Back in September, Simon and I wrote two op-eds on the governance and pricing challenges of buying toxic assets. As many people have noted, those problems have not gone away. The latter, in particular, represents a formidable barrier to Tim Geithner’s latest proposal to create a public-private partnership to relieve banks of their toxic assets. (In summary, the problem is that banks do not want to sell at the price the free market will offer, because (a) they think the assets will be worth more later and (b) doing so would force them to take writedowns that might make them insolvent.)

Lucian Bebchuk also wrote an op-ed on this topic in September, and to his credit he is still trying to turn “TARP II” into something feasible in his new paper, “How to Make Tarp II Work.” The paper has some good ideas but I’m not sure it solves the basic problem, which unfortunately has to do with the laws of arithmetic.

One of Bebchuk’s key points is that there should be multiple funds buying toxic assets rather than one super-aggregator fund, for the basic reason of price competition:

The existence of such a significant number of private buyers armed with substantial capital will produce a well-functioning market for troubled assets. This will be a market in which many potential sellers (banks) face a significant number of potential buyers (the funds). The profit share captured by the funds’ private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets. At the same time, the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets. As a result, we can expect the market for troubled assets to function well, with prices set around the fundamental economic value of purchased troubled assets.

More on that last sentence later.

He also has a clever idea for how to create that competition: Have private-sector fund managers bid for government money (capital or loans – more on that in a second) by bidding the maximum percentage of capital they are willing to provide (the rest of the funding coming from the government). The fund managers willing to put up the most of their own money will get the government funding. This will use the market to minimize the amount of government money that has to be contributed.

Bebchuk also recommends lock-up provisions that ensure that investors – whether private or public – cannot withdraw money from the funds for at least three years. This will help fund managers focus on long-term value without having to worry about having to sell assets into an illiquid market in order to meet demands for redemptions.

These are good ideas. But I’m not sure they are enough to make the market work, and this is where the laws of arithmetic come in. In fact, here’s Bebchuk’s statement of the problem:

A well-functioning market will convert some of the troubled assets held by banks into cash and, perhaps more importantly, provide more reliable valuations for the troubled assets that banks will retain. While this might confirm the claims made by some banks about the value of their assets, it might lead to realization that some other banks are insolvent or inadequately capitalized, which would require infusions of additional capital. Thus, restarting the market for troubled assets might well be insufficient by itself to solve banks’ problems.

Even if you have multiple buyers willing to pay “economic value” for the assets, and multiple banks who want to sell them, you could still have a market failure; those banks could refuse to sell because it would force them to recognize losses that might make them insolvent (and no CEO wants to be CEO of an insolvent bank). In fact, this is what many people think is the case right now. All the people who might invest in a public-private partnership could buy those toxic assets right now, but they can’t agree on prices with the banks who hold those assets.

So if we want TARP II to work, it has to make it easier for buyers and sellers to agree on prices. Lock-up provisions could help, but presumably if there are private investors willing to agree to three-year lock-ups, then private fund managers could raise money from them right now. What is Geither’s public-private partnership going to change? In order to get to a price that buyers and sellers can agree on, buyers have to be willing to pay more than they are currently willing to pay (because the banks aren’t selling at their current willingness-to-pay). There’s only one way the government can do that: by sweetening the deal.

Here is Bebchuk’s example of how this might work:

Consider a $1 billion fund established with a $50 million equity investment contributed by the private manager and $950 million in debt financing from the government’s Investment Fund. In this case, while the private manager will be the first to bear any losses of the portfolio, the private manager’s potential loss from the fund’s $1 billion portfolio will be capped at $50 million. On the upside, however, the private manager will fully capture any profits that the government’s capital of $950 billion generates above the loan’s low interest.

Let’s say that I’m a fund manager, and without government money I’m willing to pay 30 cents for some asset.  That means that when I run my valuation models, there is some chance I will be able to sell it for more than 30 cents, and some chance that I will have to sell it for less, and those distributions balance each other. Government money doesn’t change that distribution of outcomes; it just changes the share of the gains or losses that I incur. In Bebchuk’s example, out of those 30 cents, only 1.5 cents (5%) are mine, so I don’t have to worry about the risk of the price falling below 28.5 cents. But I still get all of the upside. You can see how that shifts my expected outcome in my favor. Because my losses are capped at 5% of my purchase price, I might be willing to pay 40 cents intsead of 30 cents: even though my chances of making money are small (the distribution of eventual sale prices hasn’t changed), my losses are capped at 2 cents (5% of 40 cents), so I don’t need a lot of upside to compensate for my limited downside.

