Sunday, September
28, 2008
Tragedy in the
Making in Washington and on Wall Street: The Canadian Solution
"When troubles come, they come not single
spies, but in battalions."
Shakespeare
(1564-1616)
"The
liberty of a democracy is not safe if the people tolerate the growth of private
power to the point where it becomes stronger than the democratic state itself.
That in its essence is fascism — ownership of government by an individual,
by a group or any controlling private power."
"Our economy is facing a moment of great
challenge. ... We're in the midst of a serious financial crisis.”
George W. Bush, September 24, 2008
The Washington
gridlock about finding a solution to the subprime
financial crisis in the
United States is turning into a tragedy, seemingly because of a fundamental
lack of understanding and communication about the causes of this financial
crisis and the most efficient way to solve it. The nature of the crisis, the
economic consequences if it is not solved, and how it could be solved without
costing the government and U.S. taxpayers a single penny has not been properly
explained to Congress and to the U.S. population.
Indeed, in this election period, there is a clear danger
that the financial crisis is not going to be solved properly by the U.S.
government and by Congress, and that there will be dire economic consequences
in the months and years ahead, not only for the United States but also for the
world economy. A similar subprime crisis has been solved in Canada, without
costing the government and Canadian taxpayers a single cent. Although such a
solution, i.e. transforming most of the subprime mortgage-back securities into
medium term debentures, would have to be adapted to the peculiar American
situation, this can be done.
The
Canadian solution
In August 2007, it was discovered that Canada, just as the
U.S., had a subprime mortgage-backed securities problem. Since the Canadian
economy is more than ten times smaller than the American economy, the magnitude
of the problem was also smaller, but it was nevertheless acute.
Indeed,
Canada's subprime mortgage market was a smaller proportion of the total
mortgage market than in the U.S. and mortgage defaults have not been as
prevalent in Canada as in the United States. For instance, there has not been a
housing bubble burst in Canada. Overall, risky mortgage-backed paper
constituted, about 5 per cent of the total mortgage market, while in the U.S.,
subprime mortgage paper constitutes about 20 per cent of the total mortgage
market, and mortgage defaults have been rising dramatically.
Nevertheless, there was some $32 billion (CAN) of non-bank
asset-backed commercial paper in Canada. When this market became illiquid after
August 2007, as a consequence of the global credit crisis that originated in
the U.S., a restructuring committee was assembled in Canada by large pension
plans, Crown corporations, banks and other businesses holding the bulk of $32
billion in non-bank asset-backed commercial paper (ABCP) in order to find a
solution to the liquidity problem. (Large Canadian banks covered the
asset-backed commercial paper that were on their books or in their money market
funds). This was the Pan-Canadian Investors Committee for Third-Party
Structured ABCP, chaired by a Toronto lawyer, Mr. Purdy Crawford, and created
after a proposal that originated from the large Quebec pension fund, the Caisse
de dépôt. This was the Montreal proposal.
The committee ended up proposing to restructure the frozen
and illiquid securities into longer-term securities. It proposed that ABCP
notes, initially intended as low-risk and short-term debt, be exchanged for new
replacement notes or debentures that would not mature for years (seven or nine
years) while earning interest originating from the underlying primary
mortgages. The plan was approved by a Canadian court last June and is scheduled
to close by September 30, after Canada's Supreme Court refused to hear an
appeal against the plan.
The plan was designed to prevent a forced a fire sale of
the asset-backed paper and to restore confidence in the Canadian financial
system, especially in the money market funds. And it did all that without the
government risking a penny of taxpayers' money.
Of course,
those entities that had invested in what they believed to
be liquid and relatively high-yield 30- to 90-day debt instruments had to
accept new notes maturing within nine years, but most of them thought that this
was better than the alternative of outright liquidation. Those investors can
hold the newly-issued notes to maturity or they can try to trade them in the
secondary market. A market for asset-backed securities was thus indirectly
created where none existed before.
What lesson can be drawn for the current U.S. predicament?
The
U.S. Problem: Real danger of a cascading debt-deflation spiral
The financial crisis is much more severe and much more
widespread in the U.S. than in Canada. Therefore, a large scale Canada-like
solution would have been, most likely, unrealistic. Could hundreds of American
banks and pension funds get together to restructure the illiquid
mortgage-backed paper? This is doubtful.
However, the principles behind the Canadian solution can be
retained and the mortgage-backed securities could be restructured into
longer-term securities carrying interest. But because of the size and
complexity of the American financial system, this would have to involve the
U.S. government as an intermediary.
