Revised and updated September 24, 2008
The House and Senate must have two objectives when putting
together their versions of the financial bailout proposal made by
the Treasury and Federal Reserve: They must (1) restore the markets
and (2) protect the taxpayers. Congress should act clearly and
decisively to address the turmoil in the financial markets and not
burden this legislation with other issues, problems, or
projects.
These objectives should be resolved in the regular order of
business. This legislation must not become a Christmas tree. If it
does, it will likely backfire, and the intentions of either or both
objectives will fail. Sadly, the Senate's version is already on the
wrong track, and the House's is likely to follow suit.
The Good and the Bad in the Treasury Draft
Proposal
While the new Resolution Trust Corporation (RTC)-like authority
will need a certain amount of flexibility if it is to succeed in
its mission, neither the RTC nor the Treasury secretary should be
given a blank check or be free of responsible oversight. This is
true regardless of whether the new authority is structured as an
independent agency or as a subsidiary agency of the Treasury
Department or another existing agency. The new RTC-like authority
must:
- Have strict oversight over all the new RTC's
activities: The new RTC should not operate without close
and continuous oversight. While Treasury's draft proposal would
exempt the new RTC from judicial or other oversight, such a move
would be a serious mistake and should not be approved. Instead,
Congress should establish an independent council of financial
professionals to provide regular oversight of the RTC. To assure
its independence, the new oversight board should not include
representatives of either Treasury or the Federal Reserve. This
council would review the agency's activities with specific firms
and securities. This oversight should allow the RTC to act quickly
and decisively. This oversight counsel would augment with
professional expertise whatever oversight Congress chooses to
perform on its own.
- Be able to exercise rights of the purchased
securities: The new RTC should not be just a passive
holder of these securities. Instead, it should be allowed to
restructure them or take any other actions to protect the
taxpayers' interest that any other holder would be able to do. This
includes taking a role in managing assets underwritten by a
financial instrument and refinancing some asset classes if this
reduces the costs to the taxpayers.
- Be able to hold assets without sunsets: While
the draft legislation wisely requires the new RTC to end its
purchasing activities after two years, it also allows the agency to
continue to hold securities after that date. This ability to hold
assets until they can be sold for a better price instead of being
required to dump them at a set date is key to the taxpayers'
ability to receive full value from this entity. Both a limit on the
purchase time and no limit for holding assets should be included in
any final legislation.
- Allow asset sales over time to limit losses:
In order to ensure that taxpayers receive the best value for the
funds given to the new RTC, that entity should be allowed and
encouraged to sell, restructure, or otherwise liquidate them over
time. While the new RTC should be expected to liquidate its assets
as rapidly as markets will bear consistent with the taxpayers'
interest, it should not be subject to an artificial time horizon.
If it is forced to essentially dump securities into the market,
this will force down prices, thus further destabilizing the market
and increasing any costs that would be borne by the taxpayers.
- Limit taxpayer exposure: While the new RTC
must have flexibility to stabilize the financial markets, it must
not be void of any limits whatsoever. The Treasury's proposal
included an authorization limit of $700 billion--an estimate of
what it would take to have the markets functioning again--that
limits the costs to the taxpayer.
Ideas Missing from the Treasury Draft
- Severance packages should be at risk: In order
to ensure that incompetent executives do not benefit from their
criminal mismanagement, damaged parties should be encouraged to use
their existing legal rights to file civil suits to recover bonuses
or termination compensation obtained in violation of law or in
breach of their fiduciary duties.
- Additional limits: To reduce the possibilities
of moral hazard, additional limits beyond the dollar amount should
be included. What started as a housing problem has infiltrated to
other areas of the financial markets. So, while the new RTC should
have flexibility to stabilize the markets, it should purchase
securities only at a deep discount, where the market for the
security is having difficulty clearing. This will exact a cost on
the asset holder and ensure that only dysfunctional markets are
eligible.
A Clean Bill Is Essential
As Congress considers this legislation, it is hearing from many
quarters about additional and often extraneous proposals various
members and special interests want to see added. Some of these
include otherwise worthy proposals such as indexing capital gains
for inflation, related but foolish proposals like adding funds so
community organizations can purchase more idle private property,
and the truly absurd like adding bailout money for the Big Three
automakers. In addition, one suggestion is to attach the whole
package to the Continuing Resolution (CR) to provide the funding
needed so the federal government can continue to operate.
