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A Modest Bailout Proposal

posted by Adam Levitin

There are two ways to do a bailout: wholesale and retail. The current proposals all look like retail-level proposals--individually negotiated deals with separate institutions. This sort of bailout, however, is (1) high on transaction costs and (2) vulnerable to favoritism (will Goldman be the first institution served?).

We might do better with a wholesale bailout: have the Treasury essentially do a tender offer through a reverse Dutch auction, with a maximum offer price (say 75%). A two-week only offer for all MBS paper that was rated AAA a year ago, starting at say 15 cents on the dollar. Then inch the price offer upward until either (1) the whole pool of funds is gone or (2) the two-week window is closed. Then move on to AA paper, and so forth, until the funds are exhausted or all the paper has been sold. Anyone who doesn't sell in this time window...no bailout for you!

There are lots of ways in which one could fine-tune such a wholesale proposal. The idea of starting with the top grade paper and inching downwards is to try to shield against adverse selection (time window helps too with risk-averse firms and directors scared about litigation). One can of course futz with the price--it could easily include an equity stake, ala the Dodd proposal.

This process would have several advantages over a piecemeal individualized bailout:

(1) completely transparent and no room for favoritism. The auctions would be easy to monitor, and there would be no room for obfuscation through small print in reports issued to Congress;

(2) low transaction costs--very few commissions paid to the financial services industry. Those savings will offset adverse selection issues;

(3) no self-dealing concerns from using financial institutions as agents;

(4) much, much faster, bringing stability to the market sooner--it doesn't do Treasury any good to get $700BN if it takes them a year to spend it;

(5) indeterminate whether or not more expensive for Treasury. If one believes in the market mechanism and has concerns about whether Treasury (or its self-interested agents, who will surely be paid cash commissions, rather than having a stake in the deal's outcome for Treasury) can properly value MBS, this is at least as good of a way to do it.

fwiw, we've done wholesale bailouts before--just think of the Gold clause abrogation. A wholesale bailout would be quick and dirty, but likely not any dirtier (and quite possibly a whole lot cleaner) than a retail bailout.

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