TARP2: A totally alternative relief programme

Riccardo Cesari 18 October 2008

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After years of deregulation and decades of loose control and mistrust in the systems of surveillance and supervision of financial intermediaries, a disrupting crisis of confidence has erupted in the US and has quickly reached all developed economies.

The “perfection” of this “storm” is, I believe, in the clarity of its origins and its apparently unavoidable and tragic results.

The first version of the Paulson Plan involving $700 billion was rejected by the US Congress because (apart from obvious electoral reasons) you cannot ask people to finance the consequences when the true causes of an economic disaster have not even been considered.

The fundamental causes of this crisis are simply mortgage defaults, the poisoned windfalls of both credit deregulation, allowing lending of no-quality (no-doc mortgages) and financial deregulation, allowing for wild securitisation with abnormal leverages (up to 4000%), and retail selling with no transparency to worldwide individual savers who are, ultimately, the lenders of last resort of the system.

An alternative household-oriented plan

In the US, subprime and Alt-A mortgages, i.e. the riskier mortgages, amount to about $850 and $1000 billion, respectively.

Assuming that $1 trillion has been securitised, i.e. included in structured assets, and that the default rate is 50% (at the moment, foreclosure and delinquencies are at about 8% of total mortgages) you obtain a total of about $500 billion.

At a rate of 7%, a 10-year amortising plan requires an annual repayment of $70 billion.

Considering the total $1850 billion of mortgages, total annual repayment amounts to $260 billion.

Therefore, a truly effective Troubled Assets Relief Programme must defuse the two real causes of the crisis by 1) re-regulating the markets (what Paulson did not do in the Blueprint for Regulatory Reform, last March) and 2) helping households unable to manage their real estate debt (what Paulson did not do in September).

In particular, in order to infuse new trust and help the orderly functioning of the markets we need to introduce a compelling re-regulation of assets (assessment of risks with capital adequacy rules), of liabilities (using transparency and fair valuation principles), of all financial intermediaries (supervision of banks, but also of leasing, factoring, and consumer credit firms), and of the markets (providing incentives for the transfer of trading from the abnormal OTC markets to the official ones).

On these points, the Bank of Italy-Centrale Rischi (active since 1962) and Consob-Issuer Rules could represent illuminating experiences.

Secondly, a “mortgage relief plan” for households would produce many positive effects:

  • It would provide the required guarantee for the underpinnings of credit derivatives, eliminating the basic cause of this crisis.
  • It would be less costly and diluted in time.
  • It would counteract the domino effect that is ruining financial firms.
  • It would have relevant anti-cyclical effects in the current pre-recession phase.

Of course, such a plan (as any other) would require some time and present difficulties in selecting households truly in trouble with their mortgages. However, the announcement effect would be positive and, in any case, it seems much less difficult to evaluate the income position of a borrower than to price a toxic asset made by credit derivatives with unknown underpinnings.

The approved plan

As an alternative to “real” intervention in favour of households with housing debts, different “financial” plans have been proposed, based on the balance sheets of intermediaries:

  • the re-negotiation of debts and maturities;
  • the swap between debts and equity;
  • the acquisition of troubled assets by the State, using cash (Paulson) or Brady-style bonds (Spaventa)

In the final version of the plan, the original “socialistic” recipe has been somewhat amended with elements of alternative approaches in order to obtain congressional approval and to raise the bill from $700 to $850 billion.

Instead of tackling the fundamental causes, the plan tries to solve their effects by “socialising the losses” of the financial intermediaries while letting the households’ asset and liability problems remain a private issue.

The news is that, with the Paulson Plan, a “banker-broker-market maker” State comes to life. Having seen that two wrongs don’t make a right, we might try with three.

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Topics:  Financial markets

Tags:  mortgages, Paulson plan, troubled assets

Professor of Mathematical Finance at the University of Bologna

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CEPR Policy Research