Spero Consulting

Update: the House failed to pass the first bailout bill. Here is a seri­ous and effi­cient alter­na­tive that could be imple­mented very quickly…

But first a bit of our usual crit­i­cism: while dis­mayed, we were not sur­prised by the polit­i­cal response to the finan­cial cri­sis sur­round­ing the issuance and hold­ing of sus­pect mort­gages and mortgage-​related securities.

We’re peeved at Repub­li­cans because many of them claim to be con­ser­v­a­tives, yet pro­pose no seri­ous free mar­ket solu­tions. Their insur­ance plan seemed lame and lit­tle dif­fer­ent than sub­si­dized, under-​priced flood insur­ance offered to hur­ri­canes vic­tims – some­times after the fact. It exac­er­bates moral haz­ard problems.

We are upset with the Democ­rats, too, who claim that it is a cri­sis of free mar­kets, when many know that a sub­stan­tial part of the inter­twined set of prob­lems was the result of Con­gres­sional med­dling and the usual (and expected) inef­fec­tive regulation.

In addi­tion, we are espe­cially annoyed with many, so-​called con­ser­v­a­tive com­men­ta­tors and investors who claim to be for free­dom and free mar­kets, but run to the fed­eral gov­ern­ment when­ever times get tough: “Mama, Mama, do some­thing, I’m scared.” (That’s one of our gen­eral crit­i­cisms of baby-​boomers; many whom seemed to have never grown-​up, par­tic­u­larly the older ones.)

The Wall Street Jour­nal has failed us: Unfor­tu­nately, our crit­i­cism extends to that for­mer bea­con of free mar­kets, The Wall Street Jour­nal’s edi­to­r­ial page. Its pub­lished prin­ci­ples seem to dis­solve when the staff becomes afraid of pos­si­bly lower ad rev­enue, cir­cu­la­tion, or home val­ues.¹ See today’s A Main Street Res­cue, for an exam­ple of their inconsistency.

In that respect, we agree with many of the let­ter writ­ers on today’s edi­to­r­ial page, who com­plain about the bailout and the journal’s recent lack of free-​market prin­ci­ples. (We par­tic­u­larly like James Lang’s let­ter, which states that $700 bil­lion is enough to buy out­right the equity in the top 11 banks by mar­ket cap­i­tal­iza­tion.) Of course, that may have changed over the week­end to include, say, the top twenty.)

Reg­u­lar read­ers know that we’ve spent much of our blog­ging effort dur­ing the past week crit­i­ciz­ing the bailout and gov­ern­ment offi­cials, pri­mar­ily Mr. Paul­son and Mr. Bernanke, but to date we haven’t offered a solu­tion of our own.

As always, we do think that the best start to solv­ing a com­plex prob­lem is to do noth­ing and think. (We do offer more than that below.) That strat­egy tends to min­i­mize neg­a­tive, unin­tended con­se­quences and fol­lows from our motto of “thought before cal­cu­la­tion,” which in this case would gen­er­al­ize to “thought before action.” That’s why we often admon­ish read­ers to take the cru­cial part of the Hip­po­cratic Oath in all such activ­i­ties: do no harm.

Our Pro­posed Solu­tion goes beyond the pre­vi­ous paragraph’s rec­om­men­da­tion of thought­ful iner­tia, but does not require cen­tral plan­ning by fed­eral bureau­crats or con­stant over­sight by a myopic and expe­di­ent Congress.

Change the tax code to moti­vate pri­vate investors and invest­ment man­agers (and other firms) to solve the prob­lem with­out fed­eral assis­tance. How?

By allow­ing (new) pri­vate pur­chasers of cer­tain classes of mort­gages and secu­ri­ties to imme­di­ately expense the item’s his­tor­i­cal cost or take an unre­al­ized loss for the full pur­chase price (with­out the usual loss-​limiting, gain-​offsetting rules for cap­i­tal losses that lead to loss carry-​forwards, etc.).

The upfront tax sav­ings would be at the buyer’s mar­ginal rate. Does the reader think this would pro­vide sub­stan­tial liq­uid­ity for these dis­tressed assets? We do! Do you think that hedge funds, pri­vate equity funds, and other finan­cial firms would be will­ing to pur­chase these assets, orga­nize funds, and dis­trib­ute own­er­ship rights to other investors, includ­ing indi­vid­u­als? We do!

We believe this imme­di­ate tax ben­e­fit would induce investors to bear the risks of loss asso­ci­ated with valu­ing and buy­ing these difficult-​to-​understand secu­ri­ties, and it would require a sub­stan­tially smaller invest­ment by the US gov­ern­ment – this time in terms of tem­po­rary oppor­tu­nity cost of lost tax rev­enue, rather than as a direct investment.

We also pro­pose to tax the real­ized cap­i­tal gains when these items are resold or real­ized at some min­i­mal rate, say, 5%. We have no the­o­ret­i­cal jus­ti­fi­ca­tion for the 5% rate, but we want it low enough to reward the pur­chasers for bear­ing the risk, but high enough to recoup some of the lost rev­enue of per­mit­ting the imme­di­ate tax write-​offs.

In that regard, we need to deter­mine the opti­mal tax basis for such sales, as well as par­tic­i­pant eli­gi­bil­ity, i.e, who would be allowed to par­tic­i­pate? Could cur­rent dis­tressed hold­ers be buy­ers, too?

As it stands we would argue that the tax basis to cal­cu­late real­ized gains should be zero, rather than the orig­i­nal pur­chase price. We need to think about how this rate-​basis com­bi­na­tion affects incen­tives to buy and hold or sell these mort­gages and issues, as well as the effect of such a plan on val­ues of other asset classes, e.g., CMBS. Sim­i­larly, our ini­tial impulse would be exclude the major, cur­rent hold­ers, i.e., the likely largest sell­ers, from also buy­ing, but see argu­ments both ways.

We con­jec­ture that such rewards would gen­er­ate suf­fi­cient inter­est from investors and fund man­agers to quickly orga­nize and invest thereby (pri­vately) mit­i­gat­ing the liq­uid­ity cri­sis in a market-​based solution.

Nei­ther our pro­posal nor any other pro­posal – short of nation­al­iza­tion – will elim­i­nate liq­uid­ity issues. The cri­sis has taught banks and investors that cer­tain insti­tu­tions are not as capa­ble or safe as was once thought. Those dimin­ished firms and orga­ni­za­tions will con­tinue to suf­fer from a lack of will­ing lenders and investors, but isn’t that the way it is sup­posed to be?

There is more to write on the issue, but we’d pre­fer to pub­lish the idea and per­form a few after­noon activ­i­ties that gen­er­ate cur­rent – rather than poten­tial future – rev­enue. More­over, we need to think more about some of the details men­tioned above. (Look for revi­sions to this post and new, related posts tonight and tomorrow.)

So, dear reader, what do you think? Should the fed­eral gov­ern­ment imple­ment its a new, House-​approved ver­sion of its cur­rent plan. Or should it step aside and sim­ply pro­vide an envi­ron­ment for entre­pre­neurs and investors to bear the risk and solve the prob­lem them­selves? We fre­quently quote Austin Pow­ers: “It’s freee­dom baby, yeah,” which we pre­fer to some squares in the gov­ern­ment run­ning the show. So, unsur­pris­ingly, we’re all for our plan.