…One approach is to purchase mortgage-related debt or other troubled securities. This approach has the advantage of going to the heart of the current turmoil, which began and is still centered in mortgages, mortgage-backed securities (MBS), and derivatives of those securities. Yet this approach has significant disadvantages as well.
First, the affected debt instruments are quite heterogeneous, which makes setting appropriate prices and quantities very difficult. If all MBS were alike, the government could simply undertake a reverse auction, purchasing the cheapest securities on offer until the market yield was driven down to the desired level. But MBS differ in the probability of mortgage repayment and other characteristics. If the government said it would buy a certain amount of AAA-rated MBS at the lowest price offered, and a certain amount of AA-rated MBS at the lowest price offered, it would be placing undue weight on ratings that have been widely derided, and current holders would likely sell the government the lowest-quality securities within each ratings class. Derivatives of MBS are even more idiosyncratic, so running an effective reverse auction for them would be even more difficult. Instead of auctions, the government could consider buying eligible securities at a pre-set premium over current market prices—except that the illiquidity of financial markets now means that market prices for many of these securities do not exist. Alternatively, the government could use its judgment—or the judgment of a hired investment firm—to decide which debt securities to buy and from whom and at what price, but the potential for inefficiency, unfairness, and abuse in such a system is high.
A second problem with buying troubled debt is that it provides the most help to the financial institutions that made what are, in retrospect, the worst investment decisions. Banks that stayed clear of this debt or sold such debt at cut-rate prices earlier this year in an effort to move beyond the crisis would receive no direct gain from such a program, while banks that made the biggest commitments to low-quality mortgages and have delayed dealing with their balance-sheet problems would be the biggest beneficiaries.
Third, this approach saddles taxpayers with significant downside risk but limited potential upside gain. One crucial feature of the Treasury and Federal Reserve rescues of Fannie Mae, Freddie Mac, and AIG is that taxpayers received substantial equity shares in these companies and could receive solid returns if financial markets rebound.
An alternative to the government buying certain types of debt from financial institutions is for the government to make equity investments in a wide cross-section of such institutions. For concreteness, suppose that the government offered to make an equity investment in every firm regulated by a federal or state banking regulator equal to 10 percent of the market value of the company as of September 1st in exchange for a 10 percent equity stake in the company. (The 10 percent figure is illustrative. As with the first approach, a judgment about the appropriate total amount of government funds would need to be made.)
With this approach, the government would not need to determine the appropriate prices and quantities of individual mortgage-related securities, it would not be providing a greater reward to companies that have made the worst investments, and it would gain the opportunity for taxpayers to receive a higher return if the financial system recovers more strongly. Still, objections can be raised.
First, the even-handedness of these investments means that they would not focus on the firms facing the greatest stress, which might damp the immediate bang-for-the-buck. However, the even-handedness also means that the government would not be bolstering companies in trouble relative to those in better health, as under the first approach. Therefore, the crucial restructuring of the financial sector—away from institutions and business models that failed, and toward others that proved more robust—would continue. The financial sector might heal more slowly, but it would also heal more solidly.
A second difficulty would be choosing the companies that would be eligible for this offer. Limiting eligibility to banks would offer no direct help to non-bank firms that have suffered large financial losses, although they would benefit indirectly from the stronger financial condition of banks. Expanding the set of eligible companies would enhance the effect on financial stability, but would be hard to do in a way that distinguished between firms with significant and minor financial operations.
More from Doug Elmendorf at Brookings.
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