Opinion

Build a better bailout

The Paulson plan should target bad loans, not burned investors.

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Desperate times may call for desperate measures, but that didn't stop Treasury Secretary Henry Paulson's plan from getting a chilly reception in Congress this week. Senators from both parties assailed the $700 billion bid to restore confidence in financial markets, declaring it unacceptable. "We have to look at some alternatives," Sen. Richard Shelby of Alabama said.

The good news is that there is a very promising alternative to consider – one that could be grafted onto the Paulson plan. It represents a much better investment of $700 billion, it's been used successfully before, and it would help troubled homeowners more directly.

At the heart of this crisis lie two sides of the same coin: Heads are the bad home loans. Tails are the toxic securities that financed these mortgages. The former is what's pushing many homeowners into foreclosure. The latter is what's sinking Wall Street.

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The Paulson plan primarily deals with the tail side of the coin – the investors who got burned handling hot subprime securities. A better plan would start with the head – the bad loans themselves.

The Treasury Department's chief strategy is to buy back large quantities of toxic mortgage-backed securities. These purchases would remove troubled assets from the balance sheets of selling institutions, and (hopefully) clarify the prices of similar securities held by other investors.

How this price clarity would come about is unclear. Will the government's purchases be considered accurate measures of market value or merely fire sales by frantic firms facing bankruptcy? The ownership of underlying mortgage pools will still be highly fragmented. The mere shifting of ownership of large quantities of securities may do little for price discovery, and could serve simply to transfer government resources to selling institutions.

A more effective strategy would be for the government to target the source of the toxicity by buying actual loans, not the securities that back them. It could do so by taking ownership of entire mortgage pools, starting first with the lowest quality (and most toxic) ones.

With congressional authorization, the Treasury could force the purchase of these assets through eminent domain and make an immediate payment of an estimate of the loans' current fair value, which would then be later reviewed for adequacy by a judicial forum.

This approach has several advantages.

First, purchasing whole pools of loans would force liquidation of the mortgage-backed securities used to finance those loans. Investors would get an immediate distribution of the government's cash plus any residual interest that results from after-the-fact judicial valuation. Critically, whole issuances of the most complex mortgage-backed securities would disappear, and the market would receive strong pricing signals for comparable instruments.

A crucial component of this plan is that it moves whole loans (and not fractional securities) under government control. Once it holds these loans, the government can take charge of workouts and refinancings. This is the approach that the Home Owners Loan Corporation took in the Great Depression, and the Federal Deposit Insurance Corporation (FDIC) is already operating such workout programs for loans held by failed banks under its control.

If the Treasury bought these toxic pools, it could offer relief for borrowers who were misled or abused, and then deal more harshly with speculators. This strategy would empower the government to aid troubled homeowners, not just Wall Street.

A further benefit is that it could change the incentives now facing loan-pool trustees. One reason the market has struggled to adjust to falling housing prices and increasing foreclosures is that mortgage-backed securities trustees have been reluctant to renegotiate individual loans, out of uncertainty and fear of litigation. Facing the threat of forced sales to the US government and with clear guidance on how much the government is likely to pay for their loans, such trustees will be highly motivated to renegotiate loan terms on their own, further clarifying market values and enhancing price discovery.

We also need to think harder about financing the cost of government intervention. Under the Paulson proposal, the American taxpayer would pick up the bill for whatever the government loses on its $700 billion of asset purchases.

Congressional Democrats are attempting to soften the blow by requiring the government to receive an equity interest from selling firms. While laudable, this approach significantly complicates the transactions, and it doesn't fairly spread the costs of the program to all the financial institutions that will benefit.

A cleaner approach would follow the model that Congress set up in 1991 for the FDIC when it spent extra funds to shore up systemically important commercial banks: Impose an after-the-fact assessment on the entire industry to defray the costs. Congress could do the same thing with the Paulson proposal.

Once the government's losses are clear, the Treasury should assess some share of the costs – for example, one half – on all of the financial institutions eligible to participate in the program, based on some objective formula. This would be a fairer approach to cost sharing than what is being proposed. It would also give the financial-services industry a strong incentive to help the government keep costs down and avoid similar interventions in the future.

The challenges facing the Treasury and Congress are formidable and urgent. But even in the face of such pressures, it's important to consider alternative approaches that may offer a more efficient and more equitable way out of the nation's difficulties.

Howell E. Jackson is a professor of law at Harvard Law School. A coauthor of "Regulation of Financial Institutions," he has served as a consultant to the US Department of Treasury.

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