Financial Stabilization Proposal

The proposed solution (HR1424) to the current financial crisis is inadequate and ill-conceived. It does not address the problem at the correct point in the financial system and is likely to be very costs to the US taxpayer.

A better solution, based on an approach that has precedent and has proven to work is available. This document presents an analytical framework for understanding the current financial crisis and an outline for a plan to stabilize the US financial system.

Asset prices, such as the prices of homes and mortgage securities depend on the supply and demand in the marketplace. A rapid decline (+16% year-over-year as measured by the Case-Shiller index) in home prices is at the heart of today's financial crisis. Therefore in order to end the crisis it is critical to stabilize the housing market.

A sharp contraction in mortgage financing and available liquidity has precipitated the decline in the housing market. In order to stabilize real estate prices we must restore liquidity in the mortgage market by making sure that all qualified buyers can receive mortgage loans and do this at low interest rates. Restoring liquidity in the mortgage market will allow for more existing homeowners to refinance and for new buyers to purchase their first homes.

The dramatic decline in available liquidity has been caused by the real and perceived increase in counterparty risk in the financial system. The rapid decline in the US housing market has lead to a fall in value of mortgage securities held by many financial institutions. As the bank losses mount, the probability of insolvency rises. These increased risks are expressed by rising financing costs for banks. The perceived risks are further magnified by the lack of transparency in the bank's assets and liabilities. In particular the huge and loosely regulated credit-default-swap (CDS) market creates the fear. Should significant defaults occur, triggering the CDS contracts, some institutions are likely to be unable to meet their liabilities leading to a wave of bankruptcies amongst financial institutions. Lowering the real and perceived counterparty risk is needed to restore liquidity to the mortgage markets and stabilize the housing market.

Counterparty risk can be reduced by improving the assets-to-equity ratios of financial institutions. Banks use leverage, which means they own assets worth many times their equity. Therefore, by providing additional equity capital to banks, Congress can MAXIMIZE the impact on the bank's capital position and minimize the amount of taxpayer money that is put at risk.

For example, a bank with $10 billion in equity can control $250 billion in assets giving it a leverage ratio of 25:1 (250/10). By providing $5 billion of new equity capital, Congress can reduce the leverage ratio to 16:1 (250/(10+5)) and dramatically reduce the bank's risk of failure thus helping reduce counterparty risk, restore liquidity and stabilize the housing market.

It is important not to provide bailouts to speculators or executives with golden parachutes. Therefore this proposal should be considered in terms of a strategic investment of the US Government in a vital part of the US economy. The US Treasury and taxpayer stand to make money on this investment. Congress can help recapitalize the financial system by purchasing preferred shares in US financial companies. Currently the US Government can issue 10-year debt obligations at an interest rate below 4%. By purchasing preferred shares that pay a 7% dividend, the US Treasury stands to make a 3% annual return on this investment.

Purchasing preferred shares that pay a 7% dividend would help recapitalize stabilize the financial system, because a 7% cost of capital is very attractive for the banking industry under current conditions. If $500 billion were to be committed, a 3% annual return would mean a $15 billion profit for the US Treasury each year, on top of the social benefits of stabilizing the housing market and ending the financial crisis.

• Provide capital to US financial industry via preferred stock purchases that would pay a 7% continuous dividend.
• The Government's equity investment in the banking system would help create an "implied" guarantee for the financial institutions. As a result the following is likely:
• Funding costs would fall, allowing the banks to lend money to borrowers at lower rates.
• The Government's investment helps establish a "bottom", enticing private investors (private equity funds, sovereign wealth funds, etc.) to step in and make investments, thus helping to provide capital.

Comparison to the "Emergency Economic Stabilization Act of 2008"

• The purchase of equity aligns the incentives of the Government and the financial institutions. Win-win scenario.
• US Taxpayers have upside potential because they are equity holders and can realize a profit on their investment.
• There is precedent to this approach. Warren Buffett has invested in companies using this approach. Similarly, Prince Al-Waleed bin Talal of Saudi Arabia has invested in Citigroup in the early 1990's. As a result, he made a fortune and Citigroup prospered.

• Adversarial relationship likely. Banks want to sell their assets for as much as possible; the Government wants to purchase them for the least amount possible. Win-Lose scenario.
• US Taxpayers have limited upside, it arises only from purchasing the assets at rock-bottom prices. If the assets are purchased at rock-bottom prices, no new capital is provided to the banking system. Therefore the only way to help the banks is to overpay for the assets.
• There is no precedent and no reliable objective way to value the assets. The assets may be hard to value, but we can be certain that the banks that currently hold the assets are in a better position to know their true worth. The Taxpayer is therefore unlikely to receive a good deal.