Gradualism and profitability, and eventually US Brady bonds, worked in the Latin American debt crisis in the 1980s. But a difficult economy will drive down the value of toxic assets and make more assets toxic. For example, falling home prices put more families in negative equity — mortgages worth more than the home. This creates an incentive to default, which increases foreclosures and lowers the value of the mortgage-backed securities on financial firms’ books.
Policymakers need a Plan B in the event that one proves necessary, modeled on the US’ rapid resolution of insolvent savings and loans in the early 1990s, together with sales of toxic assets in large blocks (to prevent so-called adverse selection from unraveling any bidding process). History is instructive.
Of the US$500 billion that the US required for the Resolution Trust Corporation (equivalent to US$1.25 trillion today), US$400 billion was returned from asset sales, for a net cost of US$100 billion, one-tenth the worst-case private forecasts of US$1 trillion. The final tab on the toxic mortgage bailout and other assets is likely to be a larger percentage of a larger amount, but still far less than the face value of the loans, because the underlying assets will in many cases retain considerable value.
In addition to bailouts and toxic asset plans, governments worldwide want central banks to monitor macroeconomic and overall financial-sector risk (as opposed to focusing on individual firms). US President Barack Obama’s administration would anoint the Fed, whose history has been to recognize crises late. The Bank of England seeks similar powers. The EU wants to establish a European Systemic Risk Board composed of the national central bank governors, chaired by the European Central Bank.
What will these central bankers do to advise on macro-prudential risk? Demand adjustments in large current-account imbalances? Call for reductions in taxes, spending, and government debt, which are the primary systemic risks? To do that could jeopardize monetary policy independence and heighten the threat of future inflation.
Dealing with financial institutions deemed too big to fail won’t be easy. The current system, which allows privatized gains from highly leveraged risk-taking but socializes losses in the event of failure must be changed to avoid episodic financial meltdowns.
To balance the benefits of scale and scope with the socialized losses to taxpayers, firms deemed too big to fail should be required to have more capital and the amount should rise disproportionately with size.
Converting some portion of debt to equity under predetermined solvency-threatening conditions would provide an extra layer of protection. Add a higher bar for government bailouts, and these stronger incentives would induce private financial institutions and investors to take responsibility before disaster strikes.
Michael J. Boskin is T.M. Friedman professor of economics and Hoover Institution senior fellow at Stanford University. He was chairman of the US president’s Council of Economic Advisers under former US president George H.W. Bush.
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