A Better Solution (than a government takeover)

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.