Obama’s Priority: A Better TARP?

What should President-elect Barack Obama’s first priority be as he considers the state of the economy?

Much attention has attached to the question of who will serve as Obama’s Treasury secretary. Fortune’s Andy Serwer says Larry Summers, a former Treasury chief now with Harvard, is the leading candidate, with the support of his former boss, Citi (C) senior counselor Robert Rubin. A Summers appointment would come as no surprise, though there are those who note that Summers and Rubin were among the officials who oversaw the dismantling of the financial regulatory structure that began under former President Bill Clinton — a move that now looks less than prescient, to say the least.

But some people say the Treasury secretary question pales in comparison to the need to unlock the credit markets, which, despite some recent thawing, remain largely frozen. Jeff Miller, CEO of NewArc Investments, writes that the biggest threat to the economy stems from the lack of confidence in financial institutions, a mistrust he attributes to the presumption that big banks’ mortgage-related holdings are worthless.

While that may overstate the point, it’s become clear during the markets’ shellacking over the past two days that questions about financial companies’ health are far from settled. Citi has dropped 19% and Bank of America (BAC) 17% since Tuesday’s election-day rally. The only way out of the death spiral, Miller says, is to find a way to match the sellers of troubled assets with private-sector buyers.

“We hope that you will use your power to create a price discovery mechanism where we can find stability in financial assets,” Miller wrote in a blog post styled on a memo to the president-elect. “There is no single action that you can take before Inauguration Day that will have more impact.”

Trying to set prices for debt instruments that no one wants to buy except at a steep discount takes us back to the earliest versions of the Troubled Asset Recovery Plan, proposed in September by Treasury Secretary Hank Paulson. The Treasury never said exactly how such price discovery would work, beyond pointing to the possible use of reverse auctions. In the rush to shore up the financial system, though, the focus soon turned to pouring money into banks in a bid to rebuild their capital and, hopefully, get them lending again.

Despite the detour, a price-discovery effort is eminently workable, Finacorp Securities chief economist David Merkel argues. He sketches out one possible scenario in a post on his Aleph Blog, though he cautions that even a well-designed reverse auction might reveal some casualties.
“Finding the market clearing price will make the markets start moving again,” he wrote, “but it also might prove that some financial institutions are inverted (negative net worth), if not insolvent (can’t get enough cash to pay all immediate claims).”

Which brings us back to the too-big-to-fail problem that Paulson, Fed chief Ben Bernanke and other policymakers have been struggling with ever since Bear Stearns went belly-up in March. Despite government actions like last month’s TARP capital purchase plan, which showered $125 billion on nine big financial institutions, there’s still no game plan in place for what to do when a big bank’s poor health is exposed and possible buyers — as in Wells Fargo’s (WFC) purchase of Wachovia (WB) — aren’t available.

Merkel says one answer is to set up an expedited Chapter 11 bankruptcy proceeding that would allow bad debts to be renegotiated or reduced. Another advocate of the so-called cramdown approach is University of Chicago Professor Luigi Zingales, who wrote in September that the government should force the creditors of troubled institutions to swap their debt for equity, or forgive some of their debt claims.

Calling such an arrangement a “lesser evil” than the initial Paulson approach, which proposed government purchases of troubled assets, Zingales says cramdowns make sense for taxpayers, though they won’t be popular with the well-connected investor class.

“It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain,” he wrote. “Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition.”

But while forced restructurings may be unpopular with creditors, Zingales says they would be good for the economy and even, believe it or not, for investors. He notes that stock and bond prices actually rose after the government instituted such a plan during the Great Depression.

“For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system,” he wrote. “The time has come to save capitalism from the capitalists.”

By Colin Barr, Fortune Magazine, www.cnnmoney.com, November 7, 1008, 6:51 AM