Buying illiquid mortgage-backed securities from financial firms might make sense - if the institutions are forced to include equity positions or stock options as part of a package deal.
Sopranos Translation: if we're going to bail these crooks out, at least let's get a piece of their action.
The reaction to the (meagre) details of the Bush Bailout Plan has been swift, and almost universally negative, with a rare bipartisan concensus emerging that making Uncle Sam an unrestrained Garbage Collector of Last Resort simply ensures taxpayers will be royally screwed (see Vyan's scary post on this).
But there is one relatively straightforward alternative to the U.S. simply purchasing toxic assets (or actually taking over the institutions that own them a la AIG) - requiring companies that want the Treasury to purchase their illiquid portfolios to include equity positions or stock options as part of a package deal.
No one right now has any clear idea what the mortgage-backed securities involved are worth. It's obvious, though, that the companies involved want to unload them at their own marked-down book price, at worst, as opposed to a much lower market price. The likelihood under the Paulson plan, even with a reverse auction, is that the government will pay way too much for something nobody wants - the insider institutions involved will simply collude to keep prices higher than they would be in a fair and genuinely open market.
While establishing a market or fair-value price for these complex instruments will be difficult, obviously some means must be found to encourage institutions not to over-price their assets.
Let's say Firm A is carrying toxic instruments on their books at $800 million. Firm B has similar assets it values at $700 million. No buyer, however, outside Easy Mark Uncle Sam, is willing to pay more than $500 million for them.
The firms don't want to sell these instruments to the Treasury for $500 million for a good reason - that would reduce their capitalization by hundreds of millions of dollars, impairing, not improving, their ability to make loans. Since reducing liquidity isn't something anyone wants, this is a problem for us as well as the firms. What's required is a sane compromise.
So, for example, we might offer to buy the assets of either firm for $700 million, but with an accompanying grant of warrants or actual shares with a dilution value of $100 million.
Firm A would have its capitalization reduced or diluted by $200 million, Firm B by $100 million. This is only fair, because otherwise we'd be rewarding companies for overstating the value of their assets. Uncle Sam is paying $100 million more, in effect, than true market value, but the compromise nevertheless looks like the best possible deal for both parties: 1) the firms haven't suffered as much they would have if the Treasury had only paid them $500 million, 2) the firms now have ready cash on their balance sheets in place of murky illiquid assets, greatly reducing the uncertainty that has been the greatest bane for financial stocks and therefore stabilizing the markets, and 3) best of all, the U.S. Government has an ownership position giving it an upside to a successful bailout.
While the illiquid investments are unlikely to prove profitable in the long run, the multi-million dollar stakes granted in the financial firms themselves are much more likely to increase in value. For once, the rewards, as well as the risks, of the rescue plan will be "socialized", without requiring a wholesale government takeover. Assuming the institutions involved clean house properly - and new, wide-ranging regulation is a necessity to avoid a simple repeat of head-in-the-sand recklessness down the road - Uncle Sam (and his taxpayer nephews and nieces) will actually stand to benefit for a change from heroically propping up the system.
It's actually happened before - the government made money from the stock options it received in the Chrysler bailout.
My proposal isn't perfect. Current shareholders in the firms involved will likely see their investment drop in the short term. Executives who made bad decisions will suffer the wrath of investors and may even lose their jobs.
Boo hoo.
Instead of another Bush-era Trillion-Dollar con job, we will be saving capitalism from itself, while letting the good guys - us - reap the rewards if the plan works out.