In short, the larger the proportion of government funding, the higher my willingness-to-pay. The purpose of Bebchuk’s auction is to find the fund managers willing to do the job with the least government funding.

This all makes sense, but here are the issues. First, the government financing in this example is a government subsidy. If the taxpayer is taking on the downside (after the first 5%), but none of the upside, and charging the fund manager a low interest rate, then that’s a losing proposition. Looked at from another perspective, if the fund manager’s expected take has gone up, then someone else’s expected take has gone down. Maybe it’s a subsidy we have to grant for the public interest, but there’s still no free lunch. (The government could contribute some capital instead of debt, but then the government’s capital has the same characteristics as the private capital, and the same amount of debt will be required to sweeten the deal sufficiently.)

Second, it still might not work. We don’t really know what the gap right now is between buyers’ willingness-to-pay and sellers’ reservation prices. A government sweetener will increase buyers’ willingness-to-pay, but there is a limit: if buyers think that an asset is worth 30 cents, and the chances of it ever being worth more than 50 cents are infinitesimal, then they will never pay more than 50 cents – and we don’t know if that’s enough to get the banks to sell. So it’s possible that we could set up the most efficient possible mechanism for distributing government financing to the most well-incented fund managers, and the market could still fail.

In the end, if Treasury is going to go down the public-private toxic-asset-purchasing path, then I think Bebchuk has some good suggestions. But there’s still no magic bullet here.

The Administration is obviously floating ideas to assess potential reactions, particularly from Congress.  Today’s front page WSJ article on banking should be seen in this light.  It’s obviously not a fully-fledged proposal, but the concepts are there to elicit opinions and I don’t think it’s particularly helpful if we hang back.

The article raises the possibility that bad assets from banks will be divided into two parts, (a) bought by an aggregator bank, and (b) insured against further losses by the government.

We’ve covered the general principles of an aggregator bank and good/bad bank splits elsewhere.  Let me focus here on the specific (and credible) permutations in the WSJ article.

The bad bank would only be for assets that have already been marked down heavily by banks.  These the aggregator would buy at this (low) book price.  Hopefully, there would be less overpaying than in the original Paulson concept, but the pricing is still murky.

The heart of this proposal is the insurance idea.  This would be (much) larger than, but along the same lines as the Citigroup II deal in November and the Bank of America deal in January.  The problems with this approach are threefold.

1. There is not enough potential upside for taxpayers.  Throwing in relatively few warrants, as with Citi and BoA, does not make much of a difference – even if the strike price is more favorable than in TARP I.
2. There is not enough explicit recapitalization.  Proponents hope that cleaning up the balance sheets in this way will bring in coinvestment from the private sector.  But this seems likely to come slowly and in small amounts in the foreseeable future.
3. There will be nowhere near enough transparency in this structure.  The insurance provided by the government will almost certainly be too cheap relative to the risks, but evaluating this properly will be impossible for outsiders.  (To see what I mean, look at the details of the Bank of America deal.)

Putting limits on bank executive pay make us all feel better, but it will not address the fundamental issues.  The government will ride in to save the banking system.  Shouldn’t the taxpayer get a fair return on his/her investment in this venture – particularly as the whole banking system clean-up is likely to cost us over 10 percent of GDP, so “potential upside” really means “limiting our total losses” and “making sure not all the ensuing profits fall into the hands of already-rich private parties”? 

And wouldn’t we like to feel confident that many incompetent bank executives will lose their jobs, while someone breaks up the “too big to exist” banks? (Our current proposal is along these lines is here, but of course there are other reasonable options.)

Yesterday, Tim Geithner told reporters, “We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system.” On its face, I think most Americans would agree that a private banking sector is better than just having one big government bank. But “private” can still mean a lot of different things. For starters, here are three: (a) day-to-day operations are managed by ordinary corporate managers who are paid to maximize profits, rather than by government bureaucrats; (b) those profits flow to private shareholders, rather than the government; (c) the overall flow of credit in the economy is determined by private market forces, rather than the government.

When people debate “nationalization,” it’s not always clear whether they are talking about ending (a) and (b) or just (b).  The recapitalizations to date under the TARP Capital Purchase Program have bent over backwards to avoid either one. Because the government purchased nonconvertible preferred shares, it has no ability (that I know of, although Robert Reich thinks otherwise in an article I’ll come back to) to turn them into common stock with voting rights that lead to management control; and because the shares pay a fixed 5% dividend, they are a lot like a loan, where any profits after paying off the loan flow to existing shareholders.

