the sell-side. The government should establish the value of these assets (Mr. Bernanke being the valuation analyst here), and sell these assets to private and institutional investors at a premium in exchange for government insurance on the credit of these assets. So basically, act as the investment banker for the transaction and the insurer as well for the buy-side, which will be responsible for taking some of the investment risks of owning these securities from the taxpayers.

I think this approach is good because it leaves the government as a last option, and secondly, government guarantees plus bargain values should be able to generate a pretty sizable market. This approach retains all the positives of the current bailout plan, but also transfers a portion of the risk of ownership from taxpayers to private investors and institutions. Sounds fair?

Additional specifics to the plan: the insurance would be issued in the form of a put option. An example of a transaction would be:

Bernanke determines that the ytm of a security would give it a value of 30 cents to the dollar. The government then markets the security to a wide variety of potential buyers by offering a 7 cents premium, which would result in a selling price of 37 cents with an attached put option that would allow the investor to sell the security back to the government at 30 cents under a specified timetable. So basically, the taxpayer’s money would only suffer a write-off if the value of the underlying security drops off to less than 30 cents to the dollar, which suffers less exposure than purchasing the asset at 37 cents .

The key thing here to note is that between prices of 37 and 30, the loss is taken by private investors, rather than by the taxpayer. So this is an allocation of risk from the taxpayers to market participants.

In addition, the put options would have different expiration periods, which would suit a wider variety of potential investors, thus attracting more potential buyers.

The advantages of my plan over the current government plan:
1). encourages participation of private money and diminishing the role of the government in financial dealings.
2). better protects taxpayer money by spreading the credit risk of the underlying securities to private investors and institutions.
3). allows private investors to recapitalize the books of distressed institutions in the form of the insurance premium rather than taxpayer money.
4). having the government as an ultimate guarantor of the security would provide the needed liquidity for the market of these instruments.

Curiously, House Republicans led by Eric Cantor of Virginia came out with an identical plan the next day, which called on Federal insurance and insurance fees. My plan only differed in that I proposed a sizable insurance fee from the purchaser to recapitalize the banks.

Paulson opposed the insurance plan vehemently, but ended up utilizing its features in two of its most prominent bailouts: Citi and BoA. Systematic insurance isn’t without risks, but I would much rather take the contingent obligations than to allow centralized allocation of capital.

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One Response to Insurance would work much better

  1. Traingwheels says:

    I think this plan looks sound on paper but in practice will likely result in a financial system dependent on the support and infrastructure from the government indefinitely, which is a scenario the government does not want to be put in. It goes completely against free-enterprise.

    Asking Bernarke to price all those insurance premiums is no small task. Essentially the US reserve is going to become the biggest investment bank in the world, a role I don’t think it can really take in light of all the cutbacks during the Bush term. And if the following suggestion is to increase the size, it becomes a slippery slope. At what point are we just a patient who is on life support and should just pull the plug and help a new patient.

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