In the U.S., for example, the mortgage market (residential
and commercial) is about $14 trillion, that is a size equal to the annual gross
domestic product (GDP). Overall, the U.S.'s total interest-bearing debts are
now a staggering $51 trillion (consumer, corporate and government debt), that
is to say a level of total debt more than three and a half times the annual
GDP. For decades in the past, the ratio of debt to GDP was about 1.0. This
shows the extent of American current over-indebtedness.
In the short run, however, there are two urgent problems
faced by the U.S. economy that must be solved with as little economic
perturbation as possible.
First, there is the most urgent problem of solving the
overhang of illiquid mortgage-backed securities which were created as the
equivalent of liquid commercial paper. They must be urgently aligned more
closely with the more long term mortgages downstream they are based on. Since
much of this illiquid mortgage-backed paper is found in the $4 trillion money market funds market,
there was and there still is the danger of a run on such funds in the coming
days and weeks if investors fear for the safety and liquidity of their
balances. A collapse of the market in money market funds would be
equivalent to the banking collapse of the 1930's, since this is where companies
park most of their required cash flows in the short run.
The second
American financial problem is related to the approximately $2.7 trillion in
municipal securities outstanding, a large proportion of which have been relying
on a bond insurance system that is teetering on the brink of collapse. The Fed
partly solved this problem temporarily when it announced on Tuesday, September
16, that it had loaned $85 billion (for two years) to the largest world insurance company, American
International Group (AIG),
in exchange for a 79.9 percent stake in the company, thus avoiding a
formal bankruptcy filing for AIG. This was, of course, after announcing that
the U.S. Treasury promised to inject some $200 billion in the government
sponsored Fannie Mae and Freddie Mac in preferred shares, in order to solidify
their mortgage lending operations and their $5.3 trillion joint debt.
The Bush administration's proposal to create a fund of $700
billion to buy back illiquid mortgage-backed paper does not seem to have been
structured in a manner that would avoid an outright subsidy to the American
banking sector. If it were to be used to recapitalize private banks, this
amount would be too small. This need not be. In fact, much of the legitimate
fear that many Americans have that large amounts of public money are going to
be used to subsidize Wall Street firms can be avoided, and the amount required
to restructure the subprime-based securities market could be considerably
reduced.
Indeed, there is a way for the U.S.
Treasury to play an intermediary role in restructuring most of the illiquid
mortgage-backed paper that creates so many problems today, not the least would
be the possible collapse of large segments of the U.S. financial system.
Since time is of the essence, Congress could approve the
creation of a U.S Government Mortgage Restructuring Trust (MRT), designed
to exist for a twelve-year maximum period, that is, until 2020. Such a
government trust could buy back, at a fair market value (including
a substantial discount to reflect poor liquidity and poor marketability),
illiquid but still solvent mortgage-backed securities, held by banks or money
market funds.
Simultaneously, the government trust would have the power
to reissue mortgage-backed debentures with a maturity of nine years or less and
carrying interest financed by the underlying mortgages thus acquired, and in an
amount large enough to cover at least the initial cost of acquisition. The Fed
and its twelve regional banks, plus Fannie Mae and Freddie Mac, could play an
important role in creating a liquid secondary market for such government-backed
securities. Because of this reissuance feature, the $700
billion guarantee initially proposed by Sec. Henry Paulson could be reduced,
possibly to a more palatable level of $250 billion.
Such an operation would relieve the U.S. banking system
from short-term mortgage-backed securities that are presently de facto
frozen, because there is no market for them. It would also allow American
savers and investors to include in their IRAs or 401(k) plans safe and
profitable investments. Moreover, it would provide capital to the mortgage
market and help turn the housing slump around.
And, what's more, such a debt restructuring operation need
not cost the government and American taxpayers a single penny, in the end. To
the contrary, the program can be structured in such a way as to generate a fair
return on the government's initial investment.
Simultaneously, a regulatory ban on the issuance of any new
securitized mortgage-backed paper could be issued. The same could apply also to
the dangerous practice of elevating the credit rating of certain bonds or
debentures through reliance upon the credit-default (insurance) market. These
were the two main corrosive “innovations” which have resulted in the
present financial mess.
Moreover, such a
restructuring plan could be kept simple and totally transparent.
In conclusion, this is something that the Bush administration and the U.S. Congress might want to consider if they hope to get out of the ideological and political deadlock they have talked themselves into.
___________________________________________
Rodrigue Tremblay is professor emeritus of economics at the University
of Montreal and can be reached at: rodrigue.tremblay@ yahoo.com.
He is the author of the book 'The
New American Empire'.
Visit his blog site at www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check Dr. Tremblay's coming book "The
Code for Global Ethics"
at: www.TheCodeForGlobalEthics.com/
_____________________________________
Posted, Sunday, September 28,
2008, at 5:30 am
Email to a friend:
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