However, the two could theoretically be separated. If we want taxpayers to benefit from any recovery by the banks, but we are worried about government bureaucrats making lending decisions, the government could theoretically buy a new class of common stock that earns dividends and trades on the market like ordinary stock, but has diminished voting rights – say, enough for the government to appoint a minority of the board of directors. In other words, letting the taxpayer benefit from banks’ future recovery does not necessarily imply government bureaucrats.

(As an aside, Sweden plunged wholeheartedly into (a) as well as (b), although it did later reprivatize the banks it took over.)

More broadly, though, what about (c)? In the financial sector, the flow of credit is not determined solely by banks’ lending decisions – or, rather, those lending decisions are heavily influenced by the secondary market for their assets. As the story has been told many times, mortgage lenders were pushing subprime loans because investment banks wanted them to fill their securitizations, and they wanted to fill those securitizations because hedge funds and other investors on the other end wanted those CDOs. In this model, the banks are the intermediaries, and the investors with the money in the first place are the ones determining where credit goes, on the large scale.

The government has always been in this game. One of the best-known examples is Fannie Mae and Freddie Mac (although, whenever I bring up those names, I feel bound to mention that they actually provided a declining proportion of housing money during the boom, precisely because everyone else was piling in), who influence the mortgage market by buying mortgages on the secondary market. But the government has become a much bigger player in the last few months. In the latest move, the Treasury Department is setting up a conduit to buy new and existing student loans from lenders. The goal is to give those lenders a market where they can resell student loans, which will hopefully encourage them to make those loans (because now they don’t have to worry about the loans going bad – although I believe many of these loans were already guaranteed). Like the already-announced program to buy asset-backed securities, this is an attempt to restart (influence) the flow of credit by intervening in the secondary market. Conceptually, the government is trying to lend its own money, using the banks solely as originators, since the banks are nervous about lending their money. Although I am probably misusing the term, it’s an attempt to get around the liquidity trap: if banks prefer cash to any non-cash assets, then give them a way to immediately turn loans into cash.

(Still, I’m confused about why you would open the program to existing as well as new loans. If banks can sell existing loans to the conduit, then they will do that, and it won’t necessarily stimulate new lending.)

(Also, I tend to think that a program like this one has positive externalities, in that education is a good thing. Although, as a commenter on my earlier post whom I greatly respect argues, subsidies for education just end up pushing up the price of education.)

As Robert Reich points out in his article, even the “bad bank” idea doesn’t necessarily keep the banking system in private hands. He has a good description of the current situation, though I’m not sure I agree with him over the degree:

But as the Mini Depression worsens, “toxic assets” are no longer all that distinct from a vast and growing sea of non-performing or endangered loans on the banks’ balance sheets. Toxicity has spread to loans made to people and companies that were good credit risks as recently as early last year but are now bad risks. You don’t have to be an honest financier (no oxymoron intended) to figure this out: Ten percent of Americans are behind on paying their mortgages. Millions more are behind on paying their credit-card bills. Hundreds of thousands of small businesses are behind on paying their own bills. Auto suppliers are can’t pay their bills. And so it goes.

As a result, he says, a government “bad bank” might end up buying most of the assets in the banking system (that seems like an exaggeration, but I get the point), and suddenly the government is the biggest bank around. That is, if it isn’t already.

If you are worried about government influence over credit, it’s always been here, and it’s increasing, because without the government there might not be any flow of credit in certain markets. It does make sense to debate the forms that influence should take, but there’s no getting rid of it.

The Financial Times has just published an op ed by Peter Boone and me, arguing that aggressive bank recapitalization and toxic debt clean-up is essential in the U.S. – and that this can be done with strong protections for taxpayers and without nationalization.  The FT did a great job cutting our draft down to fit their print edition (of Tuesday, January 27th); I don’t think they took out anything crucial.  But, just in case, after the jump is the full article as submitted.

(Note: newspapers usually like to choose their own titles for op eds, and the FT is no exception.  But I like their choice and I’ve used it as the heading for this post.)

_________________________________________

If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say when confronted by the current situation of the United States: nationalize the banking system.  The government has already essentially guaranteed the liabilities of the banking system (and no one can risk a Lehman re-run), bank assets at market value must be massively lower than liabilities, and a severe global recession may yet turn into the Greatest Depression.

