Tragedy in the Making in Washington and on Wall Street:
The Canadian Solution
By Rodrigue Tremblay
"When troubles
come, they come not single spies, but in battalions." -
Shakespeare (1564-1616)
"The liberty of a democracy is not safe if the people
tolerate the growth of private power to the point where it
becomes stronger than the democratic state itself. That in its
essence is fascism — ownership of government by an individual,
by a group or any controlling private power."
Franklin D.
Roosevelt (1882-1945), 32nd US president
"Our economy is facing a moment
of great challenge. ... We're in the midst of a serious
financial crisis.” - George W. Bush, September 24,
2008
28/09/08
"ICH" -- - - The
Washington gridlock
about finding a solution to
the subprime financial crisis
in the United States is turning into a tragedy, seemingly
because of a fundamental lack of understanding and communication
about the causes of this financial crisis and the most efficient
way to solve it. The nature of the crisis, the economic
consequences if it is not solved, and how it could be solved
without costing the government and U.S. taxpayers a single penny
has not been properly explained to Congress and to the U.S.
population.
Indeed, in this election period, there is a clear danger that
the financial crisis is not going to be solved properly by the
U.S. government and by Congress, and that there will be dire
economic consequences in the months and years ahead, not only
for the United States but also for the world economy. A similar
subprime crisis has been solved in Canada, without costing the
government and Canadian taxpayers a single cent. Although such a
solution, i.e. transforming most of the subprime mortgage-back
securities into medium term debentures, would have to be adapted
to the peculiar American situation, this can be done.
The Canadian solution
In August 2007, it was discovered that Canada, just as the U.S.,
had a subprime mortgage-backed securities problem. Since the
Canadian economy is more than ten times smaller than the
American economy, the magnitude of the problem was also smaller,
but it was nevertheless acute.
Indeed, Canada's
subprime mortgage market was a smaller proportion of the total
mortgage market than in the U.S. and mortgage defaults have not
been as prevalent in Canada as in the United States. For
instance, there has not been a housing bubble burst in Canada.
Overall, risky mortgage-backed paper constituted, about 5 per
cent of the total mortgage market, while in the U.S., subprime
mortgage paper constitutes about 20 per cent of the total
mortgage market, and mortgage defaults have been rising
dramatically.
Nevertheless, there was some $32 billion (CAN) of non-bank
asset-backed commercial paper in Canada. When this market became
illiquid after August 2007, as a consequence of the global
credit crisis that originated in the U.S., a restructuring
committee was assembled in Canada by large pension plans, Crown
corporations, banks and other businesses holding the bulk of $32
billion in non-bank asset-backed commercial paper (ABCP) in
order to find a solution to the liquidity problem. (Large
Canadian banks covered the asset-backed commercial paper that
were on their books or in their money market funds). This was
the Pan-Canadian Investors Committee for Third-Party Structured
ABCP, chaired by a Toronto lawyer, Mr. Purdy Crawford, and
created after a proposal that originated from the large Quebec
pension fund, the Caisse de dépôt. This was the
Montreal proposal.
The committee ended up proposing to restructure the frozen and
illiquid securities into longer-term securities. It proposed
that ABCP notes, initially intended as low-risk and short-term
debt, be exchanged for new replacement notes or debentures that
would not mature for years (seven or nine years) while earning
interest originating from the underlying primary mortgages. The
plan was approved by a Canadian court last June and is scheduled
to close by September 30, after Canada's Supreme Court refused
to hear an appeal against the plan.
The plan was designed to prevent a forced a fire sale of the
asset-backed paper and to restore confidence in the Canadian
financial system, especially in the money market funds. And it
did all that without the government risking a penny of
taxpayers' money.
Of course, those
entities that had invested in what they believed to
be liquid and relatively high-yield 30- to 90-day debt
instruments had to accept new notes maturing within nine years,
but most of them thought that this was better than the
alternative of outright liquidation. Those investors can hold
the newly-issued notes to maturity or they can try to trade them
in the secondary market. A market for asset-backed securities
was thus indirectly created where none existed before.
What lesson can be drawn for the current U.S. predicament?
The U.S. Problem: Real danger of a cascading debt-deflation
spiral
The financial crisis is much more severe and much more
widespread in the U.S. than in Canada. Therefore, a large scale
Canada-like solution would have been, most likely, unrealistic.
Could hundreds of American banks and pension funds get together
to restructure the illiquid mortgage-backed paper? This is
doubtful.
However, the principles behind the Canadian solution can be
retained and the mortgage-backed securities could be
restructured into longer-term securities carrying interest. But
because of the size and complexity of the American financial
system, this would have to involve the U.S. government as an
intermediary.
