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Learning from history?
Posted by: McQ on Monday, September 29, 2008

Mary Anastasia O'Grady wonders why we haven't learned how to approach our problem from Chile's 1983 financial crisis.

Of course one of the reasons is Paulson panicked Congress by claiming the sky was falling if they didn't hand over $700 billion. It apparently had the desired effect:
This produced a predictable result: It spooked holders of dollars around the globe, and by Thursday credit spreads had widened to record levels. Over the weekend pressure on Congress was increased to hand over the $700 billion Mr. Paulson said he needs to execute his plan.
But, as she points out, the approach he favors has some real downside problems:
The main problem with buying distressed and hard-to-value assets from a bank is that, if the bank is to attract new capital, it is necessary for the government to overpay. And while the value of those assets may eventually move higher, the taxpayer is exposed to great risk, risk that really belongs to the bank and its shareholders. Such a huge federal expenditure also raises the risk of inflation.

A further problem is that the Treasury is itself engaging in hedge-fund speculation. This expands the role of the state in the economy at a time when downsizing that role is more important than ever.
How did Chile handle a very similar crisis in '83? Well, suffice it to say, not like that.
One alternative to the Paulson plan would be to provide secured loans to troubled institutions as a way to allow them to recapitalize. The collateral against the loans would be bank assets (presumably impaired assets) but the transaction would be similar to a "repurchase agreement." In this transaction, otherwise known as a "repo," the borrower is required to repurchase the securities, with interest, in the future in order to retire the loan.

Chile used such an instrument to recover from its 1983 banking crisis. It is true that the government intervened directly in two banks, wiping out shareholders, removing management and nationalizing the firms. Those banks were later re-privatized in a sale that gave tax incentives to encourage Chileans to participate in the offering.

The many other banks that were in trouble were handled differently. For those, the government provided loans that were secured by bank assets, with an agreement that the banks would later repurchase those assets.

These "repos" had conditions attached, including a provision that the shareholders could not take profits out of the company until the loan was repaid. This meant that shareholders were asked to give something in return for getting rescued by taxpayers; and it gave the bank a strong incentive to get back on its feet and return the money.
Unfortunately the momentum in Congress is now headed toward the passage of some very bad legislation which we'll be living with for years to come. That's what happens when panic is allowed to sway the emotions and rush judgement. There are alternatives and there are more free maket alternatives. But they've not been really discussed or explored in this unseemly rush to "do something" when it is not at all clear that anything - or at least anything in a rush - must be done. What Chile did is far superior than what we're contemplating:
Another advantage of this model over the Paulson plan is that although the Chilean government took the bank assets as collateral against the loan, it did not adopt responsibility for managing the assets. That role stayed with the bank.

It was important that the government was a subordinated creditor; otherwise it would have been difficult to bring new capital into the bank. But if the U.S. were to use secured loans, it might not be necessary to make the loans at subsidized rates, as Chile did. Chile was in a depression. In the U.S. case, a penalty rate might be preferred in order to ensure that the banks will use the facility only as a last resort.
The banks worked it out in the market, the government had a standby role, and the help financial institutions took was required to be paid back in full before any profits were shared with share-holders (who were lucky to have been spared being zeroed out by failure).

I have to wonder why this sort of plan, given it's history of success with minimal government intrusion, wasn't at the top of the list of ways to approach the problem?
 
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Damn, that was the kind of thing I have been looking at as well. You and Dale are on the right track. Luckily we have time, it will take time to get the bailout going, and it will be done in stages. We can still get this right.
 
Written By: Lance
URL: http://asecondhandconjecture.com
"...given it’s history of success with minimal government intrusion..."

I suppose it would just be cynical of me to say that you answered your own question, right there.
 
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