Nationalization would simplify enormously the job of cleaning up the balance sheets of the banking system, without which no amount of recapitalization can make sense.  An asset management company would be constructed for each nationalized bank, and loans and securities could be clearly divided into “definitely good” and “everything else”.  The arbitrariness of this procedure is not a worry when it all belongs to the government in any case.

The good loans would go into a newly recapitalized bank, where the taxpayer not only holds all the risk (as now) but also gets all the upside.  Careful disposal of the bad assets would yield lower losses than feared, although the final net addition to government debt would no doubt be in the standard range for major banking fiascos: between 10% and 20% of GDP.

As soon as you reveal that the country in question is the United States, the advice has to change for three reasons.  First, nationalization is an anathema in the U.S.  Second, there is good reason for this – the government here really has no track record of running successful business enterprises.  Third, most important, think about what would happen if the American political system gets the bit of directed credit between its teeth, with all the lobbying that entails.  If you want to end up with the economy of Pakistan, the politics of Ukraine, and the inflation rate of Zimbabwe, bank nationalization is the way to go.

Yet no one other than the government is available to recapitalize the banking system, and without sufficient capital, lending cannot be stabilized and any incipient recovery – based on the fiscal stimulus and the pending large mortgage refinancing program – will be strangled at birth.

The problem is not just pervasive financial and macroeconomic instability, it’s the scale of the recapitalization needed to cover the real losses faced by banks – remember Citi and Bank of America required “survival bailouts” and today are valued merely as options.  Additional capital is also needed to support the banks’ (and everyone else’s) desire for higher capitalization in the future. And, with the world economy still deteriorating, we need even more capital as a cushion against the worst case recession scenario.

And these are just the direct recapitalization components.  The asset management companies must pay cash for the distressed assets.  Buying at current market prices should protect most of the taxpayer investment and is the only approach that will find political support.

Adding these together suggests that the government will need to come up with “working capital” in the region of $3trn-4trn.  If things go well, at the end of the day the losses to the taxpayer should be quite limited, with the final cost closer to $1trn.  But this requires that the taxpayer gets enough upside participation.  How is this possible without receiving common equity which, at today’s prices, would imply controlling stakes in the banks (i.e., nationalization)?

We could receive a large amount of nonvoting stock, but a majority silent shareholder is an oxymoron who distorts the incentives of managers towards more bad behavior. And the last thing we need is further political backlash.

The most politically robust solution is to have the government acquire not voting stock but warrants – the option to buy such stock.  These warrants would convert to common stock when sold, and a Resolution Trust Corporation-type structure can manage the disposal of these controlling stakes into the hands of private equity investors.  New owners would restructure bank operations, fire executives, and break up the banks (particularly if some anti-trust provisions are added).

The sticking point will be banks refusing to sell assets at market value.  The regulators need to apply without forbearance their existing rules and principles for proper loan provisioning and for the marking to market of all illiquid assets.  We know they can do this in individual cases – NCC, for example, was forced out of business despite seeming well-capitalized by any publicly available measure.  It’s the big, politically powerful banks that have caught way too many breaks.

The law must be used against both accountants and bank executives who deviate from the rules on capital requirements.  This will concentrate the minds of our financial elite.  Either they will raise capital privately or the government will provide, but this time on terms favorable to the taxpayer.  The banker’s lobby, of course, will protest loudly.  Good thing we now have a U.S. President who can stand up to them, otherwise we would eventually collapse into nationalization.

By Peter Boone and Simon Johnson

For a complete list of Beginners’ articles, see the Financial Crisis for Beginners page.

With the regularity of a pendulum, the focus of discussion has swung back to the banking system (September: Lehman and AIG; November: Citigroup; January: Bank of America, and everyone else). And as everyone waits in anticipation for the Obama team’s first big swing, there has been increased discussion of . . . Sweden, including a recent New York Times article and a fair amount of blog activity, with a broad overview by Steve Waldman. (For other accounts, see this Cleveland Fed paper and a review of the crisis published by the Swedish central bank (which, according to Wikipedia, is also the world’s oldest central bank).)

Why Sweden? Because Sweden had its own financial crisis in the early 1990s, and by many accounts did a reasonably good job of pulling out of it. A housing bubble, fueled by cheap credit, collapsed in 1990, with residential real estate prices falling by 25% in real terms by 1995 and nonperforming loans reaching 11% by 1993, while the Swedish krona fell in value by 30%, hurting a banking sector largely financed by foreign funds. As Urban Backstrom said in a 1997 paper, “[the] aggregate loan losses [of the seven largest banks] amounted to the equivalent of 12 percent of Sweden’s annual GDP. The stock of nonperforming loans was much larger than the banking sector’s total equity capital.” In other words, the banking sector as a whole was broke.

