In the sector of the blogosphere pushing hardest for immediate bank nationalization, the reaction to the new details leaked Monday on how the Treasury may seek to restart markets for toxic mortgage-backed securities was predictable: just another pointless rejiggering of the same basic idea proposed by Hank Paulson last September. Once again, the government would overpay for the bad assets with taxpayer money, allowing the private sector to escape the consequences of their failure to properly evaluate risk.
Which is not to say there weren't any details. Instead of one big "bad bank" that would soak up all the stinking garbage, the Treasury now wants to create "multiple investment funds to purchase the bad loans and other distressed assets," reported the Wall Street Journal. The funds would be run by private investment management managers who would be required to put up some capital of their own in order to participate. The rest of the funding, possibly in the form of loans, would come from the government.
In some respects, the plan looks remarkably similar to a scheme outlined by an economist at Harvard Law School, Lucian Bebcuk, first in a paper released last month called "How to Make TARP II Work" and then, on Tuesday, in a more easily comprehended piece, "Jumpstarting the Market for Troubled Assets," published in Forbes on Tuesday. (Thanks to Mark Thoma for the tip.)
As is true of the new Treasury plan, Bebcuk describes a system in which multiple funds compete against each other to purchase toxic debt, instead of just one big player. This would avoid the thorny problem of having only one market player determine the prices for the toxic debt. But Bebcuk also adds another, more intriguing tweak. The private managers compete to be part of the government program by bidding against each other on how much capital they will contribute on their own. Theoretically, then, if the government is offering too good a deal, there will be enough competition to get a piece of the action to ensure that it is relatively less of a handout.
To ensure that the government does not overspend, private managers should not only compete for troubled assets after they obtain capital from the government but also compete upfront for the right to participate and receive funding from the government's program. Such a market mechanism can ensure that the government provides funding at a level and under terms that will be least costly to taxpayers while still inducing the establishment of private funds with the desired amount of aggregate capital.
I'm sure that critics will argue that this is just another layer of complexity designed to wish away the central fact -- the toxic assets are irredeemably toxic, and no wand-waving will change that. And they may well be right. But what struck me after puzzling through this is the parallel it offers to governmental attempts to deal with another set of truly toxic assets: greenhouse gases.
What the Treasury is trying to do is set up a kind of cap-and-trade system for bad debt. In this case, the "allowances," or the right to pollute, are the government loans helping private players buy up the existing pollution -- the toxic mortgage-backed securities. Obama's budget calls for a cap-and-trade system in which "allowances" are auctioned off, instead of just handed out, as was done semi-disastrously at the outset of Europe's Emissions Trading System several years ago. Here, the right to participate in the program is what is being auctioned off, and the more who participate, the less the government pays.
In this scenario the bank nationalizers are similar to cap-and-trade critics who push for a carbon tax, or direct emissions limits set by the EPA. They want the government to just go ahead and order a top-down solution, and not try to tweak markets to get the desired outcome. In both cases, politics limit options. A carbon tax is considered anathema by most politicians, and despite some murmurs of support for bank nationalization by some American legislators, I suspect that Congress would find it unpalatable if the White House announced plans to seize Bank of America, Citigroup, Wells Fargo and J.P. Morgan Chase.
Another troubling parallel: The bad bank attempts to solve a complex problem with more complexity, just as cap-and-trade is a complex attempt to cope with an incredibly thorny challenge. But greater complexity inevitably ensures greater opportunities to scam the system.
Thinking of the bad bank approach as a cap-and-trade system raises, at the very least, the possibility that a system could be designed that would lower the government's costs in the financial system rescue package. That would be laudable. But there is also an obvious place where the analogy breaks down. In a cap-and-trade system, the government sets a cap on the amount of greenhouse gases industry is permitted to emit. That creates the incentive to participate in the program in the first place. There is no such mandatory incentive to participate in the bad bank scheme. And an auctioning process won't work if nobody wants to bid, no matter how good the terms are.