A Plan for Addressing the Financial Crisis

Abstract:     
This paper critiques the proposed emergency legislation for spending $700 billion on purchasing financial firms' troubled assets to address the 2008 financial crisis. It also puts forward a superior alternative for advancing the two goals of the proposed legislation - restoring stability to the financial markets and protecting taxpayers.

I show that the proposed legislation can be redesigned to limit greatly the cost to taxpayers while doing much better in terms of restoring stability to the financial markets. The proposed redesign is based on four interrelated elements:

* No overpaying for troubled assets: The Treasury's authority to purchase troubled assets should be limited to doing so at fair market value.

* Addressing undercapitalization problems directly: Because the purchase of troubled assets at fair market value may leave financial firms severely under-capitalized, the Treasury's authority should be expanded to allow purchasing, again at fair market value, new securities issued by financial institutions in need of additional capital.

* Market-based discipline: to ensure that purchases are made at fair market value, the Treasury should conduct them through multi-buyer competitive processes with appropriate incentives.

* Inducing infusion of private capital: to further expand the capital available to the financial sector, and to reduce the use of public funds for this purpose, financial firms should be required or induced to raise capital through right offerings to their existing shareholders.

Compared with the Treasury's proposed legislation, the alternative proposal put forward in this paper would provide a far better way to use taxpayers' funds to address the financial crisis.

The approach of buying troubled assets through privately managed and competing funds put forward in this paper, which was subsequently followed by the Treasury in its March 2009 plan for buying troubled assets, is further developed in "How to Make TARP II Work," a February 2009 discussion paper available at
http://ssrn.com/abstract=1341939

The proposal for using competing private funds for buying trouble assets put forward in this paper is further developed in How To Make TARP II Work (Harvard Law & Econ. Discussion Paper No. 626, 2009), available at http://papers.ssrn.com/abstract =1341939, and in “Buying Troubled Assets, Yale Journal on Regulation, 2009, available at http://papers.ssrn.com/abstract =1392808.

Keywords: Financial crisis, bailout, subprime mortgages, creditor run

JEL Classifications: E5, G1, G2, H3, H5, H6, K2, N2

Accepted Paper Series