So what did Sweden do? If the options on the table in the U.S. right now are (a) additional recapitalization, (b) an aggregator bank to buy up bad assets, and (c) nationalization, the Swedish solution included all three. First, in late 1992, the government guaranteed all bank creditors (but not shareholders), with no upper limit. Because investors did not at the time question the solvency of the government, this meant that they would continue to lend money to the banks, and the central bank provided unlimited liquidity just in case. Although the U.S. has guaranteed new debt issued by banks, and there is virtually an implicit blanket guarantee for at least the largest banks, there is still uncertainty among bank creditors, as witnessed by credit default swap spreads.

However, even if an insolvent bank has access to credit, it is still an insolvent bank, hoping somehow to become solvent, so it’s unlikely to lend or, even worse, it may be tempted to make extremely risky loans as the only possible path to solvency. As a condition of government support, government auditors reviewed the balance sheets of the all the banks involved, with the goal of taking writedowns immediately and showing the true state of affairs. When it turned out that two major banks, Nordbanken and Gota, were insolvent, they were nationalized (Nordbanken was already largely state-owned), giving the state control of over 20% of the banking system (by assets). Gota was merged into Nordbanken, which only held onto “good” assets, and the “bad” assets were moved to two new entities, Securum and Retriva. These entities were capitalized by the government, and bought 21% of Nordbanken’s assets and 45% of Gota’s assets. This is an example of the good bank/bad bank plan that has gotten so much attention lately. Nordbanken itself (the good bank) was recapitalized by the government, to the tune of 3% of GDP, and become a healthy bank, while Securum and Retriva were told to get whatever value they could out of the bad assets.

Securum and Retriva were run like a cross between private equity firms and asset management companies, both managing and improving assets and also finding buyers for the assets. According to the Cleveland Fed, they managed to return $1.8 billion out of their $4.5 billion in initial capital to the government, for a net taxpayer loss of $2.7 billion. (I can’t figure out if the government also lost money on the loan guarantee, although the sources I read implied that it didn’t.) And Nordbanken, after being run by the government, was eventually privatized (the government’s ownership share is now 19.9%), and the taxpayer recovered the capital put into it in the rescue. As I said above, this is generally seen as a success story, although the Cleveland Fed does have a sobering conclusion:

the cost of the crisis to Sweden was not limited to the capital spent by the [asset management companies]. There have been significant income and output losses associated with the crisis. In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared. Cerra and Saxena (2005) found that the crisis caused a permanent decline in output that can explain the entire fall in Sweden’s relative income. So, even well-managed financial crises don’t really have happy endings.

The Swedish story is usually used as an argument in favor of nationalization, and that’s not an implausible inference to draw. But another lesson you can draw is that it’s not the nationalization per se that matters, but the pricing of the bad assets. The key was that the banks were forced to write down their assets in one shot and then to sell them to the bad banks at realistic prices. That cleaned up their balance sheets and, once they were recapitalized, allowed them to operate as healthy banks. As we said a long time ago, TARP was a fine idea as long as it paid fair value for assets and was combined with recapitalization to fill the resulting hole in bank balance sheets. The same holds for an aggregator bank. The problem would be letting the banks decide which assets they want to sell, and then letting them unload them on the aggregator bank at inflated prices. That solves nothing.

It looks like a bank aggregator for bad assets is pretty much a done deal.  David Axelrod said yesterday we should expect a new approach within a few days, and leading reporters (NYT, Washington Post) have discerned that this is likely to include a “bad bank” into which troubled/toxic assets can be disposed.

We don’t yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery) but it’s not too early to think about the global implications, at least in qualitative terms.

The backdrop, of course, is that the international banking environment is very unsettled at present, probably worse than any time since mid-October.  Ireland just had to nationalize its previously most aggressive mortgage lender (i.e., in Irish mortgages) and the UK seems poised to announce a further scheme for helping banks (and probably forcing them to lend, although the British property sector looks highly dubious).  “Bad banks” are in the air, in all senses of the term.

Let’s say the US launches a comprehensive bank recapitalization and balance sheet clean-up scheme, with broad support on Capitol Hill.  This bolsters confidence in the US banking system, causing a rise in equity prices and – most important – a strengthening of debt, both for banks and perhaps for leading nonbank corporates.  Three international consequences seem likely.