In the U.S., for example, the mortgage market (residential and
commercial) is about $14 trillion, that is a size equal to the
annual gross domestic product (GDP). Overall, the U.S.'s total
interest-bearing debts are now a staggering $51 trillion
(consumer, corporate and government debt), that is to say a
level of total debt more than three and a half times the annual
GDP. For decades in the past, the ratio of debt to GDP was about
1.0. This shows the extent of American current
over-indebtedness.
In the short run, however, there are two urgent problems faced
by the U.S. economy that must be solved with as little economic
perturbation as possible.
First, there is the most urgent problem of solving the overhang
of illiquid mortgage-backed securities which were created as the
equivalent of liquid commercial paper. They must be urgently
aligned more closely with the more long term mortgages
downstream they are based on. Since much of this illiquid
mortgage-backed paper is found in the $4 trillion
money market funds market, there was and there still
is the danger of a run on such funds in the coming days and
weeks if investors fear for the safety and liquidity of their
balances. A collapse of the market in money market funds
would be equivalent to the banking collapse of the 1930's, since
this is where companies park most of their required cash flows
in the short run.
The second American financial problem is
related to the approximately $2.7 trillion in municipal
securities outstanding, a large proportion of which have been
relying on a bond insurance system that is teetering on the
brink of collapse. The U.S. Treasury partly solved this problem
temporarily when it announced on Tuesday, September 16, that it
had loaned $85 billion (for two years) to the
largest world insurance company,
American International Group (AIG),
in exchange for a 79.9 percent stake in the company, thus
avoiding a formal bankruptcy filing for AIG. This was, of
course, after announcing that the U.S. Treasury promised to
inject some $200 billion in the government sponsored Fannie Mae
and Freddie Mac in preferred shares, in order to solidify their
mortgage lending operations and their $5.3 trillion joint debt.
The Bush administration's proposal to create a fund of $700
billion to buy back illiquid mortgage-backed paper does not seem
to have been structured in a manner that would avoid an outright
subsidy to the American banking sector. If it were to be used to
recapitalize private banks, this amount would be too small. This
need not be. In fact, much of the legitimate fear that many
Americans have that large amounts of public money are going to
be used to subsidize Wall Street firms can be avoided, and the
amount required to restructure the subprime-based securities
market could be considerably reduced.
Indeed, there is a way for the U.S. Treasury to play an
intermediary role in restructuring most of the illiquid
mortgage-backed paper that creates so many problems today, not
the least would be the possible collapse of large segments of
the U.S. financial system.
Since time is of the essence, Congress could approve the
creation of a U.S Government Banking Restructuring Trust,
designed to exist for a twelve-year maximum period, that is,
until 2020. Such a government trust could buy back, at a fair
market value (including
a substantial discount to reflect poor liquidity and poor
marketability),
illiquid but still solvent mortgage-backed securities, held by
banks or money market funds.
Simultaneously, the government trust would have the power to
reissue mortgage-backed debentures with a maturity of nine years
or less and carrying interest financed by the underlying
mortgages thus acquired, and in an amount large enough to cover
at least the initial cost of acquisition. The Fed and its twelve
regional banks, plus Fannie Mae and Freddie Mac, could play an
important role in creating a liquid secondary market for such
government-backed securities. Because of this reissuance
feature,
the $700
billion guarantee initially proposed by Sec. Henry Paulson could
be reduced, possibly to a more palatable level of $250 billion.
Such an operation would relieve the U.S. banking system from
short-term mortgage-backed securities that are presently de
facto frozen, because there is no market for them. It would
also allow American savers and investors to include in their
IRAs or 401(k) plans safe and profitable investments. Moreover,
it would provide capital to the mortgage market and help turn
the housing slump around.
And, what's more, such a debt restructuring operation need not
cost the government and American taxpayers a single penny, in
the end. To the contrary, the program can be structured in such
a way as to generate a fair return on the government's initial
investment.
Simultaneously, a regulatory ban on the issuance of any new
securitized mortgage-backed paper could be issued. The same
could apply also to the dangerous practice of elevating the
credit rating of certain bonds or debentures through reliance
upon the credit-default (insurance) market. These were the two
main corrosive “innovations” which have resulted in the present
financial mess.
Moreover, such a restructuring plan could be kept simple and
totally transparent.
In conclusion, this is something that the
Bush administration and the U.S. Congress might want to consider
if they hope to get out of the ideological and political
deadlock they have talked themselves into.
Rodrigue Tremblay is professor
emeritus of economics at the University of Montreal and can be
reached at:
rodrigue.tremblay@ yahoo.com. He is the author of
the book
'The New American Empire'.
Visit his blog
site at
www.thenewamericanempire.com/blog. Author's Website:
www.thenewamericanempire.com/.
Check Dr.
Tremblay's coming book "The Code for Global Ethics" at:
www.TheCodeForGlobalEthics.com/
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