To show that it can act decisively, Congress should pass a
clean, standalone bill addressing the immediate financial market
issues only. If the bill is weighed down with other proposals, then
the President should veto it and force Congress to come back and do
it right. The Senate's language takes a bad step in that direction,
and the House proposal contains similar worries.
Proposals in the Senate Version That Should Be
Avoided
Sadly, the Senate failed to resist the temptation to load up the
legislation with its own pet provisions, and including them would
be a serious mistake. The new RTC should focus on restoring the
markets, not on providing funding for other programs or serving as
a platform for other goals. Already, the draft Senate legislation,
which has been endorsed in general by House Financial Services
Chairman Barney Frank (D-MA), includes a number of these bad ideas.
Congress should avoid the following misguided provisions:
- Provide capital to financial institutions in return for
equity: As proposed in the Senate draft, contingent shares
of either debt or stock would be issued to Treasury at the time a
financial institution sold bad assets to the new RTC. If the assets
sold for less than what Treasury paid for them, then the shares or
debt in the amount of 125 percent of the loss would become the
property of the agency. Government ownership of financial
institutions should be avoided, and bureaucrats should not have a
say in the management of any firm.
- Allowing bankruptcy courts to revise
mortgages: It would allow bankruptcy judges to arbitrarily
reduce mortgage payments by either reducing the interest rate to
the current market level or reducing the amount owed to the current
value of the house. Since mortgages are secured by using the house
as collateral that could be sold in the event of a default,
bankruptcy courts until now have given borrowers the choice of
either paying the mortgage contract as written or surrendering the
home to the lender. Such a move builds in a greater chance that the
mortgage contract will not be paid as agreed. In order to protect
their shareholders, financial institutions must price that
uncertainty and add it to the cost of a mortgage. As a result, it
will be much harder for new or low-income homebuyers to find
mortgages, and all homebuyers will find it more expensive to get a
mortgage.
- Placing caps on executive compensation: While
legislators and others are understandably angry at the financial
executives who caused the problem, a pay cap will be
counterproductive by driving the most talented executives to
companies not affected by the proposed bailout. Placing weakened
firms in the hands of lesser talent just increases the chance that
the firms will be mismanaged. Pay should be decided by the company,
its shareholders, and the executive, not managed by a congressman
or a bureaucrat. In addition, every congressional attempt to impose
pay caps on executives has failed because the market devised new
ways to pay them.
- Diverting funds from the new RTC to pay for other
programs: This provision would require that 20 percent of
any profitable transaction would be deposited into a special fund
that pays for low-income housing. This would apply regardless of
whether the overall activities of the new RTC are profitable, which
is highly unlikely. This provision would only increase the cost to
the taxpayer. In addition, it circumvents the usual appropriations
process, thus making it harder to keep track of spending.
Other Provisions That Should Not Be
Added
- Using the bill to impose new regulations on financial
firms: While the current financial regulatory structure is
archaic and needs to better reflect the current state of the
industry, this should be done through considered, well-reasoned
effort, not as a knee-jerk reaction to the current financial
situation. The financial industry should not be "Sarboxed" in the
same way that the accounting industry was damaged by
Sarbanes-Oxley.
- Requiring firms to raise capital: A number of
firms have already fallen short in their attempts to raise new
capital, and this approach is unlikely to have much impact as a
stand-alone reform. Instead, it would be likely to force yet more
firms into cut-rate mergers.
- Easing capital standards: One of the primary
causes of the savings and loan crisis in the early 1980s was
Congress's decision to reduce their capital standards under the
theory that they would grow out of the problem. Such a move failed
then--in fact, it added to the problems--and would be no more
successful now. A major problem today is the loss of confidence in
financial institutions, not their capital levels. For instance,
HBOS in the U.K. was forced into a merger despite its being well
capitalized and exceeding minimum capital standards.
Keep the Right Focus
Members of Congress should focus on restoring the financial
markets, and they should do so with the interests of the taxpayers
at the forefront. These two critical goals can be achieved by
ensuring the new RTC-like authority has the flexibility it needs to
address the turmoil in the financial markets under a stringent and
appropriate level of oversight and with limits firmly in place. The
legislation should not become a springboard for funding for other
programs or as a platform for other goals. Such measures will not
restore the markets, and they will not protect the taxpayers.
David C. John is Senior
Research Fellow in Retirement Security and Financial Institutions
in the Thomas A. Roe Institute for Economic Policy Studies at The
Heritage Foundation. J. D. Foster assisted in the preparation of
this paper.