First, this move forces the rest of the G7/G10 and the eurozone to do the same, or something very similar.  If we have very strong (and government backed) banks in the US and somewhat more dubious banks anywhere in other industrialized countries, money will flow into the stronger US banks.  Think back to the consequences of the original infectious blanket guarantees in Ireland in October; the effects now would be similar.  You can think of the UK’s upcoming moves either as a smart way to get ahead of this, or as something that will further a destabilizing wave of competitive recapitalizations – the policy is good, but doing it without coordination across countries can trigger Iceland-type situations.

Second, if all major economies need to back the balance sheets of their banks, then we have converted our myriad banking sector problems into a single (per country) fiscal issue.  Who has sufficient resources to fully back their banks?  This obviously depends on (a) initial government debt, (b) size of banks (and their problem loans, global and local), and (c) underlying budget deficit.  Ireland and Greece will be in the line of fire, but other weaker eurozone countries will also face renewed pressure.  Officials are currently (slowly) trying to work through this predictive analysis, and there is some sketchy thinking about preemptive preparations, but events are moving too fast - and the international policy community again can’t keep up. 

Third, in some countries – particularly emerging markets but also perhaps some richer countries – the foreign exchange exposure of banks will matter.  Here the issue will be whether the government has enough reserves to back (or buy out) these liabilities; the problems of Russia since September foreshadow this for a wide range of countries.  The absolute scale of reserves does not matter as much as whether they fully cover bank debt in foreign currency.  Most emerging markets face significant difficulties and need some form of external support in this scenario, particularly as both commodity and manufactured exports from these countries will continue to fall.

If, by great and fortuitous coincidence, the US and global recession is already at its deepest – as some in the private sector now hold – then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus.  Such outcomes are not yet reflected in asset prices, and the problems for banks – and the implications for fiscal sustainability – around the world will mount.

Financial support for distressed countries within the eurozone, from the G7, and across the G20 will help; the scale may be beyond what the IMF can readily handle by itself.  But this is a very big global fiscal problem, and the appetite for large-scale official rescue financing in the face of these problems remains uneven.

Sheila Bair is delivering a sensible general message: we need dramatic action to clean up banks’ balance sheets and, presumably, to recapitalize them.  This initiative apparently has support from influential senators, such as Kent Conrad and Charles Schumer.  Many Republicans also seem inclined to come on board. 

I like an aggregator-type approach; this is quite consistent with the RTC-inspired structure that we have been advocating (see the WSJ.com article linked through that post for details; such ideas are consistent with and an update of our proposals from September, November, and December).  But some of the details currently being floated seem less than ideal.  Given that the design work on this program is still ongoing and the new Administration will, without doubt, seek broad support on Capitol Hill, I would suggest that the following points be considered or even stressed in the upcoming deliberations.

1. The idea that banks should take equity in the aggregator really doesn’t make sense.  We are trying to increase available capital in the banking system, not find new ways to commit it.  (Historical aside: back in the early spring of 2008, when I was still with the IMF, our proposals contained something equivalent to such a structure; but that train has now left the station.)

2. There is really no reason for the aggregator bank/RTC to overpay for the toxic waste.  We should pay market prices – this is the only fair and reasonable thing to do, and anything else will surely lead to a nasty political backlash.  Market prices are sometimes hard to determine, but this is a matter where outside evaluation and transparent procedures can deal with the issues.  (Note: no need for a complicated auction of the kind proposed this fall.)  If these market prices are below the banks’ marks, then they will need more capital.  The RTC should be set up to provide this capital, for example on the terms that we have suggested.  In any case, it is essential to have full reporting to Congress on all details (Open Door or Closed Door, as appropriate).

3. Banks need capital and the taxpayer needs to see value from this unprecedented and regrettably necessary intervention.  There may be a temptation to conduct the entire banking program just through waste disposal, and this is what powerful people on Wall Street want.  But at the very least, the RTC should receive a considerable amount of warrants (options to buy stock) at a low strike price; these should convert to common stock (with full voting rights) when the RTC sells them.  This will enable the RTC to recover value, while selling stakes (and perhaps even control) to new owners.  Given that large banks have repeatedly demonstrated their inability to measure risk, let alone control it, we should have some confidence that this process will lead to the break up of behemoths and a more competitive financial landscape (and let’s back this up with supportive anti-trust legislation, just to be sure.)

The leadership of the US banking system failed completely.  It’s time to clean up the mess that they made, and Sheila Bair’s proposals are along exactly the right lines.  But let’s make them operational in a way that is fair to the taxpayer.  This would be appealing change for President Obama to present to the country in his first 10 days (I don’t think we can wait 100 days).